With EU endorsement of the new International Accounting Standard covering defined benefit (DB) pension plans (IAS 19 rev 2011) due in the next couple of months, many plan sponsors are yet to prepare for the new footnote disclosures explaining their DB plan risks and how they are being managed, according to Mercer. The consultancy has outlined five areas of impact for DB pension risk management for plan sponsors to consider as they prepare for adoption of IAS 19 rev 2011 over the next year.
The new footnote disclosures are principle based and are designed to give equity analysts and credit rating agencies a better insight into the approach plan sponsors are taking to DB risk management. This includes explaining any unusual plan specific risks such as Trustee powers over contributions or plan termination, as well as explaining the amount, timing and uncertainty of the plan sponsor’s future cash flows to DB plans.
“There are already comments from equity analysts that this will lead to an increased focus on the risks posed by DB plans,” said Warren Singer, Mercer’s UK Head of Pension Accounting. “Questions are being asked about the impact on cash contributions of the next round of funding valuations, especially if there is any further adverse market experience in the current low bond yield environment. Given that reported profits will no longer be automatically rewarded for holding equities rather than bonds, the new IAS 19 and the footnote disclosures may cause plan sponsors to re-evaluate their approach to DB plan risk management.”
Mercer’s analysis has highlighted the following five themes:
1. Improved comparability by removing the subjective “expected return on asset” assumption: Companies that have relied on bullish expected rates of return on asset assumptions to automatically improve their reported profit, irrespective of actual plan asset performance, are likely to face a significant change in Key Performance Indicators (KPIs) that needs explanation to investors and analysts. This may prompt plan sponsors to review how KPIs are affected by actions to reduce DB plan risk.
2. Removal of the option to defer recognition of gains and losses: Companies that have historically used deferred recognition and have large unrecognised losses will face a step change in their balance sheet position. However, there is also a potential improvement in future reported profits, such that early adoption of the new IAS 19, may be attractive.
3. Focus on longevity risk management: From a pension accounting perspective, a pension increase exchange is likely to be a more attractive way of managing longevity risk. This type of approach can achieve more certainty in future cashflows and lead to an immediate reduction in the DB plan risk reflected in financial statements.
4. Focus on DB plan liability management: New IAS 19 clarifies that routine benefit payments that are part of the terms of the plan do not need to be accounted for as settlements. This may encourage some plan sponsors to consider agreeing long term enhancements to transfer values so that more DB plan risk is transferred to members without triggering settlement costs in the P&L.
5. Focus on DB plan risk transfer: For those companies who want to transfer the risk to an insurance company and are willing to lock in to current low bond yields, the accounting implications of a buy-in are generally more attractive to reported P&L than a full transfer via a buyout.
“As many companies prepare to adopt new IAS 19 in 2013, a failure to prepare for the footnote disclosures that explain DB risk management may lead to some companies being viewed negatively compared to peers when analysts look at DB plan risk with a renewed focus,” concluded Mr Singer.
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