Reforming the reporting on pensions by Chartered Institute of Management Accountants

Reforming the reporting of pensions CIMA comments on the Accounting Standards Boardâ&#x20AC;&#x2122;s paper on the ďŹ nancial reporting of pensions

Use current salary levels?

Use risk free discount rate?

Use actual returns?

Contents 1

Executive summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

Background to the Accounting Standards Board’s (ASB) proposals . . . . . . . . . . . . . . . . . . 6

CIMA’s input . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

Discussion paper responses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 4.1

Future salary increases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

4.2

Changes in pension asset and liability values . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

4.3

Risk-free discount rate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

4.4

Regulatory measures of pension deﬁcits replacing accounting measures. . . . . . . . . . . 15

4.5

Presentation in the ﬁnancial statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

4.6

Other ASB proposals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

So where next? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

References and further reading. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

Figures Figure 1

Responses to questions raised in the ASB discussion paper . . . . . . . . . . . . . . . . . . . . . . 4

Figure 2

What is PAAinE? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

Figure 3

Report Leadership. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

Reforming the reporting of pensions | 1

1 Executive summary Accounting for pension obligations is an important financial reporting issue. Research1 has shown that at their 2007 balance sheet date, the total pension deficit of FTSE Global 100 Index companies stood at £18 billion and this figure is estimated to have almost doubled to £30 billion by mid 2008 due to falling asset values, mainly in equity markets. This same research also reveals that the current international pension standard, (IAS 19) Employee Benefits, is showing strain under the severe pressure. For instance, companies reporting under IAS 19 disclosed a far wider range of rates used to discount liabilities than was the case 12 months previously. As a result the numbers presented are far less useful for company comparison purposes. The global market turmoil experienced this year emphasises the volatile nature of pension accounting. According to Watson Wyatt, the actuarial consultants, the aggregate pension deficits of UK FTSE 100 companies were wiped out during the month of September 2008. A combined deficit of £12 billion at the start of the month was estimated to have turned into a surplus of around £30 billion by the end of the month. Despite collapsing stock markets hitting pension asset valuations, much higher corporate bond rates (used to discount future liabilities) have resulted in a significantly lower present value of future cash outflows. Such turbulent times serve to illustrate the importance of robust accounting principles. The International Accounting Standards Board (IASB) recognises the need for reform in the financial reporting of pensions and has announced that it intends to work with the US Financial Accounting Standards Board (FASB) towards a common replacement standard. The European Financial Reporting Advisory Group (EFRAG) some time ago established a research programme designed to stimulate debate, primarily in Europe, on financial reporting developments with a view to influencing the future thinking of the IASB. This initiative is known as PAAinE (Proactive Accounting Activities in Europe) and the accounting for pensions was soon added to its agenda. The UK Accounting Standards Board (ASB) was chosen to lead this project and they published a discussion paper, The Financial Reporting of Pensions in 2008. CIMA has demonstrated a commitment to improvements in the accounting for and understanding of company pension obligations through its publications on pension risk and longevity assumptions and its work with the Report Leadership initiative (see page 11). It was natural that we would decide to respond to the ASB discussion paper and to enrich our response we hosted a seminar to discuss the issues raised. We were very pleased to welcome Andrew Lennard, Director of Research at the ASB to the seminar and we thank him for a very cogent presentation of the key topics in the discussion paper. Following this seminar, discussions at CIMA’s Financial Reporting Development Group (FRDG) and consultation with our membership, CIMA commented on the ASB discussion paper.

Accounting for Pensions 2008, Lane Clark & Peacock – www.lcp.uk.com

2 | Reforming the reporting of pensions

The ASB has published the responses that it received for the public record. In total, it received over 100 submissions from respondents as diverse as the United Bible Societies Association, the National Association of Pension Funds, the International Actuarial Association and individual accountants. Replies were mainly from the UK but there was also input from countries including Canada, South Africa, Belgium, France, Germany, Switzerland, Ireland, the Netherlands and Norway. CIMA reviewed the public record of responses and summarised, at a high level, the degree of agreement with the following eight questions raised in the discussion paper: 1) Should a liability to pay benefits that is recognised be based on expectations of employees’ pensionable salaries when they leave service, or on current salaries? 2) Do you agree that changes in assets and liabilities relating to pension plans should be recognised immediately, rather than deferred and recognised over a number of accounting periods or left unrecognised provided they are within certain limits (a corridor approach)? 3) Do you agree that the financial performance of an entity should reflect the actual return on assets, rather than the expected return, and that the expected return should be required to be disclosed? 4) Do you agree that the discount rate should reflect the time value of money only and therefore should be a risk-free rate? 5) Do you agree that regulatory measures should not replace measures derived from general accounting principles? 6) Do you agree that different components of changes in liabilities and/or assets should be presented separately? 7) Do you agree that the consolidation of pension plans should be subject to the same principles as are usually applied in determining whether consolidation is appropriate? 8) Do you agree with the objectives of disclosure identified in the discussion paper? There were a number of other questions raised in the discussion paper including some concerned with the accounting by pension schemes as opposed to company sponsors. The eight questions that we have focused on above are those that we believe are key to the future development of the financial reporting of pensions by company sponsors. Not every response addressed all of the questions raised, but Figure 1 (page 4) summarises the responses of those that did.2

For illustrative purposes, we have not attempted to assess the size of the constituency or the relative merits of the supporting arguments when summarising the responses made to the ASB questions. 2

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Figure 1 Responses to questions raised in the ASB discussion paper

Use current salary levels Immediate recognition Use actual returns Use risk-free discount rate Do not use regulatory measures Show components seperately Apply normal consolidation principles Disclosure objectives % 0

40 Agree

100

Disagree

CIMA disagrees with the proposals to use only current salary levels to determine future pension obligations and to use a risk-free discount rate. We agree with each of the remaining questions although we believe that further work should be undertaken into the possibility of using forecast cash flows derived from regulatory measures to determine pension liabilities. The consultation period for the discussion paper ended in November 2008 and the ASB set about reconsidering the issues prior to issuing final recommendations in 2009. These recommendations will be published by EFRAG as part of the PAAinE initiative that seeks to influence the development of accounting thought, specifically at the IASB. The IASB timetable shows that they plan to issue an exposure draft of proposed amendments to IAS 19 in the second half of 2009. The proposals are anticipated to include presentational changes and the abolition of both deferral options and the use of expected returns in the income statement. Companies are now much better informed about their pension obligations than ever before and as this knowledge increases further, then the buy out of pension liabilities by insurance companies and other providers of bulk annuities is likely to feature widely in the future. In 2008, Lane Clark & Peacock, the actuarial consultants, estimated that buy out deals totalling some £10bn were on the horizon and to date there have been a number of transactions including a Cable and Wireless (C&W) deal which totalled £1bn. The current market crisis is likely to slow this trend but we expect enthusiasm to return once calmer financial conditions return.

4 | Reforming the reporting of pensions

Figures released by the Office for National Statistics show that membership of private sector defined benefit schemes continues to fall. In 2006 these schemes had 3 million members, but by 2007 membership had fallen to 2.7 million, only 47% of which were in schemes still open to new members. In its response to the discussion paper, the National Association of Pension Funds (NAPF) expresses its fears that the ASB’s proposals taken with other expected changes could create a ‘mix toxic enough to kill off the UK’s remaining defined benefit provision.’ Punter Southall, consulting actuaries, were commissioned by the NAPF to carry out calculations on the potential effects of the proposals. Using FTSE 350 scheme data as at 31 December 2007, Punter Southall estimated that a change from the current AA-rated bond discount rate to a risk-free rate would increase liabilities by £250bn. The current economic turmoil can only deepen company board’s concerns regarding the perceived cost of pensions. Boards are likely to tend towards more risk adverse strategies. Recognition and presentation policies relating to pensions will affect their views on whether they should shed pension risks relating to investment, longevity and other difficult to control and expensive to hedge risks. CIMA does not believe that pension standards should be artificially engineered to produce results that favour keeping schemes open, nor does it believe that the vast majority of those arguing against the ASB’s proposals would approve of rules skewed in this way. There is no one right answer and the impact of reporting a wrong number could be catastrophic for pension provision. For those involved in pension accounting and those hoping to get further defined benefit pension gains, this debate is crucially important and we urge them to participate. The aim of this paper is to summarise the issues raised in the ASB paper and to offer CIMA’s perspective on these issues with a view to influencing the debate in this area during the redeliberation phase of the ASB’s work. It is expected, at some time following the publication of the final PAAinE report, that the IASB will issue a discussion paper containing its thoughts on the future direction of pension accounting. This document will then serve as a useful reference text for those participating in the consultation.

How CIMA helps you to become involved If you would like to comment on any of the issues contained in this paper then please email CIMA at innovation.development@cimaglobal.com CIMA also publishes a monthly electronic newsletter, Insight, in which there is a regular feature on ﬁnancial reporting developments. To sign up for this publication, please visit the CIMA website at www.cimaglobal.com Also on the website is a database of consultations that allows our members to access the details behind current and past consultations as well as contribute their thoughts on the developments proposed. See www.cimaglobal.com/cdb

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2 Background to Accounting Standards Board’s proposals The UK has a history of leading thought on the accounting for pensions. The Accounting Standards Committee (ASC) started the process over 20 years ago with the then ground breaking Statement of Standard Accounting Practice No. 24. In 1990 the ASB took over the task of setting accounting standards in the UK and set about revisiting pension accounting. This led to Financial Reporting Standard No. 17 which was published in 2000. When it was decided that the PAAinE initiative should undertake a major project on the ﬁnancial reporting of pensions it was understandable that the European Standard setter chosen to take the lead should be the ASB.

Figure 2 What is PAAinE? Proactive Accounting Activities in Europe is an initiative of the European Financial Reporting Advisory Group (EFRAG) and the European National Standard Setters, that aims to stimulate debate in Europe on important items on the International Accounting Standards Board agenda at an early stage in the standard setting process. By doing so it hopes that Europe can participate more effectively in the global development of ﬁnancial reporting standards. A further description of the PAAinE initiative and its various projects are available on the EFRAG website (www.efrag.org)

But why should we be looking again at the way companies report their pension obligations? IAS 19 has now been adopted by over 100 countries and so, much of the world now produces consistent financial reporting of pensions. Or does it? According to the IASB itself, both users and preparers of financial statements have criticised the accounting requirements for failing to provide high quality, transparent information about pension obligations. For example, delays in the recognition of gains and losses and an inadequate measurement methodology give rise to misleading figures in the balance sheet. Also multiple options for recognising gains and losses and lack of clarity in the definitions lead to poor comparability. As a result of accounting standards, such as FRS 17 and IAS 19, which require net pension surpluses and deficits to be reported on the face of company balance sheets, there is now a greater focus on the financial implications of pension arrangements and the way in which they are reported in financial statements. The regulatory environment, pension asset investment policy and pension benefits provided by employers have all changed in recent years, undoubtedly as a result, in some part, to changes in the accounting for pensions. Pension arrangements have become more complex and there is a recognised need to improve IAS 19. The IASB is undertaking a project that aims to address a limited number of topics leading to an improved pension standard by 2011. But is it sufficient to seek only to improve IAS 19? The ASB, EFRAG and others believe not. They are seeking a fundamental reconsideration, albeit within the current IASB framework, of the accounting that should be required for pensions. Working in conjunction with EFRAG’s PAAinE Pensions Working Group and its own Pensions Advisory Panel the ASB published a discussion paper, The Financial Reporting of Pensions, in January 2008. This discussion paper represents a comprehensive analysis of the key issues affecting the development of pension accounting and a first step on the long road towards a replacement international standard.

6 | Reforming the reporting of pensions

3 CIMA’s input CIMA ran a seminar to review the discussion paper and Andrew Lennard, Director of Research at the ASB, was present as were Charles Tilley, CIMA Chief Executive, CIMA’s Financial Reporting Development Group (FRDG), a number of CIMA members and others interested in the future of pension accounting. Based upon these discussions and the views of the FRDG, CIMA responded to the ASB paper which closed for comments in July 2008. In total, the ASB received over 100 responses to the discussion paper and they have recently commenced consideration of these inputs prior to issuing ﬁnal recommendations in the second half of 2009. The ASB paper makes several proposals in its discussion paper. Some are more controversial than others and we have reviewed the areas that attracted the most interest. In this report we summarise the ASB’s proposals and provide CIMA’s perspective on each proposal drawn from comments made by participants at our seminar as well as input from CIMA’s staff.

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4 Discussion paper responses 4.1 Future salary increases Discussion paper proposals Current practice for assessing pension obligations based on final salary is to assume a certain level of future salary increase. The ASB paper, however, proposes that this should change. The argument is that, as future salary increases are usually discretionary, the present commitment, and hence the liability, should relate to current salary levels only. Proponents of this view argue that it is wrong to anticipate future salary increases. They believe that only benefits to which the entity is presently committed to pay should be recognised as liabilities. The impact of this change would be to reduce reported liabilities and deficits compared with those reported under IAS 19. This view was not unanimous within the ASB and the contrary argument was described in the discussion paper. Membership of a final salary pension plan is usually regarded as being more valuable than membership of an average or current salary plan. This valuation differential is based on the premise that there will be future salary increases during the employee’s career. If the value of one pension promise is different to another then they should not be reported at the same liability amounts. Responses to the discussion paper Respondents to the ASB’s discussion paper that expressed a view on this question were split very evenly between agreeing that future pension liabilities should be based on current salary levels (51%) and disagreeing (49%). Those agreeing with the ASB mainly relied on the general principle that bases accounting on the present value of the future obligation. The National Association of Pension Funds, for example, said in their response ‘while it can be argued that because pensions are deferred pay, an estimate of the total cost of the service should be allocated to the period in which it was delivered, we feel that there are stronger reasons to accept the general accounting principle that it is incorrect to account for future events over which one has discretion.’

Use actual returns on assets in income statement rather than expected returns

49% Disagree

51% Agree

Others took perhaps a more pragmatic view regarding a certain level of salary increase as inevitable especially for an organisation preparing financial statements on a going concern basis. For instance, Nestle SA of Switzerland responded ‘the liability for pension benefits should be aligned with near retirement salaries which take into account expected future increases based on a constructive obligation. We consider that those future salary increases should be restricted to inflation and general changes of an entity’s salary scale, because there is a valid expectation from the employees that they would receive such increases.’

8 | Reforming the reporting of pensions

CIMA perspective The tone of the discussion at CIMA’s seminar was not supportive of this proposed change. One attendee commented ‘measuring the future liability based on current salary levels seems to be divorced from reality – every year companies have to give increases to their workforce or risk industrial action or increased staff turnover.’ It was also pointed out that measuring the future liability based on current salary levels would build up a wall of cost as employees got older. It would become prohibitively more expensive to give a pay rise to an older employee relative to a much younger employee due to the number of pensionable service years to which the increase would need to apply. This was felt, in the words of one attendee to lead to potential ‘bad behaviour’ in some companies. CIMA’s response to the ASB noted that the discussion paper’s proposal that the liability should be based on current salaries was a majority view of ASB members and although we found merits in this proposal we believe that it is divorced from reality. It would seem consistent with other accounting standards that the liability to pay benefits is based on the benefits that the employer is presently committed to provide i.e. current salary levels. However, every year the majority of companies award salary increases to their workforce and not to include an estimate of these increases in the calculation of pension liabilities appears to be counter intuitive. We believe that the question of whether or not to include future salary increases cannot be looked at in isolation from other areas of accounting for pensions under review in the discussion paper. For instance, if pensions liabilities are to be based on no increases in salaries or other factors such as deferred rights, this should perhaps be combined with using a ‘real’ discount rate which excludes inflation.

4.2 Changes in pension asset and liability values Discussion paper proposals The value of pension assets and liabilities can change significantly from one accounting period to the next. Some current financial reporting standards require or permit deferral of these changes. One kind of deferral mechanism is to spread these changes forward, for instance over the remaining service life of employees rather than recognise them immediately as they arise. Another method is the so called ‘corridor’ approach currently permitted by IAS 19, whereby gains and losses that fall within certain limits need not be recognised at all. The arguments in favour of deferral mechanisms are: • Immediate recognition implies a degree of accuracy in the measurement of assets and liabilities that is rarely seen in practice. The measurement changes are often as a result of changes in assumptions rather than stemming from an actual economic event of the period. Introducing what can be significant volatility into the reported results of an entity on this basis may present a misleading view.

• Pension liabilities are very long term and the assets held to fund these obligations are similarly held for the long term. Short term volatility is irrelevant as market ﬂuctuations can be expected to reverse.

• Immediate recognition may cause signiﬁcant volatility in reported results which can lead to entities making decisions about pension provision that are not economically effective and short term in their thinking.

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Supporters of immediate recognition counter as follows: • Why should pension assets and liabilities be treated any different to other assets and liabilities in the ﬁnancial statements, many of which are difﬁcult to measure and clouded with a degree of uncertainty?

• Volatility is an inherent risk of market participation. Financial statements should seek to report the economic events of the period and to assume that certain events will reverse in the future, whereas others will not, is inconsistent.

• Deferral options inevitably require complex and arbitrary rules and often result in the balance sheet not faithfully reflecting the position of the plan. At best these mechanisms impair transparency and at worst they may be said to undermine the true and fair nature of the financial statements. The discussion paper concludes that all changes in the amounts of pension deficits and surpluses should be reported in the period in which they arise. Current accounting standards require the ‘expected’ return on pension assets to be recognised and reported in the profit and loss account. The difference between actual and expected returns is either presented outside of the profit and loss account as part of other comprehensive income, or spread over future accounting periods. Proponents of this approach argue that this method best portrays the future sustainable earnings from the pension assets and so assist in predicting the entity’s pension contributions. They are concerned that to report actual returns would introduce volatility into the financial statements which they believe to be irrelevant. Arguments against the inclusion of expected returns rather than actual returns include:

• The expected return is a budgetary amount used for planning purposes and as such it has no place in ﬁnancial statements that are designed to reﬂect the outcome from economic events of the period.

• The use of an expected return is an example of ‘smoothing’ which can lead to entities reporting results that are not representative of their activities in the period.

• The amount included as an expected return is often not an estimate from the management of the entity but rather an estimate provided by their professional advisors. As such the expected return tends to reflect general market expectations rather than an assessment of the return expected from the pension asset portfolio specific to the entity. The ASB concludes that the actual return should be recognised rather than the expected return which, together with the recommendation to eliminate deferral mechanisms would, if adopted, not have a particular impact on reported deficits or surpluses – they are equally likely to increase as decrease. However there will be much more volatility in both the total reported pension expense in any given period and the total surplus or deficit recognised on the balance sheet.

10 | Reforming the reporting of pensions

Responses to the discussion paper Nearly 90% of those responding on this issue agreed with the ASB’s view – immediate recognition of changes is preferable to deferral. AstraZeneca (AZ) is one of the leading international companies with regard to its corporate reporting practices (see the latest best practice corporate reporting publication from the Report Leadership initiative in which AZ is commended). In its response to the ASB on this question, AZ commented ‘we believe that immediate recognition would lead to better clarity for reporting, providing users with more readily understandable and hence measurable information regarding entity positions at the reporting dates. We also believe that by adopting a deferred approach, the net obligation or asset recognised on the balance sheet is misleading.’

Immediate recognition of changes rather than deferal 10% Disagree

90% Agree

Figure 3 Report Leadership Report Leadership is a multi-stakeholder group that aims to challenge established thinking on corporate reporting. The contributors to this initiative are CIMA, PricewaterhouseCoopers, LLP and Radley Yeldar, a communications consultancy. The group believes that corporate reporting should be more relevant, informative and accessible. It should provide investors with what they want without inundating them with unnecessary detail. As part of the initiative, Report Leadership seeks to align external reporting more closely with management reporting, recognise the complexity of business today and provide reporting that will adapt readily to other media. Its initial, Generico, publication focuses on three area of topical interest:

• Effective communication through clear messaging and navigation. • Modelling the future through the provision of contextual information that allows investors to assess the quality and sustainability of future cash ﬂows.

• Rethinking the ﬁnancials to provide greater detail on revenue, costs, segmental information, pensions and debt. Subsequent work includes the reporting of executive remuneration, online reporting and real life examples of best practice reporting. For more information on the Report Leadership project and free downloads of its publications visit: www.reportleadership.com

Reforming the reporting of pensions | 11

Although the ASB proposal was overwhelmingly welcomed, support was not unanimous. The International Actuarial Association (IAA) based in Canada, was concerned that this change would misrepresent the volatility of pensions in comparison with other areas of accounting in which there was no requirement to mark-to-market. The IAA concluded that ‘there should be no changes that make pensions seem more risky than under current accounting standards until accounting standards treat all assets and liabilities consistently.’

Use the actual returns on assets in income statement rather than expected returns

36% Disagree 64% Agree

There was also widespread support for the ASB proposal to use actual returns on assets in the income statement rather than expected returns. However, over a third of views disagreed with the approach. The Association of Corporate Treasurers commented that ‘the current rule that the expected return from the assets is brought in and the balancing difference from the actual return is taken up in non operating and financing, by what ever name, presents a more meaningful picture’ [than using actual returns]. They concluded ‘we accept that taking an expected return is not a perfect approach but it more closely reflects that the plan will be holding a very long term asset position and taking a view on overall returns rather than wanting to be driven by short term market effects.’ Shell, the Anglo-Dutch oil company, was also sceptical, ‘plan deficits are often not funded immediately but may instead be eliminated over a number of years, while the benefits of a plan surplus are likely to be realised only gradually, through reduced contributions. Similarly the use of the long term expected return in calculating the amount for the income statement reflects better the impact on an entity’s cash resources, in that actual losses do not necessarily require urgent cash funding and the entity may not immediately benefit from gains. Therefore the amount to be reported in income should be consistent with the existing approach, and all other components reported in other comprehensive income (with some form of recycling through net income).’ The majority of views expressed were in favour of the use of actual returns rather than expected returns, although, not all without reservations about the effect of volatility. Balfour Beatty, for instance, commented that ‘these proposals will introduce additional volatility into the income statement. Including actual return on pension assets will not help an investor to understand the true performance of the business. Despite the increasing complexity of accounts, and ever greater disclosure, price earnings ratios remain one of the fundamental valuation tools used by investors and these recommendations would in a number of cases make these ratios meaningless as a tool for valuation and comparison.’ These concerns for the investor were not shared by the CFA Society of the UK which represents leading members of the investment industry who responded, without reservation, to the ASB proposals – ‘agreed.’

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CIMA perspective No arguments were put forward at the CIMA seminar against the removal of either the smoothing provisions of IAS 19 or the use of expected returns. One attendee was concerned about the effect on the balance sheet – ‘volatility in the recognised pension deficit might adversely affect a company’s ability to pay a dividend by decimating distributable reserves. If these proposals go through then we need to keep up the pressure on the EU to change the law relating to distributable profits.’ CIMA agrees with the proposed removal of deferral mechanisms as they are a source of complexity and opacity in financial reporting. We believe that the expected return on assets is subjective and very likely for any individual year to be a poor indication of actual returns. We do not consider the use of expected returns in financial statements to be reliable and would prefer the use of the actual return on assets. There will undoubtedly be increased volatility in financial statements if these changes are made to pension accounting standards. But it should be possible to explain this volatility (subject to the final outcome of the IASB’s Financial Statement Presentation project) through appropriate presentation and clear narrative disclosure. We share the concerns expressed above in relation to the effect of volatility on the balance sheet, but this is not in our view a valid reason to maintain the status quo. We have long supported a solvency approach to the question of distributable reserves and we continue to call for a change in the law relating to dividend payments3. We also believe that loan covenants will need to be reconsidered. As well as a long term project to revisit accounting for pensions, the IASB is looking at short term improvements to the current standard, IAS 19. One of these improvements is the abolition of deferral mechanisms such as the corridor approach which is covered in the discussion paper, Preliminary Views on Amendments to IAS 19 Employee Benefits. This paper was issued in March 2008 and consultation closed in September. CIMA’s response, consistent with its views expressed to the ASB, favoured the use of actual returns in the income statement rather than expected returns. Following consideration of the consultation responses, the IASB plans to issue an exposure draft of definite proposals by the end of 2009 and a final amendment to IAS 19 sometime in 2011. The effective date of the amendment is unlikely to be before accounting periods commencing on or after 1 January 2013.

The ASB hosted a meeting on alternative capital maintenance regimes in February 2008.

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4.3 Risk-free discount rate Discussion paper proposals IAS 19 requires future pension obligations to be discounted back to present values using a high quality corporate bond rate; typically the rate applicable to AA rated bonds is used. The ASB challenges this thinking; it argues that risk is best dealt with away from the discount rate by either disclosure or adjustment to the expected cash flows. As a consequence the paper proposes that the cash flows should be discounted at a risk-free rate. The discussion paper does acknowledge that in theory pension liabilities should reflect a margin for risk but is concerned that some of the risks, such as future changes in longevity, are simply ‘unknowable’ and therefore unquantifiable. The discussion paper concludes that users of financial statements will be better served through disclosure about sensitivities and changes in assumptions arrived at through best estimates. Responses to the discussion paper Of the ASB proposals covered in this paper, the suggestions that future pension obligation should be discounted back to their present value using a risk-free rate received the most criticism. Nearly three quarters of views disagreed with the proposal to move to a risk-free rate such as that associated with government gilts.

Use a risk-free discount rate

26% Agree

74% BP feels that ‘discounting at a risk-free rate is in Disagree our view wholly inappropriate, as the pension liability is based on the aggregate of pension cash flows which are not risk free and can be expected to vary significantly.’ They continue ‘if the pension liability/deficit were traded in the open market the price of this asset would be expected to settle at a level which would provide sufficient returns to investors to compensate them for this expected variability in their cash flows. The yield on these pension balances would therefore be higher than the yield on government issued bonds. While there is no perfect market which sets an arm’s length price for pension liabilities, these observable are based on the pricing levels seen in the pensions buyout market.’ BT’s response reflects both criticism of the ASB proposal and also the difference in views as to which would be the appropriate rate to use. Their response states ‘the difference between the interest rate on a bond and that on a risk-free security arises from two elements – a compensation for lost liquidity and a credit risk adjustment. For a pension scheme, which has to meet liabilities over an extended period, liquidity is not relevant. Consequently, it expects to be rewarded for a lack of liquidity. Also the pension scheme assumes risks in its investments. We believe that the interest rate used should be based on the company’s marginal cost of borrowing, thus reflecting the fact that a pension scheme is a creditor of the company.’

14 | Reforming the reporting of pensions

The European Federation of Accountants (FEE) took a contrary view – ‘we believe that the risks specific to the pension liability should normally be taken into account in the projected cash flows, using an expected value approach and that the discount rate should be a risk-free rate.’ Further support came from the German Accounting Standards Board who holds the view that ‘provided that the expected value of the cash flows is adjusted to consider any inherent risks, it is conceptually justified to discount these cash flows using a risk-free market discount rate.’ CIMA perspective This proposal was not well received at our seminar. ‘The insurance industry does not use a risk-free rate when pricing long term annuities – why should companies have to use this rate when discounting similar liabilities?’ said one attendee. To some extent offsetting the effect on pension liabilities of ignoring future salary increases, reported liabilities would increase if a risk-free, rather than a corporate bond, discount rate was used. One attendee commented on the intertwined nature of the various assumptions used in pension accounting saying ‘would making big changes be something like squeezing a jelly – apply pressure in one area and something else will pop out? If a risk-free discount rate is required then perhaps companies might just start to make less prudent assumptions in other areas such as mortality.’ Another commentator at the CIMA seminar pointed out that pensions were not the only area of discounting in financial statements, ‘if the risk free rate is relevant for pension liability discounting, shouldn’t it be used elsewhere too? But bear in mind that this would lead to booking a loss whenever a company borrowed money on normal commercial terms.’ CIMA does not agree that the discount rate should reflect the time value of money only. We believe that it is inconsistent to use a risk-free rate to discount pension liabilities and see no need to change current practice. An alternative that CIMA does believe is worthy of further exploration is to consider measuring pensions liabilities based on no increases in salaries or other factors, such as deferred rights, combined with using a real discount rate so having a consistent approach on inflation. We believe that the ASB re-deliberations should include consideration of this alternative.

4.4 Regulatory measures of pension deficits replacing accounting measures Regulators have for some time been focused on ensuring that funding of pension plans is adequate and so minimising the risk of default on pension promises. In the EU, for example, legislation has been enacted that requires pension schemes to hold assets to cover their ‘technical provisions’ (EU directive on Institutions for Occupational Retirement Provisions, 2003). Technical provisions are the amounts required, based on actuarial calculation, to make provisions for the scheme’s liabilities. It is the amount of money that, if invested at the valuation date, is expected to be sufficient to pay out future pension benefits that have been earned by past service. If there are insufficient assets within a pension fund to adequately cover its technical provisions then companies need to agree recovery plans with fund trustees/administrators. The amount of technical provisions clearly has a direct impact on the amount and timing of cash contributions that companies need to make to their pension funds. It is clear to see why some believe that these regulatory measures should be used as the basis for accounting recognition of pension deficits in their financial statements.

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The ASB paper does not support this view because ‘their principal purpose concerns the solvency of pension plans, by specifying a level of assets that must be set aside in separate funds to be available to meet the obligation to pay beneﬁts. Thus they do not purport to provide ﬁnancial statement users with decision-useful information per se about the amount of the underlying obligation to pay.’ There are other arguments that can be raised to support the ASB view: • Technical provisions typically take into account the strength of the employer’s covenant, i.e. the ability of the sponsoring company to step in to cover any funding shortfalls within a pension plan. If this ability or covenant is weak then it is likely that the required technical provision will be higher than that of an employer with a strong covenant. The effect of the strength of the covenant is seen to potentially lead to either under or over stated liabilities.

• Regulatory measures can vary from country to country and so amounts recognised in the ﬁnancial statements may not be comparable.

• Not all countries have regulatory mechanisms in place and so it would be very difficult to envisage an international standard that presupposes such a system is in place. Responses to the discussion paper The ASB concluded that regulatory measures should not be used to determine the financial reporting of pensions, and nearly 80% of responses on this question agreed with them. L’Académie des Sciences et Techniques, Comptables et Financières based in Paris, agreed with the ASB and in their response stated ‘regulatory measures include some additional requirements of prudence, have different objectives and they vary significantly from country to country.’ AstraZeneca also believes that regulatory measures should not replace measures derived from general accounting principles as this would ‘add complexity for users and inconsistency from preparers.’

Regulatory measures should not determine ﬁnancial reporting of pensions

21% Disagree

79% Agree

However, another major company, BT took a contrary position. They disagreed with the ASB conclusion saying ‘the fairest reflection of the liability in the financial statements of the entity is the cash flows the entity is obliged to make to the pension scheme in order to make good any past service benefit shortfall discounted at the entity’s marginal cost of capital.’ There are some that say that this view is too UK centric but the BT letter goes on to say ‘although legislation in different countries may lead to inconsistent measures of the liability, this will reflect the actual obligations of the entity in the territory in which it operates.’

16 | Reforming the reporting of pensions

CIMA perspective We recognise that if an entity has agreed a specific cash funding plan with regulators then it is difficult to justify, to the ordinary user of financial statements, recognising pension obligations on another basis. We are not convinced that there has been sufficient research into the differences that could arise if regulatory bases to measure pension liabilities are used rather than accounting bases and the impact that this might have on the usefulness of financial statements. But this is not to say that further research in this area might lead us to take a contrary position. There is undoubtedly a major concern now with the degree of complexity that is evident in accounting standards and financial statements. CIMA supports the various initiatives that are designed to reduce complexity in corporate reporting. The business environment and the transactions that result are many times more complex these days than they were twenty or thirty years ago. We believe that financial statements which aim to faithfully represent these transactions will, inevitably be complex themselves. But where a simplification in accounting can be achieved without sacrificing an appropriate degree of rigor and disclosure then it should be implemented. This may be the case here as to recognise pension liabilities based on regulatory measures could significantly simplify pension accounting. But there are questions which we consider still require answering: • What proposals are there for jurisdictions without a regulatory mechanism in place?

• Are there issues regarding the prudential nature of the regulatory arrangements? • How do we deal with pension surpluses? They do exist and a robust accounting principle should accommodate them.

• Regulatory models are typically designed as a minimum to avoid failure of the pension scheme. Therefore is their use for accounting purposes inconsistent with the going concern concept?

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4.5 Presentation in the financial statements The ASB report distinguishes five components of income and expense that arise from movements in pension assets and liabilities: • Service cost – the change in the pension liabilities between one accounting period and the next that arises because additional pension benefits have been granted to current employees in the period, generally in return for their services during the period.

• Finance cost of pensions – this represents the ‘unwinding’ of the present value of the liability to pay future pensions i.e. the increase during the period in the present value of the liabilities because the beneﬁts are one period closer to settlement.

• Effect of change in the discount rate – due to the generally very long term nature of pension liabilities a change in the discount rate will have a signiﬁcant effect on their present value.

• Actual return on assets – the actual rate of return, including both income and changes in fair values, but net of scheme expenses experienced in the period on the actual assets held by the scheme.

• Actuarial gains and losses – this is somewhat of a catch all component as it is typically defined as changes arising from the re-measurements of the pension deficit or surplus at the end of one accounting period relative to the previous accounting period, other than those that are separately identified. Such changes would result from altered valuation assumptions such as staff turnover rates, mortality rates etc. Having identified these components of the annual pension charge, the ASB report considers where each should appear within the income statement and concludes as follows: • service cost – within operating activities

• finance cost of pensions – within financing • effect of change in the discount rate – within financing • actual return on assets – within financing • actuarial gains and losses – within other financial performance. Responses to the discussion paper Less than a fifth of those expressing a view on this proposal disagreed with the ASB. One of those respondents, BT feels that ‘separate disclosure of the different components of changes in assets and liabilities is not meaningful.’ Others recognised benefits from separate disclosure but disagreed with where individual elements should be reported. Shepherd-Group, for instance, considered that the income statement should only reflect ‘current service costs, past service costs, expected return on assets and interest on liabilities. All other movements in the assets and liabilities of the plan including the difference between the actual and expected return on assets, should continue to be taken directly to equity via the Statement of Recognised Gains and Losses or equivalent statement.’ 18 | Reforming the reporting of pensions

Different components ofpension charge should be shown separately

18% Disagree

82% Agree

The vast majority of responses agreed with the ASB. Fitch Ratings commented ‘current disclosures of movements in assets and liabilities greatly aid the understanding of what is driving pension deficit movements.’ Watson Wyatt who provide actuarial consultancy reflect the concerns of many that whilst they agree that the different elements need to be reported separately, they do not have a stable financial statement framework against which they can map these elements. Their response comments ‘we note that the present SORIE (Statement of Recognised Income and Expense) approach has worked well, although we appreciate that this will be reviewed in the light of other accounting reforms with a much wider scope, in particular the outcome of the IASB’s project on presentation of financial statements.’ CIMA perspective CIMA’s view is that it is essential that each material component of the annual pension charge is clearly identifiable and disclosed consistently from one period to the next. This approach to presentation should provide more decision useful information than any attempt to provide net figures. We broadly agree with the presentation proposals contained within the ASB report and repeated above, although we note that the next phase of the IASB’s Financial Statement Presentation project is due to be published soon and we believe that the outcome of this project is key to the categorisation of the individual components of pension expense. It is essential that the form of the income statement and any other statement linking changes in balance sheet values, such as the SORIE, allows identification of the underlying performance of a business. The impact of market volatility on the fair valuation of pension assets should not be hidden; it should be clearly identifiable within the financial statements via a statement of other comprehensive income.

4.6 Other ASB proposals • Consolidation of pension plans – current accounting standards provide a general exemption from the usual principles of consolidation for pension plans. The ASB propose that if the employer controls the plan then it should be consolidated in the employer’s group ﬁnancial statements. If the plan is genuinely independent of the employer, where for instance it is governed by trustees obligated to act in the best interests of members rather than the employer, then the degree of control required for consolidation does not exist.

• Disclosures – the principle proposed is that the ﬁnancial statements should give adequate information on pension costs, risks and rewards, and funding obligations. Details of assumptions and sensitivity of reported amounts to changes in those assumptions should be disclosed.

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Response to discussion paper Nearly a third of responses to the question as to whether pension schemes should be subject to normal consolidation criteria disagreed with the ASB view. Accountancy firm, Horwath Clark Whitehill put forward the view that ‘it would be misleading to consolidate the assets and liabilities of both defined benefit and defined contribution schemes on a gross basis into the employer accounts as this would give the impression that the assets of the trust were available to the employer and potentially the employer creditors by overstating the assets of the scheme.’

Should normal consolidation principles apply to pension plans?

31% Disagree

69% Agree

Others considered that normal consolidation considerations relating to control would be sufﬁcient to ensure this problem would not arise and so there would be no need for an artiﬁcial ban on the consolidation of pension scheme accounts. In excess of 90% of responses to the question on disclosures were favourable. Paternoster, pension buyout specialists, are one of the respondents supporting the ASB’s disclosure proposals ‘as a general rule, the more disclosure which assists sponsors and trustees to understand the details behind the accounting numbers and the sensitivity of the scheme’s position to market and other conditions is to be encouraged.’ However, the International Actuarial Association does usefully make the point that ‘disclosures should be proportionate and material.’

Do you agree with the disclosure objectives? 8% Disagree

92% Agree

The Norwegian Accounting Standards Board felt that more work needed to be done in this area and that the final standard should include ‘comprehensive disclosure requirements.’ Swiss Holdings, a federation of 46 industrial and service groups in Switzerland, discussed the disclosure proposals with users of financial statements and identified a number of additional items of information that should be disclosed. These included information on the average maturity of the benefit obligation and sensitivity analysis.

20 | Reforming the reporting of pensions

CIMA perspective We agree with the ASB proposals for both consolidation and disclosure principles. We strongly believe that appropriate disclosure is very important. Defined benefit pensions are a significant liability for most companies. Understanding these liabilities is essential for investors and other users of the financial statements. The Report Leadership initiative addressed the issue of effective disclosure of pension amounts in the financial statements. Their publication takes the form of an extract from the annual report of a fictitious company, Generico, and addresses a number of aspects of effective corporate reporting. In terms of pension disclosures, the Generico report illustrates a number of practical suggestions:

• provide alternative views of the pension deﬁcit in the front section of the annual report • provide contextual information to aid understanding of the volatility of pension deﬁcits • explain mortality tables in more accessible, less technical language • provide alternative presentation of information eg both graphics and tables • locate all assumptions in one table • explain key terms in plain language • provide a sensitivity analysis of main assumptions underpinning the calculation of the liabilities and annual pension costs, such as fan charts as illustrated by Cass Business School in its 2008 report for the Pensions Institute.4

5 So where next? This is a long term project. The ASB was delighted with the volume and quality of responses it received and it has now commenced on the reconsideration of its proposals with a view to issuing ﬁnal recommendations in 2009. These recommendations will be sent to the IASB for consideration in their ongoing pensions accounting project and as a spur to further improvements in the longer term. The IASB intends to issue an exposure draft of proposed amendments to IAS 19 in the second half of 2009 and these proposals are likely to include the elimination of both deferral mechanisms and the use of expected returns in the income statement together with changes to the presentation of pension costs. The exposure draft will be open for comment for a period of three to four months.

An Unreal Number, Cass Business School for the Pensions Institute, January 2008.

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We have seen significant changes to asset allocation models, closure of defined benefit schemes to new members and some total scheme closures. As boards gain greater insight into the exact nature of their pension obligations, these trends will continue and the buy out of pension liabilities by insurance companies and other providers of bulk annuities is likely to be an accelerating next step. Early in 2008, Lane Clark & Peacock, the actuarial consultants, forecast a pipeline of buy out deals totalling some £10bn and to date there have been a number of transactions including P&O and Rank and most notably Cable and Wireless (C&W). The C&W deal totalled £1bn with the Prudential taking on the pension liabilities associated with 5,000 retired members and represents the largest UK transfer of retirement liabilities to date. Current market turmoil is likely to have a slowing down affect on further deals such as these but we would anticipate appetite returning once we reach more stable financial conditions. Figures released by the Office for National Statistics show that membership of private sector defined benefit schemes continues to fall. In 2006 these schemes had 3 million members but by 2007 membership had fallen to 2.7 million, 53% of which were in schemes now closed to new members. The response to the discussion paper from the National Association of Pension Funds The NAPF reports that from 2012 (NAPF) makes the point that the ASB, like other defined benefit schemes that do not standard-setters and regulators, cannot ‘operate already use auto-enrolment will be in a vacuum, indifferent to the consequences required to auto-enrol their workers of its actions.’ The NAPF fears that the ASB’s into a pension scheme. If schemes proposals taken with other expected changes auto-enrol at existing contribution such as auto-enrolment from 2012, EU Solvency rates then the cost to schemes could II requirements and increasing longevity could be about £1bn per annum. create a ‘mix toxic enough to kill off the UK’s remaining defined benefit provision.’ The ASB’s discussion paper also prompted the Minister of State for Pensions Reform to write expressing his concern about the impact the proposals could have on the future of UK defined benefit pension provision. The Minister was particularly concerned with the proposal to use a risk-free discount rate which the NAPF estimates could increase reported liabilities between 25% and 100% depending on the maturity of the scheme. The Minister concluded ‘the unintended consequences of these proposals could see many defined benefit pension schemes closing, reducing many thousands of people’s expected retirement incomes and ultimately damaging confidence in the UK pension system.’ Punter Southall, consulting actuaries, were commissioned by the NAPF to carry out calculations on the potential effects of the proposals. For FTSE 350 schemes, Punter Southall estimated that as at 31 December 2007 a change from the AA-rated bond discount rate to a risk-free rate would increase liabilities by £250bn. The current economic turmoil can only deepen company board’s concerns regarding the perceived cost of pensions. The boards are likely to tend towards more risk adverse strategies and the recognition and presentation policies relating to pensions will effect their views on whether they should shed pension risks relating to investment, longevity and other difficult to control and expensive to hedge risks.

22 | Reforming the reporting of pensions

CIMA does not believe that pension standards should be artificially engineered to produce results that favour keeping schemes open, nor does it believe that the vast majority of those arguing against the ASB’s proposals would approve of rules skewed in this way. Can the complexities of pension provision be adequately represented by a single number on the balance sheet? We think not, the Report Leadership publication, Generico, referred to above, provides a comprehensive illustration of how supplementary information, including alternative valuation bases, can be presented in financial statements compliant with IFRS. There is not one right answer and the impact of reporting a wrong number could be catastrophic for pension provision. For those involved in pension accounting and those hoping to continue to accrue further defined benefit pension benefits, this debate is crucially important and we urge them to participate.

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6 References and further reading ASB discussion paper – The Financial Reporting of Pensions Fuller details of the proposals, the reasoning underlying them and a discussion of alternative views may be found in the Discussion Paper itself, which can be obtained from the ASB website at www.frc-asb.org.uk. The EFRAG website provides access to the Public Record of responses to the discussion paper: www.efrag.org/projects/detail.asp?id=70 CIMA response to the discussion paper The full text of CIMA’s response to the ASB’s discussion paper can be accessed via the consultation database on the CIMA website www.cimaglobal.com/cdb Lane Clark & Peacock (2008), Accounting for Pensions 2008. www.lcp.uk.com Cass Business School for the Pensions Institute (2008), An Unreal Number. www.cass.city.ac.uk IASB (2008), Preliminary Views on Amendments to IAS 19 Employee Beneﬁts. www.iasb.org ASB (2008), Capital Maintenance: the way forward? A solvency based regime for dividend distributions. The ASB hosted a meeting on alternative capital maintenance regimes and a survey of proceedings is available from the FRC website. www.frc.org.uk/asb/about/pub1552/html EU (2003), Directive on Institutions for Occupational Retirement Provisions. www.europa.eu/geninfo/query/search_en.html

24 | Reforming the reporting of pensions

The pensions liability – managing the corporate risk This publication provides updated guidance to organisations on how to manage the corporate risk of pension schemes. The guidance and checklist, published in February 2008, contain the latest statistics and examples and recent changes to regulation. These include references to the pension regulator’s revised ‘clearance guidance’, ASB’s discussion paper The financial reporting of pensions, scheme specific valuation and the International Financial Reporting Interpretations Committee (IFRIC) Statement D14. The report takes a different approach from most other pension guidance by tackling pension risk from a corporate point of view. The publication has benefited from oversight by the CIMA Pensions Advisory Group, whose members include finance directors from FTSE 100 and FTSE 250 companies, leading academics, along with trustees of some of the UK’s major pension funds. The guidance offers CFOs and FDs an outline of the current regulatory framework, the potential risks from the pension liability and how to understand and better manage these risks. The checklist aims to assist companies in producing a tailored action plan for effective corporate risk management. Available at www.cimaglobal.com/pensions Apocalyptic demography? – putting longevity risk in perspective CIMA believes that longevity risk is one of the most challenging risks around today for finance directors. UK life expectancy has nearly doubled over the past 150 years, with a trend of 2 to 2.5 years per decade. This has consistently exceeded official projections. Two years extra longevity is estimated to be worth £45bn, based on the present value of defined pension liabilities across companies in the UK. There is currently no commonly accepted forecasting model when it comes to predicting longevity risk and substantial, unprecedented increases in life expectancy could potentially undermine the financial viability of defined benefit pension schemes across the UK. CIMA’s report Apocalyptic demography? – putting longevity risk in perspective, published in association with the Pensions Institute at Cass Business School, provides a checklist to finance directors who may not fully understand how seriously even small changes in mortality assumptions can affect them. Available at www.cimaglobal.com/pensions

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978-1-85971-607-6 (pdf) December 2008 The Chartered Institute of Management Accountants 26 Chapter Street London SW1P 4NP United Kingdom T. +44 (0)20 8849 2275 F. +44 (0)20 8849 2468 E. innovation.development@cimaglobal.com www.cimaglobal.com

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