GLOBAL - Companies and pension funds must be allowed to continue to use the ‘corridor approach' when assessing a sponsor's pension fund liabilities under IAS19 as any move otherwise would encourage schemes to shed risky assets, according to research by the French business school EDHEC.
The IASB first began its review of IAS19 in July 2007 to look at "the limit on a defined benefit asset minimum funding requirements and their interaction" and has issued several proposal papers since to try and rectify any complexities arising from reform of existing and proposed policy. In July this year, officials admitted the IAS19 review committee looking at how the discount rate is applied "forgot" to recognise that some pension funds would continue to apply the corridor approach to pension scheme assets - a concept which the IASB had earlier said should be eliminated. (See earlier IPE story: IASB trips up in corridor)
In response to the IASB's activity, Samuel Sender, applied research manager at EDHEC-Risk, has produced a position paper on behalf of EDHEC, reviewing the International Accounting Standards Board (IASB) proposals on IAS19, and which warns that the immediate recognition of pensions surpluses and deficits in a company profit and loss account could have a significant impact on both the pension fund and the company.
Within his paper, Samuel said the 90% minimum threshold within the corridor approach above which sponsors need not report volatility is seen as a direct incentive to manage risk and should therefore not be removed, as any sign of volatility in a sponsor's financial results is likely to force a lower risk strategy when today's ALM techniques actually enable both a minimum and maximum funding ratio.
Similarly, EDHEC's paper claimed the 110% maximum ratio ought to be seen as a legacy of tax law, which sought to prevent pension funds from amassing too much in funding to avoid tax payments, but which is no longer applicable then: "It is beyond the scope of [the IASB] paper to comment on the appropriateness of the maximum threshold. Instead, it argues "if the purpose is to create funding incentives there is no reason not to raise the 110% upper limit."
At the same time, the author said the risk is heightened for sponsors if there is no facility for the smoothing of discount rates used to assess assets and liabilities, so a solution should be sought.
The technical paper argued smoothing market yields on fixed income would help to "filter out market noise" as the actual pricing of these assets can be turbulent even though pension funds will hold as investments to be held long-term.
More specifically, EDHEC suggested yields be smoothed on a quarterly or, better still, or annual basis, as "the market for long-term bonds is relatively thin, long-term yields are noisy, and the noise in long-term yields is highlighted in the long-term zero-bond yields and even more in the long-term forward yields, both of which affect the valuation of pension liabilities".
EDHEC recommended the long-term volatility be filtered out by perhaps encouraging pension funds to calculate the discount rate on an "infra-annual basis" through smoothing of the long-end of the yield curve at around the close of the reporting period - so end of December 2008 values could be calculated with yields smoothed between 1 December 2008 and 31 January 2009.
One example presented to illustrate the extremes of volatility noted the US long-term bond yield fell by 150bps between November and December 2008 and then rose 100bp in February 2009, producing a swing "equivalent to a 400-500% relative yearly volatility".
It also argued the use of credit yields to discount liabilities also leads to "significant discrepancies between discount factors even within the same country" as one pension fund selecting a discount rate on the same day as another can still come up with "inconsistent results".
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