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Mercer floats alternative valuation approach to reduce IAS 19 P&L charge

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Mercer has raised a question mark over the calculation of net interest costs on defined benefit pension funds under International Accounting Standard 19 (IAS 19), Employee Benefits.

In an online update to clients, the consultancy said it might be appropriate in some circumstances for DB sponsors to calculate their profit or loss charge on the basis of a one-year forward rate in place of the more traditional approach of using the IAS 19 discount rate.

In current market conditions, a company showing a deficit on its DB fund could expect to reach a better P&L result were it to make the switch.

Deborah Cooper, a partner with Mercer’s UK retirement resource group, told IPE: “On the one hand, this is a legitimate reading of the standard, but, on the other, practice is entrenched, and there is a lot of inertia against any change.

“But it is important to air these issues and start a debate. We want to see the IASB or the International Financial Reporting Standards Interpretations Committee look at this question and reach a position on it.”

IPE has also learned that Jardine Lloyd Thompson (JLT) has raised the possibility of using a yield-curve valuation method.

Executive director Hugh Nolan said: “We don’t see this becoming mainstream because of the potential risks, and smaller companies might find that the expenses outweigh any gains. As a result, the population of sponsors that might seek to benefit from this approach is very limited.”

The IASB published its revisions to IAS 19 on 16 June 2011. The changes focus on three areas of pensions accounting – recognition, presentation and disclosure.

As a result, from this year, DB sponsors must apply the net interest approach to disaggregate and present items of pension expense.

They must also report service cost as a component of profit or loss, net interest income/expense on the total DB asset/liability, and pension plan remeasurements as a component of other comprehensive income.

But new doubts over the wording in paragraph 85 of IAS 19 have brought into question the basis on which companies should calculate the net interest income/expense line item.

Until now, the mainstream understanding has been that sponsors will calculate the net interest cost/credit by multiplying the balance sheet liability/asset by the discount rate.

In its November client briefing, Mercer notes that, although this “simplified approach” is one possible interpretation of the standard, another is to use “a full-yield curve valuation using market-implied discount rates for each individual future year.”

The impact of any change in the net interest calculation under current market conditions could lead to a substantial reduction in a DB sponsor’s P&L charge.

“While the yield curve is upward sloping,” Mercer said, “a yield curve valuation may also lead to a lower service cost as it will use, on average, the higher discount rates at the longer end of the curve.”

On the current shape of the yield curve, any entity adopting the alternative approach could expect to use a one-year forward rate running at less than 1%, with typical discount rates of around 4.5%.

The approach is not, however, without its opponents.

Simon Robinson, an employee benefits consultant with Aon Hewitt, told IPE: “IAS19 is quite vague in this respect, which is why some people are interpreting it as allowing this approach.”

Robinson, who also chairs the Association of Consulting Actuaries’ Accounting Committee, added: “Looking at paragraph 85, it says the discount rate should reflect the timing of the projected benefit payments, but then goes on to say a practical approach is to use a single weighted average discount rate.

“So it appears to suggest that the theoretically correct approach is to use more than one discount rate, but a practical expedient is to use a single discount rate.”

Early signals suggest any DB sponsor planning to adopt the new approach could run into opposition from their auditors.

Audit sources close to the issue, who spoke to IPE on condition of anonymity, signalled a lack of support for the idea among auditors.

Securities regulators have also put pensions accounting under the enforcement spotlight.

A spokesman at the European Securities and Markets Authority told IPE that, although enforcers have not yet addressed the specific question of yield curve valuations, “employee benefits are included as part of European Common Enforcement Priorities for 2013 year-end”.

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