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ASB given 'swap' alternative to 'risk free' discount rate

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  • ASB given 'swap' alternative to 'risk free' discount rate

UK - Pension fund associations have urged the Accounting Standards Board (ASB) to revise plans to introduce 'risk-free' discount rates for pension liabilities, and instead look at swap rates combined with a "sustainable" corporate bond spread.

In it's response to the ASB's consultation on the "Financial Reporting of Pensions" discussion paper, the The National Association of Pension Funds (NAPF) claimed the plans to switch from an AA corporate bond discount rate to one based on gilts would be likely to "further weaken and erode UK companies' defined benefit (DB) pension schemes".
 
The ASB discussion paper, published in January, suggested changes in pension assets and liabilities should be reported as they happen rather than spread into the future, and that financial statements should reflect the actual return on assets instead of estimates. (See earlier IPE.com article: ASB calls for 'fundamental' accounting review)

But the NAPF revealed it had commissioned research by consultancy, Punter Southall, which showed that switching from AA corporate bonds to a 'risk-free' rate would increase liabilities by 25% for mature pension schemes, and by up to 50% for immature schemes.

As a result, Punter Southall claimed that the estimated liabilities for the FTSE 350 would increase by around £250bn (€313bn), if the ASB proposals go ahead.

However, the NAPF suggested the choice of discount rate is "necessarily arbitrary" and claimed the ASB should either retain the existing corporate bond basis or "in view of the recent distortions caused by widening credit spreads", the ASB should "preferably" move to something similar to the existing system but "less liable to distortion".

For example the organisation suggested a "swap rate plus an amount that could be seen as a long term 'sustainable' corporate bond spread, such as one or two percentage points", which could be determined by the ASB in consultation with the market.

The NAPF claimed it prefers the use of a swap rate to a 'risk-free' government bond rate because "the swap market is more liquid, particularly at the long end, and it is the mechanism by which pension funds tend to hedge their liabilities when they choose to do so

Joanne Segars, chief executive of NAPF, said the ASB "cannot operate in a vacuum, indifferent to the consequences of their actions", and instead warned it "must offer a ‘real world' solution to the issue of accounting for pensions that takes account of the need for transparency, and the need to maintain good quality DB pensions".

The European Federation for Retirement Provision (EFRP) also argued that a 'risk-free' discount rate would be "inappropriate" given the nature of the liabilities and the risks involved, such as mortality, dependency and duration -matching risks.

As a result it said that the existing system should be retained, although as an alternative the EFRP admitted that a "swap rate plus a premium" could be used, as the swap market in mature markets is "considerably larger and more liquid than the equivalent government bond market and can be used to match the duration of the liabilities better". 

However, in its consultation response Punter Southall suggested an alternative option, where pension liabilities should be disclosed "on the basis used for Scheme Specific Funding (SSF)", as it claimed this "reflects the reality of the company's obligations to contribute to the pension scheme" but is also "relatively easy to produce".

Peter Black, principal at Punter Southall said: "We believe the principle of accounting for pensions on a risk-free basis is counter to the best estimate approach adopted for valuing going concerns and fear that use of a risk-free basis will produce very high values with serious consequences for UK companies."

However, the firm said it accepted "there is no intellectual justification for using AA bond yields as the measure of pension fund liabilities" and admitted the credit crunch had "shown this measure to be very volatile".

But instead it claimed adopting the basis set out in a pension scheme's Statement of Funding Principles, means it has already been agreed as a prudent level by employers and trustees, and takes into account the particular circumstances of the scheme.

Black said: "This would have the advantage of reflecting the basis used to determine companies' cash costs directly.  Furthermore, disclosures would be easy to produce as regular updates are required for other purposes."

The ASB discussion paper concludes that a risk-free discount rate should be used with "suitable sensitivities disclosed for the benefit of users of accounts such as analysts.

So Black argued that "users of accounts would surely find disclosure of the basis used to determine cash contributions important, so why not make this the starting basis and publish sensitivities enabling users to estimate a risk-free basis should they so desire?"

However Punter Southall admitted that for UK companies with pension schemes in countries without a SSF regime, using a swap rate with a margin "would be about the same" as a scheme specific basis, and would not have the same problems as corporate bonds as it is more liquid.

Although from a UK point of view the consulting actuarial firm claimed SSF is more "attractive", as any new system - such as risk-free or swap rates - would require more work as calculations would have to be done on a completely different basis to the existing system.

And by using the SSF approach Punter Southall clamed there could be "potentially less work" for schemes and consultants - as the systems are already in place - particularly if the annual actuarial valuations are completed at the same time as the company year end - as only one set of figures would need to be produced.

Meanwhile the NAPF and EFRP also raised objections to most of the ASB's other proposals including:

Using actual returns rather than estimated returns in companies' Income Statements; Employers providing industry-wide schemes - such as in the Netherlands - and pensions via multi-employer schemes being required to account for pensions in the same way as those using single employer schemes; Pension schemes having to show liabilities as well as assets in their full accounts

However, both organisations agreed with at least one proposal, which is to exclude discretionary future salary increases from the calculation of scheme liabilities, as they are not liabilities at the date of the balance sheet.

Segars said: "The ASB should revise its proposals, especially those relating to the use of a risk-free discount rate. These proposals are likely to further erode and weaken DB provision in the UK, increasing reported scheme liabilities and undermining scheme sponsors' willingness to provide these types of pensions."

The EFRP said it had become involved in the UK debate as pension funds are substantial investors in European listed equities, so they have a "legitimate interest" in ensuring that pension liabilities are properly reflected in company accounts, while it claimed the volatility in the current accounting standard had caused a number of employers to modify their occupational schemes.

It added: "Since both the International Accounting Standards Board (IASB) and the United States Financial Accounting Standards Board (FASB) have indicated they are committed to a long-term review of the financial reporting of pension benefits, it is important the required specific approach to account for single as well as multi- employer sponsored pension schemes is established as early as possible in this review process".   

The alternatives to the ASB proposals put forward by the organisations, follows confirmation earlier this month that the UK government planned to make "representations" to the ASB over the use of a 'risk free' discount rate in response to concerns raised by the industry. (See earlier IPE.com article: DWP to discuss reporting concerns with ASB)

If you have any comments you would like to add to this or any other story, contact Nyree Stewart on + 44 (0)20 7261 4618 or email nyree.stewart@ipe.com
 

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