Pension Accounting Changes Yet Again

Yesterday, IFRS announced changes to IAS 19 -- Employee Benefits. For those of you who are not familiar, IFRS is the major international accounting board and through IASB, the International Accounting Standards Board, they issue international accounting standards and related material.

According to the IFRS press release, the "IASB introduces improvements [emphasis added] to the accounting for post-employment benefits." In my opinion, this is very much a matter of opinion. Let's examine.

The most significant change that was made was eliminating deferred recognition of gains and losses. What exactly does this mean?

Most companies will measure their pension assets for IAS 19 purposes once each year, that occurring on the last day of the fiscal year. Under the new IAS 19, effective for fiscal years ending January 1, 2013 or later, actuarial gains and losses that occur during the year will be recognized in income immediately. Among the rationale for this is that this change will inhibit imprudent risk-taking.

I digress. When determining the obligations of a pension plan (IAS 19 calls this a defined benefit obligation or DBO), an actuary makes a myriad of assumptions (technically, the assumptions belong to the plan sponsor, but the sponsor typically defers to the actuary who is trained to make such assumptions) including, but not limited to, these:

• Discount rate: the rate at which those obligations could effectively be settled on the measurement date
• Salary increase rate: the rate(s) at which salaries are expected to increase
• Mortality: the likelihood of an individual dying at a particular age assuming that they live through the immediately preceding age
• Retirement: the likelihood of an individual retiring at particular age assuming that they remained in employment through the immediately preceding age
• Termination: the likelihood of an individual terminating employment prior to retirement at a particular age assuming that they remained in employment through the immediately preceding age

Those are some tricky assumptions to make. And, while actuaries are highly trained, there are a few things that I can tell you with certainty about those assumptions. First, they are reasonable; in fact, in many countries, they are required to be the actuary's best estimate. However, most actuaries would tell you that with regard to any assumption, there is probably a range within which any assumption might be considered a best estimate by some qualified and ethical actuary. Stated differently, it is very reasonable that on a particular date, I think the best estimate discount rate for a particular obligation is 5.80% and another actuary thinks the best estimate is 5.90%. This happens all the time and it is fine. Second, the assumption will not be perfect. In all my years of practice, only once can I remember a single defined benefit plan assumption being perfect for a single year. Or, as a colleague of mine once put it to a client when presenting actuarial valuation results, "We know these answers are wrong, but they are as close to being correct as any result you would get from anyone else."

Why did I tell you all this? It was to point out that these actuarial gains and losses that must be reflected in income are estimates. Sometimes, the estimates are very good, and sometimes, despite the best honest and ethical efforts of all parties involved, they turn out to be pretty bad.

Now, let's switch to the asset side. As I noted earlier, our clients usually measure the assets and obligations of a plan once each year, on the measurement date. Suppose a plan's fair value of assets on December 30 is $1 billion. And, further suppose that due to the breakout of civil war in Grand Fenwick (Grand Fenwick was a mythical country in a book called "The Mouse That Roared"), the plan's fair value of assets drops to $975 million on December 31. And, then when the markets realize over the New Year's Day break that the Grand Fenwick civil war has already ended, the plan's assets rebound to $999 million on January 2. The plan sponsor still reports assets of $975 million and the company's income statement will have suffered a $25 million hit because of this silly event.

This is part of the slow rush to mark-to-market accounting. Does it make sense? Sometimes? I can argue either side and I often have. But, in this case, for an ongoing plan, this is a long-term obligation which means that the asset pool should be used to mitigate risks associated with a long-term obligation. But, the amended IAS 19 will cause plan sponsors to treat this as a short-term obligation. This, in turn will cause more sponsors to freeze or terminate their plans which will cause the obligation to be, in fact, a short-term obligation.

Prophetic, isn't it ...