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Pensions Accounting: Spot the discount rate

When the US telecoms giant AT&T announced last year that it planned to discount the interest component of its defined-benefit (DB) pension liability using a spot rate, it unleashed a storm of interest among US listed companies. At a stroke, companies stand to wipe billions of dollars off their pension provision costs. 

But companies reporting under International Accounting Standard 19, Employee Benefits (IAS 19) can expect a more difficult conversation with their advisers, as they assess the pros and cons of the new approach. 

Broadly, AT&T has opted to use a spot rate for discounting its DB interest cost rather than using a single weighted-average discount rate. A 10-year spot rate, for example, is simply an average annual rate over a 10-year period

A 10-year forward rate is the rate earned between the end of year nine and the end of year 10. Both can be used to discount cash flow to the present date. And it is these fundamentals that are at the heart of the latest IAS 19 discounting debate.

There are sound reasons to adopt a more sophisticated approach to discounting, says Aon Hewitt actuary Simon Robinson. Indeed, this is precisely how practice under IAS 19 has developed in recent years (see panel). “Take a plan with one active member and one pensioner member,” he says.

“The correct discount for the active member might be 4%, while for the pensioner it is 3%. That is because yield curves typically have an upward slope – the longer a benefit is paid for, the higher the discount rate appropriate for that benefit. Over the last couple of years, UK discount rates have averaged between 3.5% and 4%.  This discount rate has been used for all parts of the accounting calculation. But now what practice is saying is that this approach is too simple.”

Meanwhile, the trend towards buy-ins by some DB sponsors has focused minds on the issue. “Full yield curve approaches can make a difference to the calculated costs on special events when companies take action to remove their pension risk,” says Lane Clark & Peacock consultant actuary Tim Marklew.

“In current conditions the more accurate yield curve approach will generally give a lower cost for a buy-in, and a greater credit to P&L [the profit and loss statement] from closing a scheme, which may be attractive to companies.”

And Simon Robinson notes there is clear support in IAS19 for this thinking. “A buy-in policy typically matches the benefits paid out to pensioners. Paragraph 105 of IAS 19 says that if you have a policy that matches some or all of the benefits under a plan, the value you place on the policy is equal to the matched benefits.”

Consultants are broadly agree that the spot-rate approach will most benefit those DB sponsors whose plans are either poorly funded or German plans using the so-called book reserve approach where there are no plan assets.

Eric Steedman, co-head of Towers Watson’s global accounting team, explains: “If you think about the IAS 19 net interest cost, we charge that on the net deficit. If that is zero, that is, if the plan is 100% funded, the net interest cost will come out at zero. Whether you do a granular calculation to get there or whether you do a traditional aggregate type of calculation, you would still get net interest of zero.

“Although the net interest for a fully funded plan would remain zero, the disclosed interest on liability and your disclosed interest on assets would change under a granular approach. But that is more of a disclosure or a decomposition point than a profit and loss impact.

“By extension, if a plan is well funded, but not 100%, the net interest cost will not be a very large number and therefore the effect on net interest of going granular may not be significant for a plan that is well funded.”

Meanwhile, staff at the US Securities and Exchange Commission (SEC) broadly endorse the spot-rate approach. SEC staff said it would not object to its application in place of a single weighted-average discount rate. “The SEC view has given a specific trigger for a lot of US GAAP [Generally Accepted Accounting Principles] preparers  to consider this issue,” says Steedman. “We haven’t had the same impetus under IFRS [International Financial Reporting Standards]. As a result, and also perhaps because the impact on net interest cost is much less significant for funded plans under IAS19 than under US GAAP, we have not seen the same opening of flood gates as we have across the pond.”

But will the new approach hold the same attraction for companies reporting under IFRS as it has in the US? “I don’t think everyone will want to apply the approach,” says Deborah Cooper, a partner at Mercer

“There are jurisdictions where the scheme is insufficiently material for the change to be worthwhile. There are going to be countries where there is an insufficiently deep market in bonds to be able to calculate the full yield curve.

“Where you have an upward sloping yield curve the interest cost is lower because a lot of your cash flows are in the next few years. It might be the case – and was between 2006 and 2008 in the UK – that the yield curve is downward sloping.  In that circumstance, you give yourself a higher interest cost.” 

But, Cooper notes, where as plan has an IAS 19 surplus, the net interest credit will be lower. So were companies, or trustees, to improve their pension scheme’s funding, the change might not be beneficial. “Again, in the UK, a lot of schemes are closed to future accrual,” adds Cooper. “This means there is no service cost so there is less potential benefit from using the full yield curve.”

Approaches to discounting

When introduced in 2005, the typical way of deriving the IAS 19 discount rate was to look at the yield on the iBOXX cash bond indices and apply that. Then practitioners began to argue that the standard requires the matching of the duration of the pension liability and the discount rate. 

A further evolution was to match the pension liability’s future cash flows and the yield curve to give a more precise answer. From there it has become reasonably common for consultants to investigate using a different discount rate for any buy-in policy and the service cost. 

A proposal from Mercer in late 2013 for defined benefit sponsors to calculate their profit or loss charge on the basis of a one-year forward rate found little support among advisers and auditors.

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