Defined Benefit Schemes: A Guide to IAS 19
Author:
Rickard Mills
When it comes to accounting for pensions, most Irish companies are now using FRS 17. That said, EU regulations require that the consolidated financial statements of companies publicly quoted within the EU are prepared in accordance with International Financial Reporting Standards for accounting periods beginning on or after 1 January 2005 and so organisations that have adopted International Financial Reporting Standards (IFRS), will be using IAS 19 to account for their employee benefit arrangements. While both standards (FRS 17 and IAS 19) adopt a more modern approach, the two are not identical. Each, in its own way, reflects a significant change from the older standard, SSAP 24. For the purposes of this article, Rickard Mills has chosen to focus on IAS 19.
Under SSAP 24 life was simple: every year the actuary recommended a pension scheme funding rate that became a P&L expense. Any additional special pension contributions were capitalised and expensed over the remaining average life of the pension scheme to retirement. There was no other P&L or balance sheet impact. The scheme did not feature on the employer company balance sheet.
Under IAS 19 the net pension asset / liability is recognized on the employer company balance sheet reflecting the true responsibility of the employer under the pension scheme and P&L charge is arrived at through the combination of up to six different figures.
The combination of falling asset values in 2001 and 2002 together with significant and detailed new accounting disclosures has required the Finance Director of companies to look far more closely at the make-up of the Pension charge and the balance sheet implications. This has resulted in curtailment and termination of defined benefit schemes as employers become more focused on their obligations and the volatility of measurement of same in their statutory accounts.
The note below summarises in simplistic fashion the accounting aspects for companies providing a defined benefit pension scheme to employees. It does not deal with the transitional aspects.
SSAP 24
SSAP 24 allowed the actuary make the relevant assumptions regarding the valuation of the pension assets and liabilities. This included smoothing the assets in time of volatility and using long term liability valuation assumptions which might be temporarily out of sync with the financial conditions of the time. For example, many defined benefit pension funds would have used inflation / pension increases assumptions of 2%, salary increases of 4% with 6% being used as the return on assets / discount rate on liabilities even at times when real market figures were vastly different.Similarly under SSAP 24 the cost of early retirements did not in general cause a P&L hit where a scheme was fully funded under the actuarial assumptions.
IAS 19
IAS 19 is a far more regulated, prescriptive approach to accounting for pension costs. The main concern which IAS 19 / FRS 17 attempted to address was that potentially significant pension obligations were not fully reflected in company accounts.
The accounting going forward involves a detailed P & L charge (that has six components) with the net pension surplus/deficit going on the company balance sheet (being pension asset minus pension liability plus pension deficit / asset not recognized through the P&L account).
The P&L charge consists of the sum of:
- Current service cost: the cost of providing an additional years pension for the staff of that year
- Interest on liabilities: recognizing the fact that the liabilities are a year closer than last years balance sheet
- Expected return on assets: recognizing the expected return on pension assets for the year
- Past service: including the cost of any additional accrued benefits arising through some action during the year - say a staff member retires early and his pension is increased as if he had additional years service. This could also theoretically be a revenue where existing benefits are reduced.
- Cost of curtailments/settlements: this can arise where a material change arises in either the benefits or the number of staff qualifying for the pension scheme
- Deficits/surpluses write off: where the liabilities exceed assets (or vice versa) by an amount which is greater than 10% (of the higher of assets and liabilities) then a company can either take the full surplus/deficit to balance sheet reserves or else write off the excess over 10% through the P & L over a maximum period of the average time to retirement of the scheme members.
To the extent that the deficit / asset is within the 10% corridor (and thus not recognized through the P&L account) then that amount is included in the balance sheet valuation of the pension fund.
(Note that the corridor approach is not taken in FRS 17).
IAS 19 does however impose a ceiling on the defined benefit asset that can be recognized broadly depending on whether the employer company can either get refunds from the scheme or a reduction in future contributions to the scheme.
The Balance sheet shows the net Pension asset (assets valued on a fair value basis with no smoothing) or liability with the movement from P & L to balance sheet being accounted for in a Statement of Changes in Equity (SOCE). This SOCE would include items such as cash paid into the fund and also actuarial gains or losses which arise from either experience adjustments (the effects of differences between the previous actuarial assumptions and what has actually occurred) and the effects of changes in actuarial assumptions.
Key assumptions agreed with actuary
In arriving at the above figures there are certain key assumptions agreed with the actuary and decided at the start of the period (unless otherwise stated), that are prescribed by IAS 19:
- Discount rate on liabilities: being the AA corporate bond rate for the maturity period of the related pension liability. In practice this moves daily so the liability valuation can only be fully done at year end.
- Expected return on plan assets: depends on the mix of assets in the fund
- Future salary increases: meant to approximate the annual salary increases over the life of the fund to retirement. In practice there could be an assumption on promotional increases to a certain age.
- Future pension increases: this usually means inflation (depending on the scheme rules) so a long term inflation assumption is required.
Other assumptions
Other assumptions on demographic variables must also be made. These must be unbiased and compatible with the financial assumptions:
-Staff turnover: in practice staff leaving early usually means a gain to the fund as the frozen liability (which grows with inflation under the law) is usually lower than if the employee stays (as salary increases are greater than inflation usually).
- Deaths of active members in the scheme: this can be partly insured against and so can result in a gain to the scheme.
- Mortality assumptions pre and post retirement: the industry standard should be used.
It is important to note that the assumptions underlying the scheme are recommended by the Actuary and decided upon by the Directors. All calculations are carried out by the actuary on the pension scheme. The pension assumptions and notes to the accounts are then audited as part of the annual audit to ensure they are correct and in line with IAS 19.
ISSUES ARISING UNDER IAS 19
The main result of IAS 19 is that long term liabilities must be valued annually using a short term valuation basis. This means greater volatility for the corporate in its accounts as the discount rate has implications for the components of the P&L account and the Balance sheet. It is essential that the term to maturity of the pension scheme is taken account of in determining this discount rate as one rate will not fit all schemes.
The other factors mentioned above are different in different companies and industries and need careful review for each company in getting a correct estimate of the charge.
If incorrect assumptions are made then subsequent adjustments go via the balance sheet as opposed to via the P&L.
The fact that the relevant discount rate is the rate on the last day of the previous accounting rate means that budgeting is difficult particularly in times of volatility - since 31 December 2005 the long term rate has risen by circa 0.3% resulting in liabilities falling by as much as 10% - thus showing the volatility possible.
The options available for deficits and the 10% corridor approach are relevant in that some companies have a focus on P&L and others on Balance Sheet.
The fact that the expected return on assets is credited to the P & L means that that the higher the assets and expected return thereon, then the lower the P&L charge - thus with cost of funds of lower than expected return on assets, funds injected in pension scheme would be P&L enhancing.
OTHER ISSUES
Actuarial Valuation: An actuarial valuation is required every three years whereas Statutory accounts are prepared annually. It can be helpful to update the data annually to ensure proper management of the Accounting Pensions charge.
Cost of Life Assurance & disability insurance: These costs can vary significantly between life companies - it is thus essential that regular re-broking occurs to manage the expense.
Multi Employer schemes: Care must be taken in cost allocation / balance sheet allocation if any, in the case of multi employer schemes.
Credit Rating: Given that the liabilities can be greater than the pension assets the net worth of a company can be reduced under IAS 19. This may have credit rating/ worthiness and debt covenant implications.
Mix of Assets of Scheme: The asset mix can be varied depending on the level of risk / reward required. This has consequent implications on the expected return on assets which goes through the P&L.
CONCLUSION
The change in accounting standards has added increased focus on an item which can be a significant part of a company's cost base. The result is likely to be over reactive cost cutting in this area to the loss of employee benefits unless a full understanding is gained by Finance Directors of the detailed requirements of the accounting standard which should result in more efficient compliance with its requirements.
Rickard Mills is Head of Special Finance with IIB Bank Ltd.