The following article appeared in the September 2005 issue of Defined Benefit Monitor
By: Rock Lefebvre & Amar Goomar
One of the biggest challenges facing Deficit Benefit pension plans is the accounting rules. Rock Lefebvre and Amar Goomar, of the Certified General Accountants Association of Canada, discuss one aspect, accounting for expected return on plan assets.
Over the last three years, the deficit problem with Defined Benefit plans has received significant coverage in the press throughout the world. Based on the study published by the Certified General Accountants Association of Canada, at the end of 2003 there was a deficit of $160 billion in Canada 1. By the end of 2004, the situation had worsened by $30 billion, bringing the deficit to $190 billion.
Considering these statistics, it is surprising that not much has been written about the challenges posed by current accounting practices. This article discusses one of the accounting concepts and its impact on the financial statements of a company: the expected return on plan assets. This concept is of particular interest because projecting expected return on plan assets has attracted much criticism in recent years and accounting standards-setting bodies in major countries have been examining the means to alleviate this and other accounting challenges.
Current accounting rules in Canada provide that reported pension expense is represented as the aggregate of six components. In short, their interaction in arriving at a pension expense figure is represented by the pension expense/cost equation.
From this equation, we can observe that the expected return on plan assets value is a negative cost item, that is, it results in income. It is based on an expected long-term rate of return on fair value or market-related value or smoothed value of plan assets rather than on the actual rate of return.
Basically, a company selects at the beginning of a period the rate of return it expects to earn on its plan assets in this period and records this expected return as income, regardless of the actual return on plan assets in the period. The company is, in effect, booking a budgeted figure with no requirement to adjust it in the current reporting period even if the experience differs from the budgeted figure.
Since the expected return on plan assets results in income, companies are encouraged to use as high a number as might seem reasonable.
According to a Mercer Human Resource Consulting survey, the expected rate of return on plan assets used by Canadian companies for the fiscal year ending in 2003 varied from six per cent to 9.5 per cent. Chart 1 shows a distribution of these rates for 2000 and compares the rates with 2003.
It shows that in 2000 and 2003 about 90 per cent of the companies used an expected rate of return of between seven per cent and nine per cent.
With respect to actual rate of return, in year 2003, the average pension fund generated 14 per cent, which was eroded by a strong Canadian dollar exchange rate in U.S.-denominated investments and a fall in the long-term rate of interest by about 40 basis points. In 2004, an average pension fund generated 9.5 per cent, but long-term interest rates fell by 25 basis points, offsetting most of the gain. The net result is that the percentage of pension funds in deficit remained relatively constant, that is, 57 per cent in 2003 and 59 per cent in 2004.
Actuarial Gain/Loss On Plan Assets
The difference between the expected return and the actual return on plan assets is called the actuarial gain/loss on plan assets 3.
Under current accounting rules, the allocation of actuarial gain/loss on plan assets can be spread over several years, that is, amortized over the average remaining service periods, effectively keeping them off-balance sheet for a long time. Therefore, it impacts the company’s profit only gradually over time.
A study performed by National Bank Financial 4 of 79 Canadian companies, representing around 80 per cent of the S&P/TSX market capitalization, showed that at the end of 2002, off-balance sheet pension liabilities amounted to $21 billion.
These accumulated losses represent, unless reversed by future-experience gains, the potential charge to future profits of the companies. For these companies, a sudden increase in the value of the plan liabilities or a sudden decrease in the value of the plan assets could seriously affect profit measures or balance sheet health and, therefore, affect equity valuations, debt covenants, and credit ratings.
Does this shifting of costs to future years arising from amortization really impact the expenses as a percentage of the payroll?
Let’s illustrate the issue by comparing two hypothetical companies sponsoring identical pension plans with identical investment policies.
Chart 2 shows the pension expense as a percentage of the payroll over a 25-year period for two companies. Company A is using an expected rate of return on plan assets of 6.5 per cent per annum, while Company B is more optimistic and uses a rate of 7.5 per cent. Let us assume that Company A is right and that the actual return over the 25-year period is 6.5 per cent per annum.
The chart clearly shows that Company A – which selected a more realistic rate of return – is penalized with the recognition of a higher pension expense than Company B over the 25-year period. Higher pension expense means lower profits and lower profits generally equates to a lower stock price. Is this an accurate representation of the respective company values? Probably not.
But how would the picture look if Company B was right and investment returns over the 25-year period were 7.5 per cent per annum? Chart 3 shows the pension expense as a percentage of the payroll under this scenario. Again, Company A will have reported a much higher pension expense over the 25-year period than Company B.
The conclusion to be drawn is that allowing management to predict future investment returns creates a serious lack of comparability between the financial statements of different companies within the same industry group.
In some of the major countries/jurisdictions, what are accounting standards-setting bodies doing about this disparity?
The standards-setting bodies in some of the major countries/jurisdictions are taking measures to minimize the challenges of accounting. For example, the Accounting Standards Board (AcSB) in Canada and the Financial Accounting Standards Board (FASB) in the U.S. decided in 2003 to require additional disclosures about these pension costs in the notes to the financial statements. The objective is to increase transparency and to provide more information for readers to assess the risks related to plan assets and liabilities as well as future cash requirements.
The UK Financial Reporting Standard (FRS) 17, which came into force in 2005, requires companies to recognize in full such gains and losses in the year in which they occur. The International Accounting Standards Board (IASB) is proposing to align its International Financial Reporting Standards (IFRS) for pension accounting more closely with the UK’s standards. Presently, the IASB proposal is on hold until such time as a tentative joint project with the FASB to harmonize pension accounting rules has been concluded.
In other words, the approach favoured by the UK and IASB will have a significant impact on the way pension costs are measured and recognized on companies’ financial statements as well as on the continued existence of DB pension plans.
What, if any, would be the potential impact of the adoption of FRS 17?
FRS 17 will have a significant impact on the way pension costs are measured and recognized. For example:
- It will make financial statements more transparent by depicting the real picture.
- It will result in more meaningful balance sheets, as the asset or liability recorded on the balance sheet will actually represent the value of the pension plan for the company (generally equal to the plan surplus or deficit).
- It will make pension costs much more volatile (unless 100 per cent of assets are invested in fixed income securities to immunize against changes in liabilities resulting from changes in interest rates), as actuarial gains and losses will be fully recognized as they occur. Investors will have to understand the source of the volatility in order to make appropriate assessments of companies.
- It could conceivably encourage plan sponsors to close or modify their DB pension plans as experienced in the UK.
What can we take away from all this?
Overall Best Way
At the heart of the accounting and reporting dilemma is the question of fair and accurate representation. Tied to this, is the question of the audiences making use of the reported information. Naturally, not everyone is equally served by alternative accounting treatments. But, ignoring the divergence of information preferences, we should look at the overall best way to report results on the premise that accuracy is the optimal outcome.
Thus, the real question is: what represents accuracy to readers of financial statements? Obviously, the jury is out and the reason is as follows. Mark-to-market promotes the utilization of actual or real financial market performance measurement, whereas the current actuarial and accounting landscape looks to amortize occurring results over the longer term. Reasonably, the argument can be made that the long-term characteristics of a pension plan are such that long-term matching is the most appropriate approach. Each method has merit, but the utilization of expected yields and associated deferral mechanisms better respond to the fundamentals and constructs of accounting. It is important to acknowledge that the accounting profession has been grappling with this issue for some time and has certainly not chosen to willingly mislead users of financial statements. Rather, it is a fundamental limitation which surfaces when taken in a broader societal context. Inadvertently, the significant market losses of 2001 and 2002 and the increased order of magnitude (on an absolute basis and as a function of total assets) of pension plans have served to underscore those limitations.
Rock Lefebvre is vice-president, research and standards, and Amar Goomar is senior analyst, research and standards, for the Certified General Accountants Association of Canada ( firstname.lastname@example.org email@example.com).
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CGA-Canada | Last Updated: 2005-11-28