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| Pension Schemes: Upcoming Accounting and Funding Changes |
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By
Joanne Roche, Associate Director, KPMG Pensions Advisory Services
May 31, 2011 |
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The combination of the changes proposed domestically by the NPFIG (National Pensions Framework Implementation Group) and internationally by the expected publication of a revised standard by the IASB (International Accounting Standards Board) will result in wide ranging changes for defined benefit pension scheme funding and accounting. Investment Strategy published by the NEST (National Employment Savings Trust) in the UK, which is expected to become the largest pension fund in the world, is likely to influence defined contribution schemes’ investment strategy in Ireland, as well as the UK. In the following article, Joanne Roche (Pensions Advisory, KPMG) outlines the expected changes for both Defined Benefit and Defined Contribution schemes.
Ireland - NPFIG CP “Proposed approach to Defined Benefit Provision”
The National Pensions Framework Implementation Group in Ireland recently issued a Consultation Paper on the “Proposed Approach to Defined Benefit Provision”. The consultation paper outlines:
- three alternatives for a revised statutory funding standard
- proposed legislative change to affect a “new DB Model”
- a number of definite changes to the existing funding standard
The proposed changes to the statutory funding standard will increase the cash funding requirements of defined benefit schemes under the 2 options favoured by the Group.
The Implementation Group (composed of representatives from the Pensions Board and various Government Departments), stated that it anticipates a significant number of scheme restructurings including benefit reductions through the Section 50 process following the introduction of a revised (more onerous) funding standard.
Whilst the 0.6% pension levy has attracted widespread media attention, the implementation of the changes proposed in this Consultation Paper will likely have far more wide-reaching and impactful ramifications for defined benefit pension members.
Whether introduced immediately or with a 2 year lead-in, the proposed more stringent funding standard will come at a time when few companies can afford additional contributions to pension schemes.
The fact that over half of the 1,200 Irish Defined Benefit schemes were still due to submit funding proposals in the run up to the last funding proposal deadline, illustrates the extent of the underfunding issue and the inability of companies to grapple with their pension issues under the existing regime.
Many of these organisations are expected to avail of the option to restructure / reduce benefits, a process which will become easier to communicate to members and trustees where many other companies are doing similar. The member implications are likely to be wide-ranging and we would caution against a restructuring that goes “too far, too fast”.
Stronger companies will have less flexibility to fund schemes according to their own timelines. That said, under Option (b) in the paper, if trustees have a legally enforceable guarantee from an employer to meet any deficit that arises, they do not need to hold the additional reserves, meaning their funding standard liabilities would remain at current levels.
Per the latest IAPF Investment Survey 2010, of the €48.6bn of defined benefit pension assets, €31bn was invested in equity/ property investments. The continuation of these levels of equity investment is unlikely to be sustained under the proposed new regime due to three main factors:
- a requirement to hold additional buffers for any equity investments
- a change in approach in terms of the removal of any ability to allow for outperformance on equity assets over bonds over the period of the funding proposal
- the requirement to rectify deficits over a short period, further discouraging investment in volatile asset classes.
The priority order of an underfunded scheme winding up in deficit was not discussed in the paper.
Priority order continues to be an issue for many schemes, the true extent of which only manifests itself in the event of an actual scheme wind-up.
The Government will make a final decision on the proposed new funding standard based on the advice of the Implementation Group and the results of the consultation.
UK - NEST Investment Strategy
The main themes in Defined Contribution Schemes’ investment strategy for 2011 are a continuation of the life-styling investment strategy representing the default option of choice, with renewed interest in lower cost passive management approaches, and a heightened focus on charges.
The National Employment Savings Trust (NEST) outlined its long awaited investment approach in March. It will offer a “default” retirement date fund, which targets a particular year in which that fund’s members are expected to retire.
A preference for passive management underpins the beliefs of the new fund. It also says that taking investment risk is usually rewarded in the long term and that risk derived asset allocation is the biggest determinant of long term performance. Under the approach, in the career phase where investments are made into ‘return seeking’ assets ( the majority of a working career until individuals start to approach retirement), the assets will be invested predominantly across a passive global equity tracker fund and a ‘diversified beta fund’ , also managed on a passive basis.
The diversified beta fund invests in a wide range of asset classes and its overall objective is to deliver returns similar to a 60% equity/40% bond portfolio over the long run but with 40% lower risk. The investment approach of NEST is being widely followed and will likely provide a benchmark for many defined contribution schemes, influencing investment strategy in both the UK and Ireland.
International - IASB revised standards on Pension Accounting
The IASB is expected to publish a revised standard on pensions accounting in the coming weeks, which will mean that companies can no longer keep gains and losses off balance sheet.
Many Irish entities with defined benefit pension obligations will be significantly affected by the proposed changes to IAS 19 Employee Benefits. Particularly affected will be those that either currently defer recognition of actuarial gains and losses or recognise them immediately in net income. The changes include removing options, standardising elements of the accounting and expanding the disclosures.
Many financial institutions, particularly banks and insurance companies’ balance sheets which previously employed the ‘corridor method’, will be affected.
The IASB published an Exposure Draft on Defined Benefit Plans in April 2010, with consultation ending on 30 September 2010 and implementation expected by the middle of this year. One of the key changes in the Exposure Draft is to require immediate recognition of all gains and losses arising in defined benefit plans. Today, under the “corridor” method actuarial gains and losses on pensions can be deferred and recognised in net income in later periods. Actuarial gains and losses are the difference between assumptions made about, for example, employee turnover, life expectancy and the discount rate and the actual outcome arising on post-employment benefits. Deferred recognition will no longer be allowed. Instead, all actuarial gains and losses will be recognised in full in the period they arise, as part of other comprehensive income – i.e., outside net income.
The global economic crisis increased the focus on the off-balance sheet pension liabilities that can result from the corridor’s deferred recognition. The IASB’s proposal to eliminate this deferral received widespread support and mandating their recognition in other comprehensive income will increase comparability in this area. Actuarial gains and losses can be volatile and this presentation solution keeps that volatility out of net income and earnings per share.
Another key change will significantly affect many entities’ net income. The net interest component of pension expense will now be calculated by applying a single interest rate – the rate used to discount the obligation – to the entity’s net pension asset or liability. If the plan’s assets are expected to generate a higher return in the long-term than the liability discount rate, then that higher expected return will no longer be credited to net income. Instead, any gains (or losses) for returns that are higher (or lower) than the interest rate used will be recognised only in other comprehensive income, outside net income.
The abolition of the corridor method may well be the headline story. But entities shouldn’t overlook the likely reduction in net income resulting from the Board’s new way of calculating net interest on the pension asset/liability. Given the high equity content of Irish pension funds in particular, the impact of this change will be particularly marked here, reflecting the reduced credit which can now be reflected in income. Entities will need to consider the impact of these IAS 19 revisions not only on their defined benefit plan costs, assets and liabilities but also on wider matters such as compliance with debt covenants.
The revisions include some additional disclosure requirements, which focus on the risks arising from sponsoring employee benefit plans, and changes in the definitions of short-term and long-term employee benefits. The revisions are effective for accounting periods beginning on or after 1 January 2013.
A similar de-risking theme is a feature of the recently published Consultation Paper entitled a “New Model for DB Provision”, which if implemented will result in much more onerous cash funding requirements. The proposals in this paper discourage equity investment in 3 main ways:
- removal of the ability of companies to take credit for equity outperformance in their funding plans
- requirement to hold additional ‘risk reserves’ reflecting the proportion of equities held
- requirement to make deficit repair contributions over shorter periods than before, which is likely to reduce appetite for volatile assets
Conclusion
The impacts of the recent volatility in equity markets on defined benefit pension schemes have been well documented. Perhaps unsurprisingly, regulators and accounting standard setters have reacted by encouraging investment strategies involving much reduced equity investments than heretofore. Specifically, the expected upcoming changes to IAS19 employee benefits, keeping gains and losses off balance sheet, will discourage investment in volatile asset classes such as equities.
In contrast, the soon to be largest defined contribution pension fund in the world (NEST in the UK) is advocating an investment strategy which places significant emphasis on ‘return seeking assets’ for the majority of individuals’ working careers.
Trustees of Defined Benefit Schemes influenced domestically by the NPFIG (National Pensions Framework Implementation Group) and internationally through the expected publication of a revised standard by the IASB (International Accounting Standards Board), may well question whether reactionary large scale switches out of ‘return seeking’ assets such as equities into bonds is in the best long term interests of pension members.
Joanne Roche,
Associate Director
KPMG Pensions Advisory Services,
1 Stokes Place,
St Stephen’s Green,
Dublin 2.
Tel. +353 1 410 1000
Fax. +353 1 412 1122
This article first appeared in the May 2011 edition of FS Express (Chartered Accountants Monthly Financial Services Ezine) and is reproduced here with Joannes's permission.
http://www.kpmg.com/IE/en/IssuesAndInsights/ArticlesPublications/Pages/Pensions-Article2.aspx
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