BENEFITS & COMPENSATION INTERNATIONAL TOTAL REMUNERATION AND PENSION INVESTMENT

BENEFITS & COMPENSATION INTERNATIONAL TOTAL REMUNERATION AND PENSION INVESTMENT

Changes to pensions accounting issues for companies Colin Haines Colin Haines is a partner and consulting actuary in Lane Clark & Peacock s Corporate Consulting and International practices. Based in the UK, he works closely with LCP s offices in Europe and partner firms around the world. Mr Haines advises international companies on accounting for pensions, mergers and acquisitions and global pensions risk management. He is a UK- and Swedish-qualified actuary and a Senior Examiner for the International Employee Benefits Association. Many companies around the world that report under International Financial Reporting Standards (IFRS) may soon have to change the way they account for pensions. For some, balance sheets will worsen and, for most, pretax profits may be reduced. In addition, more information will need to be provided in the notes to the accounts. BACKGROUND AND TIME SCALES This article looks at the proposed changes and sets out the impact they could have on companies around the world. Although these will not change the cost of providing pensions, companies will need to provide more information on the risks attached to their pension arrangements. This in turn could lead them to look at ways to reduce the risks, or costs, of their plans and result in more companies closing defined benefit arrangements and replacing them with defined contribution plans. These changes will be the result of proposed amendments that are currently being made by the International Accounting Standards Board (IASB) to IAS 19 Employee Benefits. In April 2010, after four years of discussion and public debate, the IASB issued an exposure draft setting out the proposed amendments. BOX 1 overleaf provides further information on why the IASB is making changes and summarizes some of the activity carried out over the four-year period. Companies now have an opportunity to provide comments to the IASB. The deadline for comments is 6 September 2010. If the IASB s proposals are then approved, it is currently expected that they will apply to accounting periods commencing on or after 1 January 2013, although earlier adoption may be permitted. The IASB is also consulting on whether the proposed changes to IAS 19 should be applied retrospectively which could then require companies to rework prior year disclosures and recalculate certain items. SUMMARY OF THE PROPOSED CHANGES The proposed changes relate primarily to the recognition and disclosure of costs for pensions and other post-employment benefits. They can be summarized as follows: Companies will have to recognize immediately the full value of the defined benefit obligation and plan assets on company balance sheets (at the moment this is optional under IAS 19). A number of changes will be made to the calculation of the profit and loss (P&L). This includes removal of the current expected return on plan assets and interest cost items, replacing them with a new item interest on net balance sheet asset/liability. All other changes to defined benefit obligations and assets will be included in a remeasurement component which forms part of other comprehensive income. The defined benefit obligation will need to include an allowance for future administration costs and, where relevant, any risk sharing or conditional indexation features. Widespread changes are being made to the information that needs to be disclosed in the notes to the accounts. BOX 2 overleaf provides information on areas that are not changing but have been considered separately by the IASB in the last few years. DETAILS OF THE MAIN CHANGES I will now look at how the above proposals would affect financial statements and disclosures. Balance Sheet The first main change is to require all companies to calculate balance sheet items in the same way. IAS 19 currently permits companies to choose one of two options and the amounts shown on the balance sheet can vary significantly under each. As a result, the use of the following two options has made it more difficult for readers of accounts to compare companies: The first option, which will be retained, is for the surplus or deficit in the pension plan to be shown in full on the balance sheet. The amount shown must be adjusted to allow for any restrictions under the existing asset restriction rules (for example, where surpluses cannot be recovered through refunds or reductions in future contributions). Any actuarial Benefits & Compensation International 1

BOX 1 Why is the IASB Proposing Changes? The IASB last made major changes to IAS 19 in 2004. Since then the number of companies reporting under IAS 19 has increased significantly as more and more countries move to IFRS as their primary accounting standard for local entities. There has been widespread concern from users of accounts that IAS 19 does not adequately reflect the true cost of providing pensions. Many analysts and credit rating agencies routinely adjust the costs of pensions and other post-employment benefits to get a better sense of the true economic impact of company pension arrangements. Similar adjustments are also made by companies and advisers when valuing companies for M&A purposes. In 2006 the IASB commenced a project to fundamentlly review all aspects of pensions and post-employment benefit accounting. The proposed changes are the result of over four years extensive deliberations including a major public consultation, with around 100 responses, in 2008. The IASB had decided at the outset of the project to limit the scope of the exercise and to defer major changes (such as the calculation of the discount rate) into a longterm project. The IASB will consider after 2011 whether to address these topics as part of a comprehensive review of employee benefit accounting. Over the same period, the US accounting standards board, FASB, has also initiated a similar project for companies that report under US GAAP, with an ultimate end goal of convergence with IFRS. However, there is still a long way to go before this can occur. BOX 2 What is Not Changing? The Exposure Draft is not changing any of the following: Calculation of discount rates. The IASB decided at the outset of this project to defer any changes to a future set of amendments. Last year the IASB decided not to proceed with proposed amendments relating to how discount rates are set in countries without deep corporate bond markets. Accounting treatment of contribution-based promises that include cash balance plans and defined contribution plans with guarantees. Following the public consultation in 2008, the IASB has decided to defer this to a later date. Treatment of termination benefits payable on severance of employment or voluntary redundancy. The IASB is issuing a separate amendment to IAS 19 concerning this, following on from a public consultation in 2005. gains or losses * are recognized in full on the balance sheet in the year that they occur and are not charged to P&L. The second option, which will disappear, is for the recognition of actuarial gains and losses to be deferred and for the asset or liability on the balance sheet to be different from the surplus or deficit in the pension plan. Amounts not shown on the balance sheet are known as unrecognized amounts and, to the extent they exceed a certain limit, are charged to P&L over future accounting periods. This is commonly known as the corridor option. Under the proposed amendments, the corridor option will be removed and all companies must use the first option. The corridor option has recently received criticism in that it masks the true size of pension deficits. In a recent paper, Moody s stated that we believe this is incongruous reporting and does not reflect the plans true economic condition 1. For some companies the impact will be significant and could result in substantial changes to shareholder equity. This change will bring closer alignment with US GAAP where surpluses and deficits must also be recognized in full. P&L Charge The second main change is the calculation of the P&L charge, as follows: The current financing items, namely the interest cost (a charge) and the expected return on plan assets (a credit), will disappear. These will be replaced by a single item equal to the interest on the net balance sheet asset or liability. This will be calculated using the same interest rate that is used to calculate the * Actuarial gains or losses comprise experience adjustments (the effects of differences between the previous actuarial assumptions and what has actually occurred) and the effects of changes in actuarial assumptions. 2 Benefits & Compensation International

TABLE 1 Impact of Change to P&L Financing Items Defined benefit obligation Plan assets Net liability Discount rate Equity allocation Bond allocation Expected return on plan assets Current IAS 19 P&L charge Service cost Interest cost Expected return on plan assets Net P&L charge New IAS 19 P&L charge following amendments Service cost Interest on net liability (asset) Net P&L charge Impact of changes to P&L charge 70% Equity Allocation 500m (400m) 100m 5.5% 70% 30% 7% 27.5m (equals 5.5% x 500m) (28.0m) (equals 7% x 400m) 19.5m 5.5m (equals 5.5% x 100m) 25.5m 6.0m (i.e. 25.5m less 19.5m) 20% Equity Allocation 500m (400m) 100m 5.5% 20% 80% 5% 27.5m (equals 5.5% x 500m) () (equals 5% x 400m) 27.5m 5.5m (equals 5.5% x 100m) 25.5m (2.0m) (i.e. 25.5m less 27.5m) NOTES: 1. This is a simplified example for a plan with a defined benefit obligation of 500 million, assets of 400 million and a service cost, i.e. cost of benefit accrual, of 20 million. An IAS 19 discount rate of 5.5% is used for this example and no allowance is made for contribtuions and benefit payments when calculating the P&L components. 2. The impact depends on the underlying asset allocation. In this example the proposed changes would result in an increase in the P&L charge of 6 million if the plan had 70% invested in equities. However, if the plan had just 20% in equities, the P&L charge would actually be 2 million lower. 3. The overall impact on a given pension plan will depend on the amounts allocated to each asset class, the underlying assumptions and the expected returns for each asset class that are assumed under the current method. defined benefit obligation and the current interest cost component. In addition, if the balance sheet item is restricted (for example, due to the company not expecting to receive any economic benefit from any plan surplus), the calculation will only take into account the restricted balance sheet items. This change means that, with the P&L charge no longer being linked to the expected return on plan assets, companies with large equity allocations are likely to face higher P&L charges. Conversely, some companies with high government bond allocations may see lower P&L charges. Example calculations are shown in TABLE 1 above. Any gains or losses that arise on a plan settlement will no longer be included in the P&L account (for example, when plan liabilities and assets are transferred to a third party, such as an insurer). Companies that currently use the corridor option will, following the removal of this option, no longer be able to spread actuarial gains or losses over future years. The financial impact of any changes to benefits will need to be recognized immediately, even if the changes are conditional on employees completing future service. These changes, if approved, will mean the pension cost under IAS 19 could be materially different to that calculated under US GAAP. This will make P&L comparisons between US and non-us multinational companies much more difficult. For example, US GAAP still allows companies to take credit for expected returns on plan assets and settlement gains/losses are charged to P&L. US GAAP also requires gains and losses to be amortized through profit and loss over future accounting periods and this difference will remain. Actuarial Gains and Losses As all gains and losses will need to be recognized in full on the balance sheet, a new component, known as the remeasurements component, will need to be calculated each year. This will comprise: all changes in the defined benefit obligation and in plan assets other than those included in the P&L charge, including any gains or losses from plan settlements, and the effect of any restrictions on the amount that can be shown on the balance sheet under the existing asset restriction rules. Companies will need to present the remeasurements component in other comprehensive income (this accounting entry covers items that have an impact on the amount shown on the balance sheet but do not need to be recognized in the P&L). Benefits & Compensation International 3

Calculation of Defined Benefit Obligation The defined benefit obligation (DBO) is the present value of all future pension payments from the company s pension arrangements in respect of employee service to the accounting date. The value is calculated using methods and assumptions set out in IAS 19. The Exposure Draft proposed the following three changes to the calculation of the DBO: Future administration costs will need to be capitalized and included in the DBO. For small plans with high administration costs, this could result in a significant increase in the defined benefit obligation. For the largest plans around the world, the extra obligation could amount to tens of millions. Companies that have plans with risk sharing or conditional indexation features (for example, plans in the Netherlands) will need to allow for these features. Companies may need to think carefully about how to do this, as the Exposure Draft provides limited guidance on how to incorporate these features when setting actuarial assumptions. Future salary increases should be taken into account when determining whether the rules of a plan will result in a materially higher level of benefits in future years. If they are materially higher in later years, this will need to be taken into account when calculating the DBO. This could result in a significantly higher DBO for certain types of plan where benefits are not linked to salary at retirement (for example, cashbalance, flat-dollar or career-average plans). Companies doing M&A transactions will need to decide whether to allow for these changes in any deal calculations. Disclosures The IASB has made significant changes to information that will need to be disclosed in the notes to the accounts. As well as additional numerical items, companies will need to provide additional narrative disclosures. This section looks at the main disclosure changes. Information on Types of Plan Companies will need to provide additional information on their pension arrangements. This will be particularly complicated for companies, especially multinationals, with a large number of pension plans and companies will need to find ways to streamline the information. For example, companies will need to disclose information on: the nature of benefits provided by their plans, the effect of the regulatory framework the plans operate within (for example, the effect of any minimum funding requirements), a description of any other entity s responsibilities (for example, trustee or foundation boards) for the governance of the plan, their exposure to risks from participating in the plans and any concentrations of risk, and any plan amendments, curtailments and nonroutine settlements (for example, transfers of liabilities to third-party insurers). Companies will be free to make decisions as to how disclosures should be disaggregated to distinguish plans, or groups of plans, with materially different risks. For example, this could be done by geographical location, by type of plan, by the nature of funding or by the type of regulatory environment (for example, insured or trust based). At the moment, companies are required to show unfunded liabilities separately, but it appears that they will no longer have to do this if they do not think it is appropriate. Reconciliation of Amounts Shown on the Balance Sheet Companies will need to provide a detailed reconciliation from the opening balance sheet asset or liability to the closing balance. Separate reconciliations will still be required for plan assets and the defined benefit obligation. Up to 16 separate items may be needed in each reconciliation and companies will need to show separately the effect of changes in demographic assumptions and the effect of changes in financial assumptions. The requirements to show historic balance sheet items and experience adjustments over the last five accounting periods, as well as cumulative actuarial gains and losses that have been recognized in the Statement of Other Comprehensive Income, have been removed. Information on Plan Assets Companies will need to supply significantly more information on the plan assets, as follows: Plan assets will need to be split into classes that have different risk and liquidity characteristics. As a minimum, companies will need to distinguish between government bonds, other bonds, property investments, the company s own equities and other equities. Details of any asset-liability matching strategies, including the use of annuities and other techniques such as longevity swaps to manage longevity risk, will need to be disclosed. These changes should improve investors understanding of how companies manage their pensions investment risks. Information on Assumptions Companies will need to disclose information on the financial and demographic assumptions used to calculate the DBO. The Exposure Draft does not state which assumptions should be disclosed, leaving companies free to choose. In addition to providing information on actual assumptions, companies must disclose information on the process used to determine demographic financial assumptions. Interestingly, there is no similar requirement for disclosing the process used to determine financial assumptions. Sensitivity Analyses Companies will need to provide a sensitivity analysis showing how changes to each significant assumption 4 Benefits & Compensation International

BOX 3 Multi-employer Plan Disclosures Companies in a defined benefit multi-employer plan will need to provide the following new disclosures: A description of the funding arrangements, including the method used to determine the participant s rate of contributions and any minimum funding requirements The extent to which the entity can be liable to the plan for other participants obligations under the terms and conditions of the multi-employer plan The total number of, and employer s proportion of, active members, retired members and former members entitled to benefits, if that information is available The expected contributions to the plan for the next period and for each of the following four years Details of any agreed deficit or surplus allocation on wind-up, or the amount that is required to be paid on withdrawal affect the defined benefit obligation and service cost. Companies must determine which assumptions are significant and provide details of the methods and assumptions used in preparing the sensitivity analyses. Companies will also need to disclose the value of the defined benefit obligations, adjusted to exclude the effect of projected growth in salaries (this will be similar to the calculation of the accumulated benefit obligation required for US GAAP). The Exposure Draft does not state whether any allowance should be made for price inflation in countries where accrued benefits are linked to price inflation (for example, in the calculation of deferred pensions in the UK or paid-up policies in Continental Europe). Future Contributions Companies will need to disclose how their participation in defined benefit plans will affect the amount, timing and variability of future contributions. They will need to provide a discussion of factors that could cause contributions over the next five years to differ significantly from the service cost, i.e. the cost of future benefit accrual. For example, a company should disclose how it expects any surplus or deficit to affect the level and timing of its contributions over the next five years and the period over which it expects the surplus or deficit to be eliminated. If the company is paying nil or reduced contributions due to a contribution holiday, it will be required to disclose the extent and estimated duration of the contribution holiday. Multi-employer Plans In many countries, companies participate in multiemployer plans where contributions are set by third parties. Such plans are often set up on an industry-wide basis or under collective agreements. They are common in such countries as the USA, Canada, the Netherlands, Belgium and Sweden. Recently, many multi-employer plans have experienced large deficits and this has resulted in the need for an increase in future contributions. Furthermore, if companies stop participating in these plans (for example, as a result of a restructuring or a business transaction), they may have to pay a significant withdrawal penalty in order to make good their share of the plan deficit. Under the Exposure Draft, companies will need to provide much more information on the terms of participation and risks attached to multi-employer plans. These are summarized in BOX 3 above and will also apply to privatized social security schemes that are defined benefit in nature and not financed on a pay-as-you-go basis. CONCLUSION Overall, given that the IASB has spent over four years discussing and deliberating on the content of the Exposure Draft, the proposed changes are, on the surface, relatively straightforward. However, there is a risk that the proposals could well bring greater investor confusion, especially when comparing companies that report under IFRS with those that report under US GAAP. The following areas are of particular significance: The removal of the corridor option is likely to be welcomed by many. This will mean that all companies will need to calculate their balance sheet items in the same way and also be consistent with US GAAP. This change could, for some companies, result in a material change to shareholder equity. The changes to the P&L charge could confuse investors. This change will also mean there will be a significant difference with US GAAP where the use of expected return on plan assets remains a fundamental part of the pensions accounting rules. This will make P&L comparisons between US and non-us multinational companies much more difficult. The requirement to exclude settlements from the P&L charge could lead to companies considering settlements (for example, plan buy-outs) that they might not have considered under the current rules due to the P&L impact. The changes to the method of calculating the defined benefit obligation bring helpful clarification. Some companies, particularly those with careeraverage plans or high administration costs, could be Benefits & Compensation International 5

faced with significant increases to the defined benefit obligation which will have a knock-on effect on shareholder equity. Companies doing M&A transactions will need to consider whether to allow for these changes in any deal calculations. The IASB is preparing to completely change the disclosure requirements. More detail and narrative will be required and this is likely to increase the length of many pension notes in the accounts. Much of the new wording is non-prescriptive, meaning that companies will need to decide exactly what information (and how much) is provided to meet the disclosure requirements. As a result, it is likely that there will still be significant variation in the information disclosed by companies around the world and they will continue to have regard for local market practice. The extra disclosures for multi-employer plans, though cumbersome, are likely to be welcomed by readers of accounts and investors. Companies will need to put in place processes to obtain the necessary information. Given the number of such plans in the USA, this could result in pressure for the US accounting standard setters (FASB) to introduce similar requirements for companies reporting under US GAAP. Finally, the IASB has been working with the FASB with the ultimate aim of producing a global set of accounting standards. The proposed changes to IAS 19 will still mean there will be significant differences between IFRS and US GAAP especially in relation to the removal of the expected return on plan assets and the new disclosure requirements. Given that it may take time for investors and readers of accounts to get used to the new changes and appreciate the new differences between US GAAP and IFRS, the ultimate goal of convergence could still be some way off. In particular, companies may be reluctant to make another set of changes so soon after making these. After four years of work by the IASB, it would be a shame if this also turns out to be one of the consequences of the new proposals. Ω The views expressed in this article are those of the author and not necessarily those of Lane Clark & Peacock LLP. References 11 Moody s: Peering Behind the Curtain of Banks Employee Benefit Obligations, Moody s Investors Service, March 2010. W: www.lcp.uk.com E: colin.haines@lcp.uk.com T: 020 7439 2266 Copyright Pension Publications Limited 2011. Reproduced from Benefits & Compensation International, Volume 40, Number 1, July/August 2010. Published by Pension Publications Limited, London, England. Tel: + 44 20 7222 0288. Fax: + 44 20 7799 2163. Website: www.benecompintl.com Produced by The PrintZone (www.theprintzone.co.uk). Prior written permission required to reprint in bulk.