The research effort of the International Accounting Standards Board (IASB) on discount rates is pretty low-key. Its 2011 agenda consultation revealed moderate support to examine discounting under IFRS. The project is limited in scope, has one full-time staff member, and might not even result in any changes.
It involves looking at all IFRSs that require discounting – IFRS9, IAS19, IAS36 and IAS37 – but will not examine the fair value measurement standard, IFRS13.
Of course, the board’s work on discounting could be relevant to any future pensions project.
The research project’s examination of discounting within each IFRS is at an early stage. It will look at the measurement objective, components of present value measurement, the measurement methodology, disclosures and terms and definitions.
Discounting is relevant to defined benefit (DB) pensions accounting. Under today’s IAS19 model, a DB sponsor must project its pension liability forward using the relevant plan assumptions and discount back using a AA-corporate bond discount rate to reach a net present value.
Balanced against the outcome that the IASB might do nothing on discount rates is the possibility that it might propose a move to a risk-free rate.
But would a shift to a risk-free discount rate be a catastrophe for DB sponsors? In monetary terms, research from Llewellyn Consulting hints that we are already there.
Their recent analysis of the influence of DB pensions on corporate equity valuations indicates that a company’s market valuation today by-and-large reflects the possibility of an increased deficit almost fully. Moreover, the report argues that market participants typically put a company’s ‘true’ underlying pension obligation, on average, at a number 20% higher than the reported obligation.
The report notes that “the impact on a sponsoring company’s market valuation over the estimation period appears to have been most consistent with the ‘fair value’ representation of DB pension liabilities and net assets – specifically, an alternative Gilts-based discount rate, as opposed to the actual reported data.’
So have we arrived at a de facto risk-free rate? Sort of, says Jon Hatchett a partner with consultant actuaries Hymans Robertson LLP: “It appears we are much closer to that than we realised. The authors of the Llewellyn Consulting report used the somewhat emotive language of a ‘fair value’. They argue equity market prices in the UK appear to broadly allow for a risk-free rate to value liabilities. For most companies, IAS19 is not fair value on the liability side in the sense that another company wouldn’t take on those liabilities at the IAS19 reserve in an arm’s-length transaction.”
He adds that you have only to look at the M&A space to see that the effective price of liabilities tends to be north of IAS19 but, nonetheless, below buyout. “The reason the price is below buyout is because of the flexibility companies have around when they have to pay cash into the scheme, combined with the limited-liability option available to shareholders.”
One of the advantages of a risk-free rate or fair-value accounting model for pensions is that it would get the issue out in the open. Llewellyn’s research points to an environment in which analysts take the accounting numbers and manipulate them because they do not trust the reported numbers.
It is, says Hatchett, “farcical” to have companies produce numbers and then manipulate them into something they believe. But, he warns, in the real world, the pressure against moving to a risk-free rate is its effect on corporate balance sheets and P&L.
“If you create a big hole in equity, it will have an impact on lending. Just because equity analysts might look through that number, it doesn’t mean credit rating agencies or banks do.” And that is the known unknown that makes the jump to risk-free a leap in the dark.