Published: May 01, 2010
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.
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. [[[PAGE]]]
The proposals have, however, come under fire from some quarters: especially from companies with DB pension schemes, which worry about the billions of pounds, euros or dollars of unrecognised liabilities that may be added to their balance sheets – as well as the reduction in reported profit. Certainly, it has been reported that the FTSE 100, for instance, would see a fall in reported profit of around £8bn. Many commentators have used this as a stick with which to beat the IASB.
Yet sponsors of DB schemes now recognise the need to improve their pension risk management and IAS 19 changes that incentivise a more thorough analysis of pension risk should be welcomed. Certainly, the thought of companies failing to effectively evaluate and manage other operational risks they are faced with is inconceivable. As such, if the pensions industry is to move forward in the future – reducing deficits and stabilising funding positions – it is increasingly apparent that improved pension risk management is a must.
Indeed, the topic of pension risk management has already migrated to the top of many treasurers’ agendas.
Traditionally, most DB pension funds have turned to liability-driven investment as a key component of their risk-reduction strategy, typically involving the transfer of inflation and interest rate risks through hedging contracts or shifting the risk towards insurers via the buy-in/out market. However, since the onset of the global financial crisis, insurance premiums have become relatively more expensive – forcing DB schemes to look elsewhere.
Last year, for example, Babcock International, the engineering support services organisation, became the first UK company to enact a longevity swap, removing some of the risk of its members living longer than expected. Longevity swaps allow a pension scheme to lock into a fixed series of payments to a third-party institution that is then liable to meet the extent of the pension payments as they fall due.
The growth of the nascent longevity swap market has been widely anticipated, with an influx of new entrants to the market and an increasing number of schemes seeking protection against the prospect of paying pensioners’ benefits well into their 90s. Indeed, since the Babcock International swap, there have been a bout of deals in the UK – with the largest involving BMW offloading £3bn of longevity risk from its UK pension scheme.
While more sophisticated risk-transfer solutions are developed in both the insurance and derivatives markets, sophisticated pension risk management platforms will become an increasingly important weapon in sponsoring companies’ armouries in the coming years. Risk analytics platforms – supported by capital markets technology – can provide sponsors with access to much more up-to-date and accurate information about both pension liabilities and assets – allowing more effective examination and measurement of the complex risks associated with their pension schemes. Such platforms enable scenario-testing of both pension assets and liabilities on a consistent basis by altering a variety of input assumptions (including inflation rates, interest rates and longevity) – something for which sponsors have long been crying out.
While sponsors recognise the need to improve scheme risk management, they have been frustrated to date with various obstacles preventing them from doing so. Indeed, the IAS 19 changes should be viewed in the context of a fast-evolving pension risk management landscape in which the current expected return-on-assets measure sticks out as unhelpful, at best.
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