Stephen Bouvier reviews reactions to the IASB's April exposure draft on IAS19
The headline feature of the International Accounting Standards Board's (IASB)
April 2010 exposure draft proposing changes to IAS19 is the decision to scrap the notion of an expected return on assets and to replace it with the so-called net interest approach. Out, too, goes IAS19's deferral or smoothing mechanisms, and in comes a substantial disclosure package.
But deprived of the profit and loss benefit of booking an equity-related expected return, will defined benefit (DB) plan sponsors now make a potentially damaging short-term move into investments perhaps aligned more closely with the discount rate objective? "There is an element of truth in that but IAS19 isn't the only driver for investing in those assets," says Ian Maybury, managing director, senior actuary and co-head of ALM and strategy with investment consultancy Redington.
Maybury continues: "There is in the UK the driver of the assumptions that are used in calculating technical provisions and recovery planning under the scheme-specific funding requirements and that is still likely to have some allowance for excess returns over risk-free in it.
"If the scheme is open to future accrual there will also be an impact on the setting of future contribution rates, but hopefully it does mean that the distortions that you get by being driven by the P&L benefit might well be removed. There is still a real-world benefit in seeking equity out-performance over a risk-free rate and sponsors will still want to take advantage of that."
Banking is one sector that could feel the pinch from both the IASB exposure draft and the Basel III update to the Basel accords. "A very obvious example of this is the major UK banks, some of which use the corridor," continues Maybury. "Even so, saying that the two changes have come at a bad time is the corollary of saying that they are simply reflecting reality.
"The sooner they come the better, in my view, but clearly it is not a great time to be having to cope with IAS19 alongside the fact that Basel III will remove some of the adjustments that are permissible on tier-one capital. I think this concern is particularly relevant in the UK given the size of the exposure UK banks have to DB schemes."
But until IASB staff open the postbag crammed full of comment letters that will inevitably land on the doorstep of their Cannon Street headquarters in London, we are left with the nagging doubt that the board might have left itself vulnerable to the charge that its exposure draft lacks an adequate conceptual basis. At the heart of the concern is whether a pension plan is a financial instrument, ‘something else', or perhaps some hybrid form of debt.
Maybury adds: "I'm far from convinced that either equity analysts or rating agencies are taking account of the full extent of pension fund exposure among the companies they analyse. They may take account of the size of the deficit. So a rating agency, say, will treat it [the deficit] as debt, but typically not allow for the fact that it can vary over time. I suspect that it is the volatility in that exposure that they typically don't allow for very well.
"The rating agencies have looked at the deficit as if it were debt, and although I agree that the liabilities are a debt, they are debt that is partially offset by an invested asset. If you just look at the deficit, you lose the fact that the two sides of the pension balance sheet have different characteristics, because the debt in this case is the net result of two things: the assets and the liabilities in a pension scheme."
The IASB can expect to find less support among its constituents for its decision to require entities to capitalise plan administration costs. Warren Singer, a consultant actuary with Mercer in the UK, has his doubts about the proposal. "What I would want to see here is exactly how they are going to be capitalised in the liability. In the UK context of the PPF levy, I would query whether plan sponsors are really supposed to be capitalising that. It seems pretty impossible to do it on a consistent and reasonable basis given the way the levy is set."
Looking back, the IASB's discussion of plan administration costs in April 2009 are unlikely to find a sound conceptual basis for the decision. And what makes the proposal all the more surprising is that when the Pro-active Accounting Activities in Europe (PAAinE) proposed capitalisation, IASB later dropped the idea.
At paragraph 4.85 the PAAinE group noted: "The ASB, taking into consideration the concern raised by respondents, has formed the view that, while its preliminary view that expenses of administering the plan's accrued benefits is conceptually sound, as a matter of practicality (and taking into consideration the likely materiality of such expenses), that it would be more appropriate to expense the costs as incurred."
The group reasoned, as a matter of practicality, that it would make more sense to put those costs through the accounts in the year in which they are incurred and that would probably be a better way of doing it. Warren Singer argues that in the UK there is "great uncertainty" hanging over year-on-year changes and tweaks to the levy. "It is revised annually and there is a scaling factor, which is set each year. I don't believe
that it can be meaningfully predicted in the future," he says.
As to whether the IASB might draw back from the precipice by latching on to a limited timeframe - two, three, perhaps five years - over which it might be possible to arrive at an estimate of the levy with a reasonably reliable degree of accuracy, Singer thinks not. "I would say that any such attempt at projection is meaningless beyond the short-term period. If you look back, for example, over the last three years, you would not have been able to do that in a very sensible way."
"I don't think that a conceptual review of how administration costs should be measured and presented was within the scope of this project. It is more of a measurement issue and that is something that the IASB was not discussing as part of this project. Currently, you have the choice either to deduct plan administration costs from the expected return or to capitalise them on the liability. My understanding of the board's tentative decision here is that it is a case of going by default to capitalisation because they were getting rid of the expected return."
Despite the SEC's chief accountant, Mary Schapiro, continuing to play her game of ‘will she, won't she' on the issue of the US adopting International Financial Reporting Standards, one reaction to watch out for is that of the US multinationals who might one day have to apply international standards. Although Tim Reay, a consultant actuary with Hewitt, said in an interview with IPE that he would give the proposals "a largely positive feedback", he cites possible US issues with the divergence that the scrapping of the expected return risks creating with US GAAP.
Reay says: "If it encourages the US to do the same, then fine, but this is not likely. And a lot of that controversy focuses on what we mean by ‘long-term rate of return on assets'. Is it the rate you expect to return over the long term, ie, as we see it under IAS19, or, as they see it in the US, is it the assumption per se that is long term?
"The expected return on assets assumed by many European companies is related to the discount rate - as the latter is effectively the expected gross return on corporate bonds, for example - whereas in the US they are loath to change that assumption from one year to the next, so it remains stuck there as a number that doesn't move around very much, ie, the discount rate moves but not the rate of return on assets. One consequence of this is that the impact of effectively replacing the expected return on assets with the discount rate could well be more significant if implemented in the US."
Put another way, this exposure draft will be even more expensive for the US than for either the UK or the EU.
One other area of the exposure draft that looks set to draw out strong views is the proposed disclosure requirement for DB pension plans. Singer says: "There is quite a lot proposed in the new disclosures, although the board has removed some material. One concern I have relates to the drafting of the proposed standard, which says that an entity ‘shall disclose' various items but doesn't remind preparers about materiality.
"I think there is a danger that it might be used as a check list of these items and lead to very long disclosures. One suggestion I would make is that real-world practice examples in the application guidance would help so that companies have a better understanding of what is required."
As for whether the board has fallen into the trap of treating DB sponsors as though they were insurance entities, Maybury says: "I have some sympathy with that view but my background is in insurance. To all intents and purposes a pension obligation is a liability sitting off a corporate balance sheet. If you look at the disclosures required of insurers, this is lightweight."
Maybury continues: "Sometimes it is sobering to run a comparison of the risks on a corporate's balance sheet - the risks inherent in its operating activities - and the ones in the pension fund. If you look at the process and control around a company's treasury function, say for debt issuance, interest rate risk, hedging of corporate risk, you can find that that risk is often dwarfed by the risks in the pension scheme.
"You might also find that the quality of the risk management and governance around the treasury function is far superior to the equivalent functions that go into managing corporate DB pension exposure.
"I think that these proposals will serve to focus minds and perhaps make people think twice about how they risk-manage pensions in comparison with other corporate functions. And I think that there are two things in the IASB's exposure draft that will drive this. The full liability will appear on the balance sheet with no deferral mechanisms, while the sensitivity disclosures should serve to highlight the degree of exposure to interest rate risk that a corporate has through its DB provision."