The Accounting Standards Board believes that a fundamental review of financial reporting for pensions is needed. Their recently published Discussion Paper on the subject contains controversial new proposals as Andrew Lennard, Director of Research at the ASB, explains.
Pensions are rarely out of the headlines, and rightly so given their importance to the financial well being of employees and the companies they invest in. A couple of years ago, many of the stories centred on FRS 17, the pioneering standard for the UK and Ireland. Whilst some vigorously defended the standard; others were strongly critical. It was difficult to keep track — especially as some critics said the liability was too big and others felt it was too small.
What was clear was that FRS 17 had introduced a dramatic change in the way in which people thought about pensions. And any standard thatmarks a major change is unlikely to be perfect, and will need revision in due course.
The Accounting Standards Board supports the current work of the International Accounting Standards Board to make incremental changes to IAS 19. The ASB has also addressed the pressing disclosure issues through the publication, last year, of recommendations on best practice in its non-mandatory Reporting Statement, Retirement Benefits – Disclosures. However, it is clear that a fundamental review of pension standards is necessary, and the IASB and the US standard-setter, FASB, have expressed a similar view. To provide input into the longer-term work of those bodies, the ASB undertook a study which has now been published as a Discussion Paper entitled
The Financial Reporting of Pensions.
To make sure that a wide variety of views were considered, we formed a special group, the ‘Pensions Advisory Panel’, which has provided a huge contribution to the paper. Collaboration with other European standard-setters and the European Financial Reporting Advisory Group (EFRAG), under the PAAinE (Proactive Accounting Activities in Europe) initiative, has ensured that the paper can be seen as the precursor to an international standard. The principles it sets out are designed to work anywhere in the world, not just in the UK and Ireland. And because the approach is reasoned from principles, it does not rely on the distinction between defined contribution (DC) and defined benefit (DB) plans, which is troublesome to apply to the hybrid plans that have sprung up in recent years.
We started with no preconceptions. We debated whether a promise to provide a pension necessarily implied that there was a liability, rather than assuming that this was always the case; we noted that under current standards liabilities seem very remote from cash flows and questioned whether this was right. This openminded stance may not be fully apparent from the result, since the broad lines of the proposals that are contained in the paper are similar to those of FRS 17 and, indeed, IAS 19. But there are some important differences and attention will naturally and rightly focus on these. So will the remainder of this article.
When a Liability Arises
Pension liabilities arise as employees provide services and the pensions promise is part of the price paid for those services. The liability is, of course, subject to many uncertainties — for example, staff turnover and the longevity of scheme members — but these affect the amount of the liability rather than its existence. The liability should include all benefits to which there is a present commitment (whether through a legal or a constructive obligation), but should not include benefits that are genuinely discretionary.
Salary Increases – In or out?
A particularly difficult issue in applying this principle arises where benefits relate to final salaries. Some consider that today’s liability relates to current salary levels only, as there is discretion over future salary increases. Others believe that the liability should include the effect of expected increases in salary, as is currently required. Which view is to be taken may depend on whether the liability is seen as the aggregate of amounts owed to individuals, or as an obligation to the workforce as a whole, since it may be feasible to freeze the salary of an individual, but impracticable to deny any increase to the whole workforce.
A change on this point would have two effects: it would reduce the amount of the reported liability and hence any deficit in the plan and, when salaries are increased, the increase in the amount of the pension already earned would have to be recognised as an expense in the period in which the salary is increased.
Under current standards, the salary of a 58-year-old can be increased by 50%, thus increasing the value of 30 years’ service by a similar amount, and the effect will simply be reported as an actuarial gain or loss. Some consider that this masks the true economic effect of awarding such an increase. If the standards were to change, it might provide an incentive to offer bonuses or other nonpensionable payments to employees rather than increases in pensionable salaries.
Whose Liability Is It?
The liability may be retained by the employer, but often is passed to a pension plan sponsored by the employer. In this case, the employer has a liability only for any guarantee it has given — typically the amount by which the liability to pay benefits exceeds the amount of assets in the plan.
Current standards provide a blanket exemption from consolidation for pension plans, but the logic of this defies understanding. The paper proposes that the usual consolidation requirements should be applied — there is nothing special about pensions — so a pension plan should be consolidated where an employer controls it.
In many cases the control test will not be met and so consolidation will not be required. A key consideration is that the plan is controlled by trustees who are obliged to act in the interests of plan members, and cannot accede to the employer’s wishes unless it is in members’ interests to do so. In many cases the regulatory framework will require that this is the case. But plans set up in some countries might be subject to laxer requirements and be effectively controlled by the employer. Consolidation of those plans would be required, and so their total liabilities and assets would appear on the employer’s consolidated balance sheet.
How Much is the Liability?
Given the complexity of pensions, it is commonly observed that only limited information can be conveyed by a single number. Much can be achieved by good disclosure, including narrative discussion. But as long as financial statements retain their current form, only one number can be put in the balance sheet — and this should be the best practicable number.
Actuarial measures focus on helping assess whether a plan is likely to be able to meet its liabilities. As many benefits will not be paid for years, it is widely believed that it is most helpful in this assessment to reflect the return on the investments which will ultimately pay the benefits. However, a different question — how big is the liability today? — is the correct focus for the most useful financial reporting. The corollary of this is that a financial reporting number may be of limited use in setting a funding strategy.
In theory, today’s liability could be quantified by looking at the pension scheme buy-out market. But a buyout of pensions is often prohibitively expensive, and so a more realistic measure is obtained by reporting today’s value of the payments that will be required. Inevitably, this means discounting.
Current accounting standards prescribe a high-quality corporate bond rate, but it is difficult to know why — different standard-setters have given different justifications. It may have something to do with risk. Risks will, of course, be already considered in the undiscounted cash flows that are used as the basis for the estimate of the liability. Some would argue that an additional cushion should be incorporated by changing the discount rate: this would reflect the presence of ‘unknown unknowns’ — outcomes that cannot be foreseen today even as remote possibilities. But such a process would be highly opaque and difficult to understand. For this reason, the paper concludes that information about risk is better communicated through disclosure, and the liability should be discounted at a risk-free rate.
Returns on Assets
Under current standards, if an employer were to draw up its financial statements for January 2008, the total cost of pensions would be reduced by the return on equities — though the overall returns on equities were negative in that month. This is hardly a faithful representation, but is the consequence of requirements to base the accounting on the expected rather than the actual return on assets. This seems unique in financial reporting: there is no other amount in the financial statements that reflects what was expected to happen rather than what actually happened in the period, so the actual return should be reported instead of the expected return. And the actual return should include all changes in asset values, not just the dividends received. The effect of this will be to make the total expense relating to pensions more volatile.
However, given that investors say they find the expected return a useful number, it is proposed that it should be disclosed in the notes. Perhaps it is not surprising that the paper rejects the smoothing mechanisms, such as the corridor, that are found in some current accounting standards. It proposes instead that all gains and losses should be recognised immediately, similar to the requirements of FRS 17.
Actuarial Gainsand Losses
‘Actuarial gains and losses’ seems to be a term invented by accountants to give some dignity to what is really a balancing figure — the difference between the total change in pension deficit in the period and those changes that are accounted for elsewhere. Under the proposals in the paper they would no longer include differences relating to the return on assets or changes in the discount rate. (The paper proposes that changes in the discount rate are reported as part of financing costs.) What would remain are essentially the results of changes in assumptions, such as longevity, which should obviously be reported outside of the operating results of the business. Perhaps a more useful term could be found to describe them, such as ‘effect of changes in assumptions’.
Accounting byPension Plans
People invest their money (or have their money invested on their behalf) in pension plans. They are entitled to expect that there is adequate stewardship of their money, and this would include the preparation of regular financial reports. In much of the world, financial reporting by pension plans has been left to regulators; standard-setters and the accounting profession have taken a back seat in framing the requirements. True, there is an international standard (IAS 26) but it is over twenty years old and reflects major compromises: for example, a liability to pay future benefits may or may not be reflected in the balance sheet, and if one is reflected it will be on an actuarial basis which is undefined, except to say that it may or may not include the effect of future salary increases.
The paper urges a fresh look at this situation, and suggests that the liability to pay pensions in the future should be reflected in the balance sheet, using principles similar to that of the employer. It also argues that there should be much greater information about the plan’s relationship with the employer (including related party transactions), the strength of the covenant— and how that affects investment strategy. Where a plan is in deficit, it should record an asset in respect of the employer’s guarantee. This asset may be taken to be the amount of the deficit, but it should be reduced where there are grounds for supposing that the employer will not be able to honour its guarantee.
Generally, pension plans should report in a manner consonant with that of modern IFRSs. In particular, standards on related party transactions should ensure clear disclosure of transactions with the employer.
Andrew Lennard is Director of Research at the Accounting Standards Board. The ASB’s Discussion Paper, The Financial Reporting of Pensions, can be found at www.frc.org.uk/asb. Comments on the paper are requested by 14 July: they will be taken into account in compiling a report which will be submitted to the IASB as a starting point for its review.
Andrew Lennard spoke about pensions reporting in an interview with Accountancy Ireland for our February podcast. If you missed the show, you can still download it
here.