Germany: BilMoG reforms ring the changes
Günter Hainz and Georg Thurnes assess the implications of the new BilMoG accounting rules for pension liabilities
Longstanding efforts to modernise the German commercial accounting standards (German GAAP) resulted last year in the profound changes effected by the Bilanzrechtsmodernisierungsgesetz (BilMoG) reform act. Currently, German companies are working to comply with the new standards, which in most instances will be applied in fiscal year 2010 for the first time. The pre-BilMoG accounting standards were generally thought to convey insufficient, or even misleading information, especially in comparison to the International Financial Reporting Standards (IFRS), which as a consequence had a distinct influence on the development of the BilMoG accounting rules.
The changes especially affect pension accounting, which in the past was often criticised as offering too many choices of method and parameter, and of tolerating a deceptively low disclosure of liabilities. Many, though not all, of these concerns are now met by the new BilMoG accounting rules. As German GAAP earnings determine the legally permissible dividend payments, among other things, the BilMoG rules affect IFRS users, too.
The new BilMoG standards mainly address the accounting of pension promises directly granted by the employer without involving standalone financing vehicles such as Pensionskassen, Pensionsfonds or direct insurance. Direct pension promises (Dirketzusagen), financed by balance sheet provisions, include so called contractual trust arrangements (CTA) where the company puts aside dedicated financial assets exclusively held to cover book-reserved pension liabilities.
BilMoG needs to be applied for the financial statement of the legal entity and for group financial statements of non publicly-traded companies. For other companies group financial statements need to be presented in accordance with IFRS. Provisions for pensions under the tax law have not been changed.
Valuation of Benefits
Before BilMoG, auditors usually accepted that pension liabilities calculated for tax purposes could also be used for German GAAP accounting, because only tax law provided detailled rules for the measurement of pension liabilities. As the valuation rules for tax purposes are quite restrictive and, for example, do not allow for uncertain future events like pension or salary increases, from an economic point of view, liabilities calculated according to these rules usually understate the realistically assumed liability.
BilMoG now requests the use of valuation methods that are based on expected cashflows under economically reasonable assumptions and this approach corresponds to IFRS principles. It seems that most companies will use the projected unit credit method of IFRS, although this is not mandatory under BilMoG, so in many cases the only difference in the measurement of liabilities between BilMoG and IFRS will be the discount rate to be applied.
In contrast to IFRS, the BilMoG discount rate is not determined by reference to market yields on high quality corporate bonds at the balance sheet date. Instead, average values over the preceding seven years have to be used which are calculated and published monthly by the Deutsche Bundesbank for durations between one and 50 years. For practical reasons, the average values are calculated from euro swap rates with various durations and are increased by a duration-independent spread to approximate the higher risks of corporate bonds. A duration of 15 years may usually be assumed on the basis of a simplifying rule, which currently corresponds to a BilMoG discount rate of about 5.25 %.
As the BilMoG discount rate is considerably lower than the 6% discount rate mandatory for tax purposes, this and the compulsory use of realistic valuation assumptions will increase pension liabilities in most cases. Depending on the type of pension promise and on the valuation methods used before BilMoG, the increase can be dramatic. Sample calculations have shown that liabilities can increase by up to 80 % for final salary plans.
This increase will not necessarily be evident from the 2010 financial statements, the first year of BilMoG application, as some transitional rules permit a gradual adjustment of the liabilities over up to 15 years. Furthermore, the possibility remains to relegate the disclosure of liabilities to the explanatory notes for pension promises made before 1987 or by means of standalone pension vehicles. For these reasons a meaningful comparison of pension liabilities will require a careful analysis of the notes, which will contain more detailed information on the pension exposure of the company than before BilMoG.
Increased attention to plan assets
Before BilMoG there were no special rules for plan assets in German GAAP as there are in IFRS. Assets dedicated to the payment of pension promises were accounted for at their book values - basically the lower of historical acquisition costs, previous year's balance sheet position and current market value - and netting with liabilities was not permitted. BilMoG brings along the following two radical changes with regard to plan assets, both of which should make it more worthwhile to assign plan assets than in
A major discontinuity in German accounting rules is caused by the requirement to net liabilities with corresponding plan assets, which was not permissible before BilMoG. Netting the liabilities and plan assets results in the funded status as accrued liability, whereby the balance sheet total is reduced and thus financial figures and indicators are improved. If the plan assets exceed the liabilities, the surplus is capitalised without regard to an asset ceiling. However, such a surplus may not be distributed to the shareholders. It should be noted that BilMoG plan assets are defined slightly differently from plan assets under IFRS, so one has to check independently for both accounting standards whether certain assets qualify as plan assets or not.
The valuation of assets at fair value instead of book value has been the most controversial issue in the BilMoG reform effort. The use of fair value measurement was ultimately rejected, particularly since it was thought to increase the volatility of earnings and to have a destabilising effect, which was a powerful argument in the difficult economic situation of 2009. However, only plan assets were exempted from this general decision. So, according to BilMoG, plan assets have to be valued at their fair value at the balance sheet date. As the fair value often exceeds the book values, hidden reserves consequently will be unlocked.
Unfortunately, the measurement of plan assets is based on current market conditions that generally are not compatible with the mandatory discount rate for the valuation of the pension obligations, which is an average over the last seven years. Thus, changes in market interest rates have an immediate impact on the asset value, but only a much smaller effect on the liability. This is especially worrying as changes in the funded status are immediately recognised in the income statement, and there is no way to even out the resulting volatility of earnings like the corridor or OCI methods of IFRS. Furthermore, this mismatch impedes a liability driven investment strategy that aligns plan assets with pension obligations and in this way tries to avoid accruing substantial net pension liabilities or at least to reduce volatility.
Impact of accounting standards
As the numerous accounting changes required by BilMoG have to be applied for financial years starting after 2009, many firms are only now beginning to consider their consequences and the necessary adjustments to their accounting practice. As yet, the implications of the BilMoG rules on company pension schemes are unclear, and auditors still have to form an opinion on many details.
However, the usually higher pension liabilities, the new dependence of the liability on assumptions regarding, for example, future salary or pension increases and the increased volatility of earnings in case of substantial plan assets, might lead companies to reduce the dependence of their pension obligations on these parameters. This could mean replacing annuities with lump sum payments and loosening the link between salaries and pension amounts.
The netting of plan assets with liabilities and the reduced balance sheet total might encourage the allocation of plan assets, even if the matching with liabilities is usually difficult due to the discount rate mismatch.
Remarkably, by a special rule, certain securities-linked pension promises have to be valued by the fair value of the underlying securities at balance sheet date. The amount of such securities-linked promises is required to depend only on the fair value of non-current securities such as stocks, bonds, mutual funds, and perhaps reinsurance contracts. If the corresponding securities exist as plan assets of the company, which is not necessarily the case, assets and liabilities may cancel each other out, because both the plan assets and the corresponding liabilities are valued at the assets' market value.
In practice, however, such a pension promise usually includes additional parts exceeding the securities-linked promise itself, for example a guaranteed minimum return or special contributions in the event of disability. For these additional parts a liability will have to be disclosed even after netting with the corresponding plan assets. The range of possible applications of this new rule and the peculiarities of its use are still unclear, as are many other implementation details of the BilMoG rules.
The new standards yield a more realistic valuation of direct pension promises, similar to IFRS, and finally allow for offsetting liabilities by dedicated assets. The main difference remains with a smoothed discount rate. There are many details to be resolved by companies, auditors and actuaries. However, German pension accounting now appears to be on the right road. It would be even better if the governmental bodies would extend the new rulings to the tax deductibility of pension accruals.
Günter Hainz is senior consultant and Georg Thurnes is MD at Hewitt Associates in Germany