Breaking Down Barriers: More efficient de-risking of defined benefit pension schemes
by Matthew Bale, Vice-President, Client Solutions, PensionsFirst Analytics
Amid the furore surrounding the negative effect that proposed changes to the international accounting standard for employee benefits (IAS 19) may have on companies’ profit and loss accounts, it is worth highlighting the positive long-term impact, says Matthew Bale, Vice President at PensionsFirst Analytics. The changes will remove a key barrier to the efficient de-risking of defined benefit (DB) pension schemes.
DB pension schemes – which are used by public and private sector sponsors across the globe – are experiencing major funding volatility and historically-high deficits as they struggle under the mounting burden of protracted pension payments due to increasing life expectancies. Underperforming global stock markets and low interest rates have blasted yet further holes in the funding of many schemes.
As a consequence, more and more sponsoring companies are looking at ways to transfer unrewarded or unmanageable risks off their balance sheets – in terms of both their liabilities and their investments. Yet there remains a significant barrier to the de-risking of DB pension schemes: the preferential treatment of pension asset returns within sponsoring companies’ profit and loss accounts. A preferential treatment that the proposed IAS 19 accounting standard changes are targeted to tackle.
Removal of a barrier to de-risking
There are currently three central elements to IAS 19 that impact pension profit-and-loss accounting: service cost, interest cost and expected return-on-assets. The initial two are straightforward, providing for additional benefits earned by current employees and the discount rate applying to future liabilities.
The expected return-on-assets component of a company’s profit-and-loss account, however, represents a clear barrier to sponsors trying to remove risk from their DB pension schemes. The provision aims simply to provide users of financial reports with an indication of expected future performance of pension scheme assets. In practice, however, it incentivises sponsors to hold higher-risk investments, often without proper consideration for the underlying risk.
The topic of pension risk management has already migrated to the top of many treasurers' agendas.
Sponsoring companies can effectively take advanced credit for the long-term expected outperformance of these assets, recording this amount as ‘profit’, irrespective of whether or not the return is actually achieved.
The inclusion of the expected return-on-assets component also benefits from the use of the so-called ‘corridor’ method, under which gains and losses arising from DB pension scheme assets can be deferred and recognised in net income in later periods.
For many companies, this element of DB pension accounting is a key feature that still clouds investment strategy decision-making, resulting in aggressive investment policies even when other factors may point to a course of de-risking.
Reassuringly, the International Accounting Standards Board (IASB) has reacted to these concerns – proposing changes to IAS 19 that will see the abolition of the expected return-on-assets component from the profit-and-loss calculation and the removal of the ‘corridor’ method from pension accounting. Under the new standard, the actual reward or loss from taking investment risk will be recognised immediately on the balance sheet, and presented separately from the profit-and-loss account.
This will result in companies no longer having to compare the benefits of de-risking against the profit-and-loss accounting implications. They will instead be able to focus on a more effective management of their pension risk.