Opening the black box
Written by Ijeoma Ndukwe
Ijeoma Ndukwe looks into what consequences the revised IAS19 will have on different countries
“From pensions ‘black box’ to financial reality” is how AEGON Global Pensions describes the changes to IAS19. Although many see the benefits of greater transparency in pensions’ risk reporting, the revisions could prove costly for many European companies with the impact varying between countries. Despite the concerns for the implications of these revisions, most companies are making preparations for these widely anticipated accounting changes.
An immediate recognition of losses and gains, eliminating the ‘corridor option’ is one of the changes outlined by the International Accounting Standard Board (IASB). According to Aries Pension & Insurance Systems director Ian Neale, the inability to spread gains and losses could prove problematic. “Where this has been used in the past, the first accounts based on the new IAS19 could show a very different picture, hence a challenge in presentation” he says. However, the National Association of Pension Funds (NAPF) says this will not involve major changes in the UK, where they say few companies make use of the ‘corridor option’.
The NAPF argues that there will be an improvement in presentation in the income statement. Theyhighlight the importance of "re-measurements being taken out of profit and loss and moved to other comprehensive income”, which they say will remove much of the pension scheme’s market-driven volatility from the profit and loss account. Furthermore, the revisions will involve an adoption of a ‘net interest’ approach to pension income and expense. NAPF policy adviser in Investment Regulation and Funding Julian Le Fanu explains that “this amendment covers the treatment in the employer’s accounts of earnings from the pension scheme assets and the finance cost of its pensions liability, and will prevent companies from booking a profit from the pension scheme when the scheme is in deficit”.
Many acknowledge the benefits of the revisions in terms of improving transparency and investor confidence in the long term. However, there are concerns about the costs associated with the changes to IAS19. Mercer partner Deborah Cooper says the effect will be felt most in countries “where there are material liabilities or multinationals with exposure to their subsidiaries’ large defined benefit schemes”. She says, however, “defined benefit pension schemes are uncommon in many European countries, so some local companies might not be affected at all by the revisions”.
According to a May 2012 Mercer press statement the removal of the expected return on assets is likely to prompt companies to shift their focus towards their choice of discount rate. However, “the discount rate prescribed by IAS19 is driven by yields on high quality corporate bonds but in most European countries the market for these has come under considerable pressure recently due to the sovereign debt crises”.
According to this press statement, the countries most affected will include the UK, Switzerland, Germany, the Netherlands and Sweden. For example, in Germany employees are often offered enrolment into ‘Altersteilzeit’ (ATZ) plans by their employer as they reach the end of their careers. This scheme offers the employee a certain level of supplementary income should they be made redundant, asked to work part-time or go into early retirement. Whereas before, these payments would have been classified as one off redundancy payments, the new IAS19 now classifies them as early retirement plans. According to the press release, “this means that the liability has to be recognised as it accrues, and will remain on the balance sheet until payments are no longer made. This will affect the company’s P&L as well as its balance sheet, providing clearer information to investors about how employees are remunerated”.
In addition, Neale discusses how some European countries have facilitated adoption of risk-sharing approaches. He explains that the form varies as, if provision costs go up for example, some allow contributions to be increased, where others permit benefit reductions.
Cooper discusses the problems new accounting standards pose. “Not everything is crystal clear [therefore] auditors have to reach some consensus about the range of sensible interpretations.” She says that it is important for firms to have some understanding of how key performance indicators are affected by the change, and that companies should determine whether any company policies such as borrowing or remuneration need to change as a result. She also mentions the importance of putting risk management strategies in place.
Furthermore, she talks through the significance of understanding some of the more technical aspects of the change. “Where the effect might differ from country to country because of local practice - for example, the treatment of administration expenses might have to change, the items to include in the calculation of the net interest cost are not entirely clear, the definition of termination benefits has been narrowed (this is particularly an issue for German employers), so some schemes previously recognised as such must now be treated in accounts as pension schemes.”
According to a 2011 paper published by Aegon Global Pensions on how companies will adapt to the new accounting standards, UK and US pension funds naturally tend to have greater equity components, with higher rates of returns than their mainland European counterparts. They say this will have to be managed more closely with the IAS19 revisions as this will increase volatility but not necessarily reported returns. They speculate that the changes could prompt plan sponsors “to revisit the risk/reward trade-offs of investing in equities or other risky investments that are expected to generate higher returns”. Alternatively, they argue “some plan sponsors may decide to modify their investment strategy to reduce risk, since they will lose the corresponding reward of the lower pension expense generated by the higher expected rate of return”.
Schroders UK strategic solutions Jonathan Smith says trustees and company sponsors should consider a risk management plan to ensure they take the right risks at the right time. “Pension schemes need to understand where the risks lie, the extent to which these risks are likely to be rewarded and which risk management tools are available… We expect pension schemes to continue to explore techniques such as LDI and flight path solutions to manage their investment risks over time.” He explains how a flight path can be implemented “where the fund manager tracks the scheme’s funding level and market conditions on a daily basis, and uses ‘trigger points’ to reduce asset and liability risks over time”.
He continues: “We also expect schemes to continue the trend of asset diversification and to begin to explore newer risk management techniques. For example, we are seeing a number of schemes looking to use derivatives to explicitly manage downside equity risk.”
The changes will bring significant costs to firms according to a report by PricewaterhouseCoopers (PwC) on the IAS19 amendments. There could be a potential £10 billion hit to reported profits across corporate UK. There are also concerns about an increase in balance sheet volatility, which PwC says could result in difficulties for banks and insurers with their capital provision. However, the long-term benefits of improved transparency and the confidence which will follow have been acknowledged by the community of pension investors who have been preparing for these changes.
Cooper says: “Although the revised standard does not apply until fiscal years starting 1 January 2013, getting appropriate policies in place is likely to take time. Companies need to determine first whether their pension scheme disclosures are likely to become sufficiently material that investors will be concerned about them, and then consider what steps they need to take to address the most significant issues.”
Written by Ijeoma Ndukwe, a freelance journalist