Few issues have generated so much controversy among Europe’s corporate pension schemes as the application of international accounting standards (IAS). In Switzerland, the introduction of IAS19 has led pension lawyers to re-define Pensionskassen as defined contribution (DC) rather than defined benefit (DB) schemes in an effort to escape its provisions. In the Netherlands, industry-wide schemes have argued that the involvement of a large number of corporate sponsors has made the implementation of IAS19 impossible.
This month, Off The Record looks at the issue of accounting for pensions. This is timely, since the UK’s Accounting Standards Board (ASB) has just proposed changes to the way pensions assets and liabilities are calculated, changes which it hopes will be adopted by the International Accounting Standards Board (IASB).
Ever since the UK’s accounting standard for pension funds FRS 17 was introduced in the 1990s - to be adopted largely by the IASB in its IAS19 standard - there has been argument about whether ‘fair value’ accounting methodology is really appropriate for pension funds.
Marking assets to market brings increased volatility to corporate balance sheets. This unwanted volatility has been blamed for accelerating plan sponsors’ move away from DB pension plans.
So, has fair value impacted harmfully on occupational pension funds and their asset allocation? Or has it benefited funds by encouraging better risk management and better asset-liability matching?
The pension fund managers, administrators and trustees who responded to our survey are clearly unhappy with the consequences of fair value accounting.
The manager of one UK pension fund observes: “I do not detect in the accountants’ proposals sufficient understanding of the concept of investment and funding in the context of corporate pension schemes. It seems OK for corporates to acquire assets - fixed asset investments, for example - and account for these taking a longer-term view of recoverability, impairment and so on, but it is not OK for pension trustees to acquire assets - based on their longer run fundamentals in terms of current yield, estimated future growth and relative valuation - and schedule cash contribution receipts as part of a perfectly rational plan to fund pensions liabilities as and when they fall due.
“The reason that it is not OK is that the mark-to-market ethos of today’s accountants means that the pensions assets bought with long-term intentions are then subject to the vagaries of short-term market movements and market spot, and option prices based on lot sizes, which often bear little resemblance to the investments held.”
He suggests the current ASB proposals will prove a distraction rather than an advance in the arguments about fair value accounting. “I sense the debate this time round will focus wrongly on the discount rate to be applied to some or all of the relevant liabilities in a pensions context, once again ignoring the investment case to be made on the assets side of the accountants’ balance sheet.”
The manager of a Swiss pension fund is equally pessimistic. “I see zero chance for the accountants to become more reasonable, and this really is a pity.”
There is a simple solution, he suggests. “In my view, liabilities should be discounted at a conservative expected rate of return, itself a direct function of the strategic asset allocation of the fund. The methodology for computing this rate of return could be subject to restrictions to avoid misuse and over-optimism. This rate would therefore be fairly stable, although not entirely, and would allow properly to account for the long-term horizon of pension plans, enabling a more aggressive asset allocation, hence a higher expected return, hence a lower pension cost.
“Deficits should be amortised over several years, although maybe not over as much as the average active life time of the members. The annual, smoothed charge should then hit the P&L.”
Yet he is realistic about the chances that this solution will be adopted: “It is a dream and unlikely to come true.”
Two thirds of our respondents agree that the application of fair-value accounting for pension funds has had a distorting effect on decisions about corporate pension funding and asset allocation.
Opinion is more evenly divided on the question of whether requiring pension funds to adopt mark-to-market accounting has had dangerous and costly results for the equity markets, companies and their pension funds. A small majority thinks that it has.
Whatever the shortcomings of the new accounting approach, it can be argued that the trend towards market-based valuation of pension plan liabilities is generally benign. This is the majority view of our respondents; three quarters agree that market-based valuation is a welcome development.
Yet there are some qualifications. One pension fund manager is in favour of the move only “as far as a true and fair view and greater transparency are concerned”.
It could also be argued that the new accounting approach has encouraged pension fund managers to make better investment decisions. The volatility created on a sponsoring company’s balance sheet encourages managers to make better asset allocation decisions. However, only a minority of our respondents agrees with this view.
Proponents of the new accounting rules point out that in the past pension accounting encouraged funds to be over-exposed to equities, but that this over-exposure has now been be corrected by fair value methodology. Here, opinion among managers is fairly evenly divided.
Three quarters of our respondents agree that the increased volatility resulting from fair value accounting has forced pension funds to focus on risk management. However, there are some who see this as merely a side effect.
One objection to fair value accounting is that it can lead to sub-optimal asset allocation decisions as corporate sponsors and pension funds over-react to short-term changes in asset values. Two thirds of the managers think this is a serious objection.
However, some feel that such over-reaction is unnecessary, and others think that fair value accounting should not take all the blame. One manager says: “I doubt whether the implementation of fair value accounting was the only reason.”
One consequence of fair value accounting is pension plans’ greater interest in removing risk from the sponsor. Three quarters of our respondents agree that fair value accounting rules are now driving pension plan design.
There is strong agreement that the introduction of fair value accounting rules has been an important factor in closing DB schemes. However, the manager of a Scandinavian pension fund suggests that the flight from DB “also has something to do with the more complex and extended reporting that must be done by pension funds”.
Some even applaud the move away from DB plans. A Swiss pension fund manager says the fair value accounting rules have provided “a welcome opportunity for some enterprises to save costs and reduce contributions”.
Smoothing is also an issue. In the past, sponsors have been able to smooth pension fund values, a methodology which enables them to iron out short-term volatility in their corporate balance sheets. Critics of smoothing argue that it encourages companies to make unrealistic assumptions about rates of return on invested assets.
A small majority is in favour of smoothing. A similar majority thinks that fair value accounting, where smoothing is no longer possible, misrepresents the long-term economic cost of pensions as an ongoing concern.
Finally, we asked whether Europe’s policymakers should pay more attention to the impact of fair valuation accounting on companies’ willingness to sponsor DB pension funds. In other words, should the state, which cannot provide benefits comparable to those of corporate pension schemes, be concerned about a mechanism - such as accounting rules - which could erode private sector pensions provision?
A majority agrees that it should. So perhaps governments should take a closer look at what the bean-counters are proposing and its impact on future retirement benefits.