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Accounting Matters: Splitting the difference

  • IFRS has determined that a sponsor contribution discount does not mean a plan is DB
  • DC excludes downside risk, but does not exclude upside potential, according to IFRS
  • The consultation runs until 15 May

If ever proof were needed that the dividing line between defined benefit (DB) and defined contributions (DC) pension promises is coming under pressure, it was a discussion at the IFRS Interpretations Committee (IFRS IC) on 6 March. 

Prompting the debate was a submission to the committee in which a constituent wanted to know whether a sponsor’s right to receive a potential discount on plan contributions affects the classification of the plan under IAS 19. In other words, does the right to receive a discount flip a plan from DC to DB?

In response, the committee has provisionally ruled – perhaps surprisingly – that it does not. According to the committee’s official decision wording: “The existence of the potential discount would not in itself result in classifying the plan as a defined benefit plan.” Indeed, this was the view of eight of the 15 committee members.

The fact pattern that the committee was asked to adjudicate concerns about a post-employment benefit plan that is administered by a third party. Under the terms of the plan, the sponsor is required to pay fixed annual contributions to the plan. The scheme’s sponsor argues that it has no legal or constructive obligation to pay further contributions if the plan has insufficient assets to pay all employee benefits relating to employee service in the current and prior periods.

Moreover, the sponsor is potentially entitled to a discount on those contributions, which is triggered by the scheme assets exceeding a certain threshold. Another way to look at this right to a refund is to say that it is a derivative whose outcome depends on the plan’s actuarial and investment risk. All in all, that might create the suspicion that the plan is in fact a DB plan. 

And so, the question for the IFRS IC to adjudicate on is whether the existence of the possibility of receiving a discount would mean that the plan is in fact a DB plan. The key difference between the two accounting outcomes, in IAS 19 terms, is that DC accounting is simpler. All the sponsor needs to do is to expense the current period’s contributions and forget about the plan.

On the other hand, with DB accounting, the requirements are more onerous. A DB plan sponsor must first measure the DB obligation using the projected unit credit method and fairly value any plan assets. The difference between the plan’s assets and its projected liability will produce either a DB asset or liability on the sponsor’s balance sheet. Where a plan is in surplus, the sponsor will recognise the lower of any surplus and the IAS 19 asset ceiling – that is, the economic benefits available from the surplus. Put simply, the calculation, which also takes account of longevity, is more complex, costly and has greater visibility in the sponsor’s accounts. 

IAS 19 definitions
When it comes to deciding which plan belongs in which accounting model, IAS 19 is structured so that any plan that is not a DC plan is automatically a DB plan. The standard DC plan is one where there is “no possibility that future contributions could be set to cover shortfalls in funding employee benefits relating to employee service in the current and prior periods”.

At its most basic, the debate coalesced around a simple difference of opinion between those who believed that the staff’s analysis and draft decision open the door to potential abuses and structuring and those that do not.

So what did the 15 committee members make of it? One of their number, Guy Jones, was clear where he stood: “In my view, I think [this question] requires a bit of a broader assessment of the substance of the of the overall arrangement. And [there are] a couple scenarios where I’m a bit worried that this analysis would imply we have a defined contribution plan when it really strikes me that it’s a defined benefit plan. 

“And the two scenarios that come to mind are if you if you set your contribution levels at an amount where you expect future refunds. It strikes me that that the employer is exposed.

“The employer is exposed to downside risk because of the amount of refund you’re going to get in the future is dependent on future actuarial experience, investment return, etc. And so setting a contribution level-up here as opposed to down here shouldn’t really change, in my mind, the outcome of the classification of the plan.” 

As for the second scenario that occurred to him, he said: “[T]he other example that comes to mind is an arrangement where you have a benefit formula that defines benefits, but it’s based on [a] certain contribution level. And the employer can perhaps choose to contribute between, you know, a low level of ‘x’ and a high level ‘y’. And, depending on the future performance of the fund, those contributions can adjust somewhere within that band.”

The challenge posed by this fact pattern, he reasoned, is that a scheme that effectively creates an expectation of a refund in those circumstances is economically the same as a DB plan that requires top-up contributions in the event of an underpayment necessitated by the fund’s investment or actuarial performance.

Dissenting voices
But not all committee members were convinced that sponsors would structure benefit promises in order to achieve an accounting outcome. Bertrand Perrin, for example, was firmly of the view that internal control processes make it unlikely that an entity would accept paying “more on a yearly basis just to structure the plan to become a defined contribution plan”.

Nonetheless, Perrin urged the committee to make it clear that additional future contributions related to past service cost meant a plan was DB, whereas future contributions in respect of future service cost made it DC. 

bertrand perrin

Bertrand Perrin: internal control processes make it unlikely that an entity would accept paying “more on a yearly basis just to structure the plan to become a defined contribution plan”

Having discussed the issue, the IFRS IC published its reasoning in its official bulletin, IFRIC Update. This explains that the committee concluded that “the requirements in IAS 19 provide an adequate basis for an entity to determine the classification of a post-employment benefit plan as a defined contribution plan or a defined benefit plan.”

Aside from its consideration of the definitions of DB and DC plans in paragraph 8 of IAS 19, the IFRS IC placed particular reliance on paragraphs 28 and BC29 of the standard. Paragraph BC29 argues that the definition of DC in IAS 19, while focused on the downside risk that a sponsor might realise should it have to make additional contributions to make up a deficit, does not rule out the upside potential of the sponsor contributing less than expected.

Accordingly, committee members decided that although the definition of DC excludes downside risk, it does not exclude upside opportunity. 

Those who disagree with that conclusion, have until 15 May to let them know, as a consultation has been launched.

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