The big shake-up
"One thing that the International Accounting Standards Board's project could achieve is that it might give people an idea of how much their pension provision actually costs," says Tim Reay, a principal with Hewitt Associates' international benefits group.
More precisely, the project in question is the London-based accounting standard setter's revisiting of its pensions and employment benefits accounting standard, International Accounting Standard 19 (IAS19).
In line with a staff proposal, board members opted to conduct the project in two phases. First, in the relatively short-term phase I, the board has said it will consider issues that it believes it can confidently address within a four-year timeframe. A more fundamental root and branch reappraisal of IAS 19 is in store for phase II.
The phase I work, covering presentation and disclosure, the definition of "defined benefit" and "defined contribution", cash-balance plans, smoothing and deferral mechanisms, plus the treatment of settlements and curtailments, is expected to produce an interim pensions accounting standard by 2010. During their July deliberations, the board acknowledged that cash-balance plans, and the proposed work on definitions, were both areas that could present substantial hurdles to progress.
Tim Reay broadly endorses the board's two-phase approach: "There was very much a sense of doing something that is practical during phase I of the project," he says. "The full solution of option pricing is quite difficult to achieve, so the board has focused on coming up with something that is realistic. In any case, there has been quite a big shift to purely defined-contribution plans."
By May, the project will, in effect, have been under way for the best part of a year. The latest IASB project summary explains that a due process discussion paper is expected "towards the end of 2007".
A final Phase I interim accounting standard is slated for 2010. Another key point to note is that although the project represents a major upheaval in the way that companies account for occupational pension provision, the even bigger picture is that the project forms part of a much wider convergence effort with the US Financial Accounting Standards Board (see box on page 28).
IASB due process - how the board runs its standard-setting projects - follows a six-step procedure: agenda setting, project planning, publication of a discussion paper, publication of an exposure draft, development and publication of an accounting standard, and finally post-issue processes. Significantly, IASB has opted to issue a due-process discussion paper on pensions accounting.
The IASB announced the composition of its IAS19 work group on 16 March this year. Membership of the group is drawn from among actuaries, auditors, preparers and users of financial statements, as well as regulators.
The board did not resume its discussions of pensions accounting until its November board meeting, where members tentatively decided to opt for immediate recognition of actuarial gains and losses, and unvested past service costs.
In what really amounted to a house-keeping session for future decision making, the board instructed staff to develop alternative proposals to address presentation issues - essentially how the actuarial gains and losses should appear in an entity's profit and loss account. Glancing back over the board's more recent decisions, particularly on the issue of presentation, this point marks the genesis of the board's subsequent consideration of a SORIE-type presentation.
The twin problem children of cash balance plans and definitions hung over the board's December meeting. First, board members considered three possible approaches to accounting for cash balance plans: the so-called IFRIC D9 approach, an embedded derivative approach, and a deconstruction approach.
On the linked issue of definitions, the board also asked staff to revisit the definitions of "defined benefit" and "defined contribution", so that contribution-backed plans, as well as asset-backed plans, receive different accounting treatment.
The board resumed it deliberations on post-employment benefits in February, as staff presented a draft section of the upcoming discussion paper summarising the board's tentative decisions on recognition and presentation.
he brief summary of the board's current view - with a heavy caveat around the notion of ‘current' - is that all changes in benefit obligations and in the value of plan assets should be recognised in profit or loss. The board agreed, however, that the discussion document will feature alternative presentations.
In fact the board's decisions to date are what is known in the context of IASB due process as tentative decisions. The current body of tentative decision making will eventually figure as a series of board positions and discussion alternatives - all on an entirely non-binding basis - in the upcoming due process discussion paper. It is feasible that the board's view will change yet again ahead of any vote to issue the discussion document later this year. In short, the whole point of the IASB's discussions to date has been to work towards agreeing the content of the due process paper. The discussions so far are in no way part of the deliberations to come on the content of the phase I pensions standard.
Before considering any alternative presentations, however, the board changed tack in March, preferring instead for entities to report changes in the value of plan assets and benefit obligations in comprehensive income.
Furthermore, they argued, the due process document will offer no board preliminary view on presentation. Although some IASB members such as Mary Barth preferred the option of reporting all changes in profit or loss, the board will also give consideration to the twin options of presenting either financing costs or remeasurement changes outside profit or loss.
The move from presenting changes in the value of plan assets and benefit obligations in profit or loss to comprehensive income is "quite a significant difference", explains Ken Wild, Deloitte's global head of International Financial Reporting. "What people need to watch here is the tie-in with the financial statement presentation project and the decisions that the board makes here," he says. "We haven't yet finalised presentational issues, but what we do know at the moment is that the move from profit or loss to comprehensive income could mean that pension costs are spun off into a separate statement, away from the main income statement, such as a SORIE or son-of-SORIE".
Against the backdrop of a discussion on cash balance plans, the board also considered three categories of post-employment benefit plan:
❏ defined-contribution promises, which the board's expects sponsors to account for in the same way as they do at present under IAS 19;
❏ asset-based promises, which companies will measure at fair value, such as plans where the value of the promise changes relative to movements in an asset or index - excluding assets or indices that deliver a fixed yield; and
❏ defined-benefit promises, again accounted for under current IAS 19.
The board tentatively decided that sponsors should account for benefit promises featuring fixed increases as asset-based promises, not as defined-contribution promises. Crucially at their 17 April meeting, the board revisited this conclusion when presented with the implications, chief among them being the challenge of drawing a conceptually sound line between asset-backed and defined-benefit plans offering broadly the same benefit promise.
The early, tentative conclusion from the current state of in-flux board thinking - again, note the caveats - is that a plan offering a variable rate of return will in all likelihood avoid the defined-benefit classification, and with it the need to fall into projected unit credit accounting. As IASB member Tricia O'Malley put it, the issue is this: "what kind of guarantee can you write that will not slip into a defined-benefit scheme?"
It is in the IASB's own interests to avoid drawing an arbitrary bright line. If it treats fixed-increase plans as asset based, IASB must then figure out how to demarcate current-salary benefits and some average-salary benefits on the one hand, from final-salary benefits and other average-salary benefits on the other.
Cash-balance plans are particularly problematic from an accounting standpoint. In fact, the term ‘cash balance' fails to capture the sheer variety of plan provision offered by plan sponsors at present around the world. Accordingly, IASB has dropped the term in favour of the more encompassing "intermediate risk plans".
The twin endpoints of IAS 19 - defined benefit plans and defined contribution plans - are more or less adequately catered for by the current IAS 19 model. But the range of plan design between these two endpoints, which has arisen as plan sponsors have sought to pass risk from the plan sponsor to the employee, does not mesh perfectly with this binary ‘either-or' choice, And so it follows that as hybrid schemes have developed, built around an element of risk transfer, an accounting disconnect has also developed around those plans that are neither defined benefit nor defined contribution.
There is a surprising range of plan designs among European countries. Belgian final salary lump-sum plans and cash balance plans invoke a modest process of risk transfer from the employer to the employee, while Swiss defined-contribution plans achieve a greater degree of risk transfer - albeit with an employer-provided investment and annuity-rate guarantee.
Examining the Swiss Pensionskassen in more detail, the defined-benefit component is the option price attached to the investment guarantee, or the value of the guarantee. It is the accounting for the value of this option component that Tim Reay believes the IASB has found to be quite a challenge.
The process of risk transfer ultimately comes back to the same endpoint: somebody loses out in the event of an adverse movement in a measurement parameter such as a movement in an equity index, or improvements in life expectancy.
Depending upon the risk allocation under a particular plan, risk can be carried by an employer, the employee or a third-party insurer. Risk is not, however, confined to defined-benefit plans. Under the Swiss defined-contribution model, a scenario which also applies in Belgium, a plan features an investment guarantee.
The IASB must figure out who accounts for the guarantee component and how. Where the plan's risk element is carried by the employer, the employer will account for the risk as a defined-benefit obligation; however, where the risk is carried by a third party, such as an insurer, that risk is a defined-contribution obligation.
Of most interest, however, is the Dutch paradigm, where the trend in recent years has been towards career-average plans. In response to the immediate recognition of plan deficits under International Financial Reporting Standards, Dutch sponsors brought in so-called collective DC plans.
Given the awareness among Dutch employers that they are under no obligation to provide a defined-benefit type provision, the development to watch will be how Dutch plan sponsors respond to both Phase I and Phase II of the IASB project.
Says Tim Reay: "The chance is that employers in these countries will shift towards even purer defined-contribution provision. In order for Dutch plan sponsors to continue to provide their current flavour of intermediate-risk plans, those plans must be accounted for as pure defined contribution or they simply won't continue to be provided."
lthough the debate around pensions accounting has often expressed itself in terms of ‘what the IASB has done to defined-benefit pension provision', an alternative view, says Tim Reay, is that the IASB and its pensions project is to a certain extent irrelevant - certainly if you are Dutch. With Dutch employers fixed on the goal of defined-contribution accounting, if they find themselves unable to get to that destination, they will simply revisit the nature of their provision.
Not that his remarks should be read as a green light for companies to ditch defined-benefit provision for defined-contribution: "If you know what your pension provision costs," he says, "you can reach an informed decision. Defined-contribution plans are not necessarily cheaper than defined-benefit plans. They might actually prove to be a more expensive route to providing the same benefits. Not only do you have less flexibility on investment decisions, the administrations costs are also higher."
In terms of where the impact of the IASB's pension accounting project might be most keenly felt, Tim Reay expects the impact of the IASB's Phase I project to have less impact in the UK than on mainland Europe: "There is a a split between the British and plan sponsors in continental Europe, where the trend has been towards amortisation. The SORIE approach is quite good as long as the balance sheet is strong.
"Generally speaking, I think that pensions are less of a balance sheet issue for companies in mainland Europe, because most companies have the majority of their employees in their home state and pension liabilities per head are particularly high in the UK."
An advantage of the SORIE approach - one of the options to figure in the IASB's forthcoming discussion paper - is that it produces a more stable figure in the income statement. This is because there is no amortisation, with gains and loses going into the SORIE. In turn, analysts can focus on an entity's ongoing profitability.
Irrespective of the presentation, Bill Robinson, a former special adviser to the UK chancellor of the exchequer and now head of economics with KPMG, says that companies must approach the information that they put into their financial statements carefully.
"My caution is that companies should be very careful before we rush to plug these deficits," he says. "There is a danger that companies might put in more money than they can afford. My other worry concerns the move into bonds, which seems to me to be putting presentation ahead of a common sense investment policy."
It is also important, he adds, to remember that a snapshot is just that: "You don't want to look at a single year and then embark on a policy of pension fund top-up. I don't think we've yet come up with the best way of dealing with these numbers."
And as Robinson points out, there there are not only accounting and reporting requirements but there policy considerations too: "I strongly believe that in any difficult issue you need to look at it from as many different perspectives as you can muster. The FRS 17 [pensions accounting standard] or IAS 19 deficit is an important measure, but so too is the actuarial deficit."
"The actuarial deficit is usually based around taking some credit for equity outperformance," he continues. "It is typically smaller than the FRS 17/1AS 19 deficit, which is discounted using a double-AA bond rate. A lot of smaller schemes have their focus on a buyout deficit, meaning that they use a discount rate of gilts-minus-half, which produces large deficits.
"Then there is also [the Pension Protection Fund] deficit, meaning that plans sponsors now need to know if they have sufficient plan assets to match the benefits promised under the plan."
But whatever the IASB's expectations from its work on pensions accounting, it has no immediate plans to address how both sponsors and investors approach the information contained in financial statements.
Towards a common accounting standard
he work of the US Financial Accounting Standards Board (FASB) on pensions accounting, although to a certain extent now divergent from the IASB's IAS 19, will eventually align the two accounting regimes when both standard setters launch their joint Phase II project.
Phase I of the FASB's pensions project aims to introduce a quick-fix improvement addressing transparency. Statement 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans—an amendment of FASB Statements 87, 88, 106, and 132(R). Introduced at the end of last year, FAS 58 requires companies to report any pension plan surplus or deficit on the balance sheet, rather than as a footnote disclosure.
Any changes in a plan's annual surplus or deficit are reported in shareholder equity and in comprehensive income, but not in net income. Smoothing remains.
As soon as the IASB has completed its Phase I project, both boards will open their Phase II work. Assuming that the IASB completes its Phase I work on target by 2010, work on Phase II could be expected to last until 2013 or beyond.
Also relevant to the way companies account for their pension obligations is the joint FASB-IASB financial statement presentation project. The project addresses how entities report components of income and expense in a bid to improve transparency and comparability across entities for users of accounts.
The implication of this twin-project approach is that issues decided by the IASB in the presentation project, currently running in parallel with the IASB's Phase I work on pensions, will determine the outcome of Phase II of the joint pensions work - before it has even started.
The range of joint projects currently conducted by both boards falls under the auspices of their work towards converging their dual accounting standards. The immediate goal for the IASB is to achieve sufficient convergence so as to persuade the Securities and Exchange Commission to lift its requirement for companies reporting under International Financial Reporting Standards to reconcile their reporting back to US GAAP in certain key areas.
Following a joint meeting in September 2002, the FASB and the IASB issued their Norwalk Agreement in which they each acknowledged their "commitment to the development of high quality, compatible accounting standards that could be used for both domestic and cross-border financial reporting".
The boards also pledged to use their best efforts to "make their existing financial reporting standards fully compatible as soon as is practicable and...to co-ordinate their future work programmes to ensure that once achieved, compatibility is maintained".
At subsequent meetings in April and October of 2005, the boards reaffirmed their commitment to converging US GAAP and IFRS. The lifting of the so-called US GAAP reconciliation after 2008 by the SEC, the boards acknowledge, depends on, among other things, "the effective implementation of IFRSs in financial statements across companies and jurisdictions, and measurable progress in addressing priority issues on the IASB-FASB convergence programme".