Top of the league
Almost every month, IPE publishes a table, Major Euro groups: personnel costs showing, in the last column, the cost of company pensions in percent of wages. More often than not, German and Swedish companies top the league, in cost terms, at least. Are the company pension benefits in these countries so much more generous than elsewhere? Are they being reported consistently in their financial statement? The answer to both questions is: NO! Then what, if any, is the issue, you might ask? Well, companies financing their pensions by book reserves generally, but not always, report their pension cost in their financial statements - and hence the tables published by IPE including interest cost, which is really a financial cost and not a component of wages. Funded plans on the other hand, offset the interest cost by investment earnings.
In the process leading up to the en-dorsement of IAS 19 (the new International Accounting Standard on em-ployee benefits) in 1998, the IAA (International Actuarial Association) submitted a proposal to the IASC (International Accounting Standards Committee) explaining that the current practice of reporting these financial items differently for funded and book reserved plans was not in keeping with the most basic accounting concept of achieving comparability between financial statements.
Thankfully, the IASC accepted this view and included a provision in IAS 19.119 under which an employer can report pension cost excluding financial items in wage cost and move the financial items into financing cost.
Incidentally, the classification of in-terest cost and return on plan assets as financial rather than wage cost is also shared, in principle at least, by the Fi-nancial Accounting Standards Board. Under Section 16 of SFAS 87 it is stated: Both the return on plan assets and interest cost components are in substance financial items rather than employee compensation costs."
Returning now to the issue: In essence, past practice is to report as employee benefit expense p for funded plans: both the interest cost and the (offsetting) return on segregated assets.
p for book reserved plans: only the interest cost without any offsetting item representing the return on internal assets held and corresponding to the level of Unfunded Accrued Pension Cost recognised for employee benefit obligations.
Now this leads to significant distortions when comparing financial statements with respect to employee benefit costs.
The following simple example will clarify the point. Suppose that three identical enterprises, called A, B and C, are all located in the same country with exactly the same retirement plan and with identically structures populations of active beneficiaries. Suppose too, that the plan of enterprise A is 100% funded on a given actuarial valuation basis, the plan of enterprise B is 200% funded on the same basis and the plan of enterprise C is book reserved. Then, using the abbreviation PBO to denote the actuarial present value of the ac-crued retirement obligations, usual current practice of calculating annual employee benefit expense for the three companies is as Table 1.
This leads to the conclusion that, de-pending on the level of funding, the same retirement plan cost is three times as much as at C than at A and that B even produces a negative cost, ie an income.
Now one could argue that this result does indeed make sense, on the grounds that the funding pace chosen by B in the past has been so prudent, that earnings on the assets invested outside of the company is now financing the plan, for the time being, at least. C has not funded for the benefits at all and has thus no outside income on assets to offset against the interest cost.
This, however, is a narrow view of the issue. There are indeed assets underlying the retirement plan liabilities of C. Earmarked or not, they are included within the general assets of the company. And C is earning a return on these assets, thereby correspondingly reducing capital costs that A and B would have had but accounted for under interest cost in the past.
Comparability in pension cost can only, I think, be achieved by excluding financial items from pension cost.
Past practice has typically been to re-port pension cost under book reserved plans including interest cost. Table 2 shows that some companies are in-deed already reporting pension cost net of interest cost.
So what is the conclusion? The conclusion is that the notes to the ac-counts should be read carefully when assessing pension cost in Germany (presumably in Sweden too). Also, I would hope that the German companies will report such cost consistently in future. IAS 19 has given this a welcome added impetus. Alf Gohdes is a partner with Watson Wyatt in Munich."