The chairman of the International Accounting Standards Board (IASB), Sir David Tweedie, might do well to listen a little more closely to Berlin than to Washington. In line with problems outlined in November last year by the executive chairman of Germany’s DRSC accountancy standard setter, Heinz-Joachim Neubürger (see end), those with an interest in such matters are now awaiting the impact of wider credit spreads on IAS19 accounting.
Regular followers of IPE’s coverage of pensions accountancy issues - who will know of Neubürger’s willingness to predict the future and the IASB’s willingness to ignore him - will surely wonder what’s new. This latest intervention comes on top of Neubürger’s warning in June 2007 that the IASB’s pensions project was about to smash spectacularly into the buffers in Germany.
Again that year, he counselled that SEC plans to restrict the accounting choices of EU businesses listed in New York was a non-starter; and then his more recent observations that the plan to give the SEC a constitutional hotline to the IASB chairman was beyond the pale.
For once he had company as a prescient observer. Speaking on his own account, Henning Göbel, attending the meeting as a representative of the International Association of Insurance Surpervisors, expressed an apocalyptic outlook for government debt.
In 2009, Göbel said he expects to see issuance of government bonds from western EU counties of about €1,000bn in the next year, simply to refinance mature bonds. “So that’s €1,000bn, which will be added to those spreads. On top of that we will have €1,600bn being added by government-backed corporate payments.”
The numbers are eye-watering. And, he warned, even sovereign states might balk at the cost of issuing debt: “Two weeks ago, Austria withdrew from issuing a government bond of €5bn, simply because the spreads were [such] that it was too expensive. The financing costs of companies going into the capital market at the moment are phenomenal. We have banks that manage to place a convertible bond at 19%.”
And this, he said, makes it “very logical that you have to go into some more risky engagements in order to refinance that 19%.
The danger remains that this wise counsel will fall on deaf ears. The IASB’s pensions team has in the past argued, for example, that it is not the role of a standard setter to consider the behavioural impact of its activities.
Now, said Henning Göbel, might just be the moment to step down from the ivory tower: “We have to address these economic problems because the countries will not be able to afford what is one of the likely scenarios of what is going to happen in 2009 and we have to react to that. And the amount of debt securities which will be issued next year will make this problem a tremendous problem and it will leave the magnitude of being a corporate problem to being a national economic problem.”
As if that were not warning enough, Göbel added: “[If] it becomes a national economic problem, then governments will address this issue, and the due process might not be at the top of their list. And so we have got to deal with that type of reception and we have got to address it in a proactive way, and that is why I think Heinz-Joachim [Neubürger] was right in saying look ahead and see if we have the right responses to that.”
Perhaps of interest to those dismayed by the IASB’s response thus far to their concerns about the proposals in the Phase I pensions project, Göbel observed that: “We can take the easy of debating this and say ‘this is how the market appreciates the risk and all this or whether companies would like to go out of fair value and into amortised cost’, that is the easy way out of the debate, but it is actually the way that brings you into the difficulties that we have seen on the 13 October, let’s be clear about this.”
Göbel could hardly have intended it, but his remarks resounded to those in the know as a cunning commentary on the IASB’s approach to its work on pensions. As the board has learned to its cost, political institutions, not the board, exercise real power. Back in October, the European Commission demanded that the board amend its financial instruments accounting standard, IAS39.
Faced with massive write-downs in the wake of the near collapse of the global banking system, European financial institutions lobbied deftly for the right to reclassify certain types of instrument from a fair-value measurement to the more benign historic cost model. The Commission’s stance was simple: either the Board makse the changes or Brussels will step in and do the job.
So as these timely warnings play out in reality, what do pension funds face in 2009? Robert Gardner, (pictured right) partner and co-founder of investment consultants Redington Partners is clear on what he thinks is the answer: “In an environment in which there is likely to be an abundance of debt issuance, the question that we have to ask is whether there is enough investor appetite to buy it all up,” he says.
“It is not is as if there were some magic pile of money. The vast majority of investors have to sell other assets in order to buy debt, and that debt will have to be priced accordingly. A major consideration is both the relative value of debt and its absolute value. So in absolute terms I might be happy with a yield of, say, 3%, but the other part of the picture is whether that represents a satisfactory yield relative to the performance of competing asset classes.”
As for the issue of the IAS19 discount rate - mentioned obliquely by Neubürger - Tim Reay, (pictured left) a London-based principal with consultancy Hewitt, counsels against knee-jerk changes: “I would say I’m not a fan of making ad hoc changes to the methodology underlying IAS19 discount rate setting. This is not just for reasons of comparative consistency but also because to do so would be to second guess the rating agencies and the markets. I don’t see why I am qualified to second guess them on the question of what makes a high quality bond.”
Overall, he explains, he would stick with the AA-rate but not follow an index blindly: “The caveat is that we need to look more at the underlying details in setting the discount rate. So, have regard to duration, look at any re-rating of bonds that has happened, consider other information such as swap rates where the information from AA corporate bonds is patchy, for example at longer durations.”
He is at pains to explain why this does not amount to second-guessing the rating agencies: “The index is a basket of yields, but the constituent bonds have different durations, from short to long. So two pension plans might quite reasonably have two discount rates if their durations are different, due for example to one workforce being older, one plan providing lump sums and not pensions and so on. And if you are looking at long durations you need to complete that informational picture by looking at other indicators such as the interest rate swap market. This is because there is a lack of long dated debt out there.”
Second guessing, he says, would be to remove 50 bonds, for example, from an index of 200 bonds because they represent the debt of financial institutions. “My argument is that I wouldn’t want to do that until the rating agencies have said so,” says Reay.
Gardner, however, notes the shortcomings of the AA corporate bond measure: “In terms of the accounting, the most relevant question is the extent to which the current IAS19 discount rate is appropriate. The current spread widening of the corporate bond market has led to a scenario where the IAS19 measure of a pension liability represents a less stringent measure than the market’s. IAS19 lets a corporate sponsor value the pension scheme’s liabilities using a AA-corporate bond rate, because they traditionally traded a modest risk premium over gilts - typically 80 bps or so. In recent months this spread has widened significantly, dramatically reducing the calculated present value of pension scheme liabilities.”
But whatever the accounting policy adopted by a sponsor, Tim Reay puts the emphasis on an area where the IASB and regulators have consistently failed to develop and implement proposals: “It is important for companies to put in as much extra commentary in their IAS19 disclosure as they can to in order to enable people to understand it. The wider variation in yields generally this year has left people with more choice over the discount rate they choose, and many auditors are quite happily accepting a broad range of discount rates. And let’s disclose a lot more about life expectancy while we’re at it.”
And as the most recent annual report for UK retailer Marks & Spencer demonstrates, the accounting impact of widening credit spreads looks something like this: “At 29 March 2008 the IAS19 net retirement benefit surplus was £483.5m (last year deficit £283.3m). The year-end discount rate, which was 6.8% (last year 5.3%), reflects corporate bond rates at the year end and has led to a significant reduction in the IAS19 calculation of the pension liability for accounting purposes at 29 March