Pensioning off SSAP 24

Pensioning off SSAP 24

The ASB's Exposure Draft on employee benefits has stirred upunprecedented interest. Peter Clark reports.

Put accounting standards and pensions together and you’ve got a double strength remedy for insomnia. Yet over 30 British companies and a dozen other UK organisations took the trouble to comment on the IASC’s Exposure Draft E54: Employee Benefits.

This unprecedented response (over a third of the submissions received) not only endorses the IASC as a major force in standard setting. It also reflects some major differences between the international committee’s proposals for amending SSAP 24: Accounting for Pension Costs, and those of the Accounting Standards Board in its discussion paper Pension Costs in the Employer’s Financial Statements (June 1995).

The Exposure Draft deals with all employee benefits but it is three aspects of the IASC’s proposals on pension costs that have drawn almost universal criticism from UK respondents.

These are that pension liabilities should be measured on a market basis rather than on SSAP 24’s traditional actuarial basis; actuarial gains and losses should be recognised immediately to the extent that they fall outside a 10% ‘corridor’; and pension liabilities should be discounted at a rate that does not reflect the risks inherent in such liabilities.

Many UK critics argue these features of E54 would lead to misleading information in company accounts, damaging changes in pension scheme investment policy and to further pressure on employers to abandon final salary pensions schemes.

Market-based measurement

Under SSAP 24, pension liabilities are determined on an actuarial basis.

This means basing the discount rate used to determine pension liabilities on the actuary’s estimate of the long-term trend of interest rates. The scheme’s assets are measured by discounting the actuary’s estimates of the cash flows from a portfolio of appropriate assets. Most UK respondents support this as the best way to deal with long-term pension liabilities.

E54 proposes a different approach, based on market values. The discount rates are then based on the interest rates ruling at the balance sheet date for a liability with the same term as the pension liability. And the assets are measured at market value.

The IASC board believes that efficient prices in a market of sufficient liquidity incorporate all publicly available information. There is no rational basis for expecting them to drift towards any assumed long-term average. In particular, there is no reason to think an estimate by an actuary – or anyone else – is a more reliable predictor of long-term trends in interest rates than the consensus estimates embodied in efficient market prices.

Actuarial gains and losses – the 10% ‘corridor’

One of the IASC’s most innovative proposals is the ‘corridor’ approach to actuarial gains and losses. These comprise experience adjustments and the effects of changes in actuarial assumptions and may arise from both the underlying pension liability and changes in the market of the scheme’s assets.

E54 proposes that actuarial gains and losses should be recognised immediately to the extent that they fall outside a ‘corridor’: where the cumulative unrecognised amount exceeds 10% of the (gross) obligation or, if higher, 10% of the fair value of the scheme assets, immediate recognition is required of the excess. Actuarial gains and losses within the ‘corridor’ are ignored.

The justification for the corridor is that estimates of pension liabilities are best viewed as a range around the best estimate. As long as any new best estimate of the liability stays within the original range, it would be difficult to say the liability has really changed. However, it is reasonable to do so once the new best estimate moves outside the original range.

Like SSAP 24, the IASC’s current standard (IAS 19: Retirement Benefit Costs) requires a different approach: actuarial gains and losses are recognised on a deferred basis, normally over the expected remaining working life of the employees concerned. Those who support amortisation argue it would be misleading to recognise actuarial gains and losses which may reverse in later years. However, this seems to amount to an unstated, and unsupported, assumption that they will reverse.

Discount rate

One of the most controversial questions is whether the discount rate should reflect risk, as favoured in traditional funding practices in countries such as the UK.

The leading contender for a risk-adjusted rate is the expected return on an appropriate portfolio of assets that would provide an effective long-term hedge against the benefit obligation. An appropriate portfolio for benefit obligations linked to final pay might comprise mainly equity securities. The portfolio actually held need not necessarily be an appropriate portfolio in this sense. Indeed, it is clear that the discount rate should not reflect the assets actually held by a scheme because the fact that a scheme invests in say, junk bonds, does not make the liability any smaller.

E54 proposes the use of a rate that is not adjusted for risk, namely the yield on high-quality, fixed-rate corporate bonds with a maturity consistent with the expected maturity of the obligations. In countries where there is no deep market in such bonds, the yield on government bonds should be used. Because this rate ignores the long-term correlation between salaries and equity returns, some respondents to E54, including almost all the UK respondents and many of the continental European companies that replied, consider it would over-state liabilities linked to final salaries.

They use portfolio theory to argue that there is a substantial negative correlation between the risk associated with the liability and the risk in the appropriate portfolio, with the result that the discount rate should be substantially equal to the expected return on the portfolio. They also feel that the inconsistency between the discount rate for the obligation and the discount rate that is implicit in the market value of the scheme’s assets would result in misleading volatility in reported profits.

However, other commentators agree with E54’s proposal that the discount rate should not reflect risk. They believe there is no clear evidence that the return on an appropriate portfolio is a relevant and reliable indication of the risks associated with a final salary obligation. For example, they note that the return on equity securities does not correlate with other risks associated with defined benefit schemes such as variability in mortality, timing of retirement, disability and adverse selection.

They also doubt whether the expected return on an appropriate portfolio can be determined with sufficient objectivity: the practical difficulties include specifying the characteristics of the appropriate portfolio, selecting the time horizon for estimating returns on the portfolio and estimating the returns on the portfolio.

Conclusion

The IASC board intends to discuss the comments on E54 at its next two meetings, in April and July, and to issue a final standard in October.

What does this mean for the UK? IASC’s agreement with IOSCO (the International Organization of Securities Commissions) has created a real prospect that countries such as Canada, Japan and the USA may soon allow foreign companies to use accounts prepared under International Accounting Standards for listing purposes. So the ASB is likely to come under strong pressure to conform the UK standard on pension costs to the standard that results from E54.

Peter Clark is a senior research manager at the International Accounting Standards Committee.

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