Discount Rates: An exercise of judgement
A pension fund sponsor in Ecuador has raised an important point about IAS 19 discount rates, reports Stephen Bouvier
At a glance
• A company in Ecuador has sought guidance on net present value calculation of DB liabilities where the obligation is denominated in dollars.
• IAS19 requires sponsors to use a high quality corporate rate to discount liabilities, or failing that a government bond rate.
• A March 2017 update by IFRIC confirms current practice and an IFRIC committee notes that the discount rate is not meant to reflect the return on assets.
There is a drought in high-quality corporate bonds (HQCB) in some countries. Then there are more and more countries around the world using International Financial Reporting Standards (IFRSs). Throw in a dozen or so countries around the world, like Ecuador, that no longer have their own currency, and it was odds on that someone from that country would eventually ask the IFRS Interpretations Committee (IFRS IC) to unpick the Gordian Knot of discounting challenges thrown up by circumstance.
Put simply, the IFRS IC has received a request to explain how a defined benefit (DB) sponsor in Ecuador should figure out which discount rate to use in order to calculate the net present value of a DB obligation where the post-employment benefit obligation in question is denominated in US dollars. The question is especially teasing because Ecuador now uses the US dollar as its official currency following the collapse of the sucre.
The problem in Ecuador is that there is no deep market in HQCBs denominated in US dollars. So, the submitter asked, should it look to other markets or countries that issue US dollar denominated debt.
The submitter also asked a second question: can an entity use market yields on bonds denominated in US dollars issued by the Ecuadorian government, or should it use market yields on bonds denominated in US dollars issued by a government in another market or country?
Before considering the committee’s response, a detour through IAS 19’s requirements could pay dividends. Those requirements are set out in paragraphs 83 to 86. At their most basic, they tell preparers to discount using a HQCB rate, or, in the absence of such bonds, a government bond rate.
IAS 19’s discounting requirements are a compromise. The standard’s original authors needed a discount rate that would be less politically sensitive and controversial than a risk-free rate. The backstop in those less turbulent times was a government bond rate that few imagined anyone would ever need. Since then, however, IFRSs have gone global and illiquid markets with a corporate-bond drought are the new normal.
IAS 19 deals with the discounting objective in paragraph 84. The discount rate, it says, “reflects the time value of money but not the actuarial or investment risk”. Crucially, as we shall discover, it continues: “Furthermore, the discount rate does not reflect the entity-specific credit risk borne by the entity’s creditors, nor does it reflect the risk that future experience may differ from actuarial assumptions.”
Perhaps unsurprisingly, the committee’s draft decision in the March IFRIC Update bats the question back. Essentially, the committee has confirmed existing practice, albeit sprinkled with a reminder to exercise judgement. The official summary of the decision reads: “[T]he entity applies judgement to determine the appropriate population of high quality corporate bonds or government bonds to reference when determining the discount rate. The currency and term of the bonds must be consistent with the currency and estimated term of the post-employment benefit obligations.
“The discount rate does not reflect the entity-specific credit risk borne by the entity’s creditors, nor does it reflect the risk that future experience may differ from actuarial assumptions”
Paragraph 84, IAS 19
Indeed, committee member Bertrand Perrin said during the discussion: “Each time we had to assess a discount rate in Africa, whatever the currency, we always managed to find a solution.… So, I think what is proposed by the staff seems consistent with what we usually practiced in the past, even in [regions] where you sometimes don’t have a deep market in corporate bonds [or] even in government bonds.
“When you [have to come up with] a solution, you always find a way to do it and to find something that is mutually compatible with the rest of the assumptions you are using to value your defined-benefit obligations.”
If anything, the conclusion was predictable. First, there were sufficient experts around the table with enough real-world experience of compromise to tell others to do the same. Second, comments made by at least one senior staff member hinted at a marked reluctance to ‘go there’ and develop any sort of interpretation.
In fact, the real surprise to emerge from the meeting and the draft agenda decision is the bold clarity around the second question posed. This question invited the committee to examine whether following the IAS 19 approach to discounting leads to an inconsistency between the discount rate and the plan’s actuarial assumptions.
The submitter argued: “This is because the US market is significantly different from the Ecuadorian market. Therefore, such a US discount rate would be inconsistent and biased in relation to other actuarial assumptions that are based on the Ecuadorian economic reality.”
IFRS IC members thought not: “The committee noted that the discount rate does not reflect the expected return on plan assets. Paragraph BC130 of IAS 19 says that the measurement of the obligation should be independent of the measurement of any plan assets actually held by a plan.”
In its draft agenda decision, the committee notes that it “considered the interaction between the requirements in paragraphs 75 and 83 of IAS 19.” Paragraph 75 does indeed require actuarial assumptions to be mutually compatible. However, IFRS IC members concluded that it is impossible to assess whether, and to what extent, a discount rate derived by applying the requirements in paragraph 83 is compatible with other actuarial assumptions. The fallback, the committee reasoned, is to apply the requirements in paragraph 83 to determine the discount rate.
Perhaps the clearest analysis came from US committee member Bonnie Van Etten, an accountant with Fiat Chrysler Automobiles in the US who appears to work with two pretty sound in-house actuaries. She explains: “I had some conversations with both of our internal actuaries just to understand… how they would view this – not from an accountant’s point of view.
“And they firmly agreed with where the staff got to and the way that they explained it to me… was the level of benefits which are to be provided to the employee are based on the local economic assumptions and the discount rate is primarily for the purpose of determining the present value as of a point in time and that has to be based on the currency in which the liability will be paid.
“So, while intuitively, when I first read it, I thought, ‘Oh, they are not compatible’, as we’ve talked through what the purpose of the different assumptions are, and how they are used to value the liability, I think that helped me to understand the difference between paragraph 83 and paragraph 84 and to help me get my head around why this was the appropriate way to read IAS 19 and value the liability.”
It is likely that the committee will not budge from this recommendation. In 2012, the IFRS considered a similar issue in relation to the drought of high-quality corporate bonds amid the euro-zone crisis. The committee’s staff concluded: “We think that paragraphs 83-86 of IAS19 provide sufficient guidance for determining the discount rate.” They concluded that entities “should apply their judgement in determining a rate that complies with this guidance, taking into account the characteristics of their capital markets.” Does that sound at all familiar?