Risk vs. Riches – can accounting standards change pension plans?

HOT OFF the press, the International Accounting Standards Board’s newly revised IAS 19 Employee Benefits has significant implications for those pension schemes that have recently graced the press due to widespread public sector strikes.

A number of changes have been made to render pension schemes more transparent and comparable: chief among these is the requirement for the schemes’ asset returns to be measured as if they were corporate bond yields, otherwise known as the AA-discount rate. These assets offer lower returns than high-risk investments such as equities but are considered more secure.

Formerly, companies predicted their asset returns, meaning those with high-risk-high-return investments could set their profit expectation relatively high. Under IAS 19 they are obliged to record their asset return as if investments were AA-discount rated bonds, irrespective of actual assets held. For this reason, some experts are predicting wholesale moves to de-risk pension schemes.

KPMG said that, as a result of the standard, as much as £10bn profit could be wiped off UK pension schemes. Many experts have been focusing on this loss of earnings for risk-taking plans, though scheme provider PensionsFirst said that, for some, the new accounting standard could make earnings appear healthier.

Assistant vice-president Matthew Furniss said schemes that have invested heavily in lower-risk assets such as gilts will see profits rise thanks to IAS 19 changes. This is because the ‘safe’ assets are generally not expected to give the same returns as top-rated corporate bonds (equivalent to the AA discount rate); under the current expected return system, such schemes would offer muted earnings, though this will change when the new standard comes into force.

So will all pension schemes shift to a lower-risk investment plan? Furniss said this is a possibility, suggesting at the very least that the changes will “encourage companies to re-examine their investment strategy”.

Swings and roundabouts

PensionsFirst research indicates that as many as 10% of FTSE 100 companies could find their pension scheme earnings plumped up by IAS 19. At the same time, post-crunch companies are under pressure to show sound investment policies and stakeholders are desperate to rebuild faith in ailing pension plans.

These factors, combined with the removal of the incentive to make high-risk investments (because assets can only be recorded at the AA-discount rate), mean schemes could turn their backs on risky investment plans.

However, experts were unanimous in saying the changes stemming from IAS 19 will have little impact on how companies are viewed. Although there might be some initial loss of profit – especially for companies with high-risk assets – there is no underlying change in schemes’ assets and liabilities and well-informed investors should know this.

The removal of the current expected return on scheme assets income statement credit – which will be replaced with interest on the scheme assets at the AA-rated discount rate – from company accounts will leave balance sheets unaffected, yet it is in the profit and loss accounts where the new standard’s impact will be felt.

For this reason, Furniss claimed, companies will be “aware of the implications of the new standard”, even if they are not immediately inspired to swap equities for gilts.

Warren Singer, a principal in Mercer’s Global Accounting Standards Group, went one step further, saying that because high-risk pension plan investments will no longer directly lead to stronger reported company profits, “this accounting change is likely to encourage better risk management from pension plan sponsors”.

There are signs that pension schemes are eyeing up lower-risk assets: Xafinity recently boasted that its liabilities are holding firm thanks to de-risking, while more secure investment plans no longer attract the same derision they once did.

It remains to be seen if – once the initial shock of ostensibly weaker profits has worn off – companies will be persuaded to shift away from low-risk assets. They will no longer benefit from stronger reported profits thanks to riskier investments, yet the potential pay-off of making such investments remains and it might take more than a revised accounting standard to effect real change.

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Fiona Westwood of Smith and Williamson.