During December, the Association organised a round table meeting of representatives from the Institute of Investment Management & Research (IIMR), the National Association of Pension Funds (NAPF), the Faculty & Institute of Actuaries (FIA), The 100 Group of Finance Directors and the Chartered Institute of Management Accountants (CIMA), to discuss FRED 20, Retirement Benefits. The Group was addressed by Sir David Tweedie and Anne McGeachin of the Accounting Standards Board on the principles behind FRED 20 and international efforts to move towards harmonised accounting on pension matters.
The consensus view that emerged was strong support for the disclosure requirements of FRED 20 which will make all matters of pension management and accounting transparent to readers, with valuations firmly based on market related parameters. However, there was considerable reservation about both the potential introduction of volatility into performance statements as a result of potentially large movements in the market value of assets, and the discount rate used to find the current value of future liabilities.
The ASB explained why an AA corporate bond rate, derived from market data, should be used to discount liabilities. This is because historical analysis shows that the corporate bond rate most closely correlates with salary increases which are the primary determinant in the inflation of pension fund liabilities.
The ASB remained willing to look at discount rates which included, at least in part, an equity total return expectation, but thus far had been unable to provide evidence to other international accounting standards setters that such a discounting approach would produce a more valid estimate of the present value of liabilities.
The problem of volatility in the performance statement is to be addressed by putting variations in the actual returns on the pension fund assets, over those expected during the year, into the statement of total recognised gains and losses. This would mean that the profit and loss account would include the expected return on equities, which might reasonably be taken under normal circumstances as exceeding that on bonds. However, the under or over performance against expectation would go into the STRGL.
This has the drawback that an out-performing investment fund would not show that out-performance in the profit and loss account since there was no proposal to recycle profits, or losses, from the STRGL. Since any increase in future benefits agreed with members of the pension fund will have to be provided in the profit and loss account immediately, and since such an increase in benefits is more likely to occur when the pension fund assets have been performing well, the proposed accounting could lead to companies being less willing to improve benefits because the cost would appear in the P&L but the funding for the improvement, the outperformance of investments, would not.
Thus far, the ASB have rejected the IAS 19 approach to smoothing in the performance statement, preferring instead to put excess volatility into the STRGL. An alternative put forward was that all volatility in both assets and liabilities should appear in the P&L with an explicit adjustment, below the line, which would smooth excess volatility over the average lives of the pension fund members in order to produce a more stable performance measure that could be used for EPS purposes.
A further disclosure could be to show the term structure of the pension fund liabilities, thus allowing analysts to use a liability discount rate different from the AA corporate bond rate when they felt such a discount rate to be appropriate. More disclosures on the investment policy of the pension fund trustees would also be valuable.
The Association intends to make a submission to the ASB on FRED 20, focusing primarily on the need to ensure that accounting for pensions does not produce an incentive for Finance Directors to change their strategy on pensions, either by exiting from defined benefit schemes or failing to augment existing schemes when appropriate. Further, it would be disruptive to the market, and arguably not in pension members' long term interests, if there were to be a substantial sale of equities and purchase of bonds by pension funds, unless this could be managed on a very long time scale or through co-ordinated share buybacks and debt issuance by corporates.
The Group agreed to meet again at the end of January to review the issues raised.