Managing the pension problem

Changes in pension costs are set to have significant impacts on how companies manage future plans, according to James Nicholson, Partner in the International Retirement Team at Aon Hewitt UK

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Increased pension cost and balance sheet volatility resulting from the changes to the international pensions accounting standard (IAS19) are serious issues which all companies should now be considering. The removal of the ability of an organisation to take advance credit for expected pension asset returns coupled with the removal of the ability to amortise pensions gains (and losses), are likely to be a significant driver for change in the way many organisations manage their pension plans.

Cost increases and volatility
For most companies, the replacement of an expected asset return based on their plan asset mix with the discount rate will result in a material increase in pension cost. This is because a typical asset mix includes a significant proportion of equities, which are almost always assumed to earn more than the corporate bonds on which the discount rate is based.

This means that in the short term, the income statement reward for investing in riskier classes of asset is removed and therefore removes one of the attractions of holding a portfolio of risky assets, although any excess growth in assets will, of course, lead to a lower cost in the long-term. The revisions to the standard are being introduced in conditions of very low corporate bond yields leading to lower discount rates and higher deficits compounding the effect of the change in standard.

This is a cost increase that may also be accompanied by greater cost volatility for funded plans. This is because any change in the discount rate applied to the obligation will automatically result in the same change in the expected rate of return applied to the asset. So, for a well-funded plan with a small deficit, the annual cost will be close to the service cost (the interest on the obligation being more or less offset by the interest on the asset). A change in the obligation resulting from a change in the discount rate without a corresponding change in the asset value could result in a greater change in this net interest item than would have arisen before the revisions to the standard (as the expected rate or return on assets under the standard before revision would not necessarily have changed at all). For funded plans, the only real way to avoid this volatility is to match the obligations with appropriate investment and as a result it is possible that we will see a greater level of investment in corporate bonds.

Balance sheet changes
For some companies, the removal of the option to defer recognition of gains and (more often) losses will result in a significant one-off balance sheet impact. Going forward, these companies will be subject to much higher levels of balance sheet volatility than they are accustomed to under the current rules. Again, this could lead to a review of investment strategy or other ways in which volatility can be reduced or limited more effectively.

However, it should be noted that for companies that currently have very large deferred gains or losses, immediate balance sheet recognition of these amounts might actually lead to less cost volatility under the revised standard, although the effect on cost will depend on the relative impact of the removal of deferred recognition and the change in how interest on the plan asset is determined.

Application of the standard
At the same time that the revisions are introduced, it is becoming trickier to select a discount rate in some markets. IAS 19 requires the use of high quality corporate bond yields of appropriate duration to determine the discount rate (or government bond yields if the market is not deep enough) without defining what high quality means.

This is a cost increase that may also be accompanied by greater cost volatility for funded plans

Up to now ‘high quality’ has been taken to mean bonds rated AA or better but the number of these bonds, especially at longer durations, has been diminishing fast as a result of multiple re-ratings. This has led to a number of companies raising questions about the definition of high quality. On the one hand, the question is raised in the context of how to expand the bond universe in order to clarify the shape of the corporate bond yield curve at longer durations. Furthermore, the question is raised as one of principle and perhaps in the context of whether the meaning of the ratings has changed over time. The International Finance Reporting Standards interpretations committee has received a request to provide further guidance on what can be considered a high quality bond, but initial tentative decisions indicate that the committee has chosen not to rule further on this issue leaving the question as a matter of judgement for companies.

Assumption setting process
The revision to the standard is also an opportunity for companies to revisit whether their assumption setting process is leading to the best estimate of all assumptions. Some companies simply use the bulk of the assumptions from their funding valuations, which may well be chosen with an eye on prudence, only adjusting for the main financial factors. Bearing in mind the higher costs and the sensitivity to the size of accounting deficit, it is clearly appropriate to revisit mortality rates, early retirement rates and so on.

Application in practice
The revised standard still leaves some open issues for companies to consider, for example whether the allowance for administration expenses should be included in operating cost (as indicated in the basis for conclusions) or in the finance item (which results in a different impact on cost), what should be included in administration expenses and whether interest on current service cost should be included in service cost or the interest item.

Tackling the problem
There are many actions that could be taken. We are seeing companies:
• Review the methods for selecting assumptions and checking that the allowance for administration expenses is appropriate;
• Review the plans on a global basis to determine how best to reduce volatility and control risk;
• Monitor how projected pension costs and balance sheet amounts are likely to change in volatile market conditions to avoid surprises;
• Consider how to reduce defined benefit obligations further to reduce the impact (e.g revisit DB to DC conversions, liability settlements etc);
• Compare their pension risk situation to their peer group, so that they can be prepared for analyst reactions to the impact of pensions;
• Appoint an international actuary to advise corporate on all of these issues (if one is not already in place).