PwC IFRS blog

Discounting the value of pension accounting

Valuing defined benefit pension obligations is seldom easy. For several years, actuaries have been debating for how long people will live – longer and longer, it turns out. But the good news that we are going to live longer than we thought comes with a sting in the tail: our pensions are going to become more expensive, unless we defer our retirement.
 
And now there is another assumption that is challenging actuaries and accountants alike: the discount rate. There is of course the debate about what this rate should reflect. Some have suggested the risk-free rate would be more appropriate – that is, however, a subject for another time. Indeed the IASB has deferred consideration of this beyond its current programme.

Currently, IAS 19, ‘Employee benefits’, requires defined benefit pension obligations to be discounted by reference to the yield on high-quality corporate bonds (provided there is a deep market in such bonds). Interpreting the words ‘high-quality corporate bonds’ is proving to be a challenge.

Let's start with ‘high quality’. My dictionary tells me that ‘quality’ is "a degree or grade of excellence or worth". So it follows that high quality must mean a high degree of excellence or worth. Typically, this is taken to mean corporate bonds rated AA or above, so we are part of the way there. But the yields on some AA-rated bonds have increased significantly in 2008. In fact, some in the market are forecasting default rates of over 30% on some investment grade bonds. Many are questioning whether the higher yielding bonds in the commonly used indices of AA corporate bonds are really high quality at all. Many of these bonds are, not surprisingly, issued by banks and financial services companies. But which bonds do you exclude? Those on credit watch, or those where only one rating agency has given a rating of AA or better, or those where the yield exceeds the average by more than a certain amount?

Even the word ‘bonds’ is open to interpretation. Going back to my dictionary, we get "a certificate of debt (usually interest-bearing or discounted) that is issued by a government or corporation in order to raise money; the issuer is required to pay a fixed sum annually until maturity and then a fixed sum to repay the principal". In fact, the indices often include convertible bonds, warrants and preference shares. Should these really be included?

Up until now, none of this has mattered a great deal, as yields have been within a fairly narrow range. But yields and spreads have increased over the past year as the credit crunch has changed market perceptions. The broader spread of yields indicates the range of discount rates used in practice is likely to be wider and, generally higher, than last year. This means that although the value of many assets held by pension plans will have fallen, the value of their liabilities may also have fallen. In some cases, the liabilities will have fallen by more than the assets, and a pension deficit could have been transformed into a surplus!

The difficulties of setting discount rates have opened up more questions than answers. Some are saying that IAS 19 is now open to abuse in the same way as some predecessor national standards. In 2007, the IFRIC issued a 22-page interpretation to tell us, among other things, what the word ‘available’ means in the context of pension plan surpluses. I wonder whether they will need to do something similar again in this case.

I would be interested in your thoughts, either by commenting here or by email.

Is it time to change direction?

Last July, in my posting "Power to the few", I touched on a subject that, on the face of it, few people would get excited about. But it goes to the heart of some of the issues now being debated not only by the profession but public policymakers, namely the objectives of financial accounting and the governance of the accounting standard setters. It is the constitutional review being conducted by the Trustees of the International Accounting Standards Committee Foundation (IASCF), the body that currently oversees the IASB.

The review is being conducted in two parts. The first of these, considering the public accountability of the IASCF and the composition of the IASB, were the subject of one of my previous postings. In the last six months, negotiations have continued with regulatory agencies regarding membership of the proposed Monitoring Board. The Trustees have just announced that they have concluded on this first stage of the review and have commenced the formal process of developing a Memorandum of Understanding between the Trustees and the Monitoring Board.

The Trustees have now issued a discussion document in support of the remainder of their constitutional review. While comments are invited on any matters related to the IASCF’s constitution, attention is particularly drawn to several key areas, including the following:

• Do the organisation’s objectives need to be revised? In particular, should the constitution continue to have as the primary objective developing standards to help participants in the world’s capital markets and other users make economic decisions? In the current economic environment, some have argued that the IASB should also be required to take into account a wider user group and other macro-objectives, such as financial stability when writing the standards. But is it possible to write standards with multiple objectives?
• How important are principles-based standards? Many commentators support the development of accounting standards based on a robust set of core principles, but would they go as far as to enshrine that objective within the IASCF’s constitution?
• Does the IASB’s independence in relation to its technical activities, in both standard-setting and determining its agenda, remain essential? Most, if not all, commentators would agree that it is essential the IASB is independent in these roles but, in practice, how is this to be balanced with enhancing the IASB’s accountability to its multiple constituencies? For example, some argue that accounting standard setters should have more regard for the views of prudential supervisors, regulators and government authorities when writing the standards (for example, regarding the implications of such accounting requirements as fair value measurement for capital requirements imposed by prudential regulators).
• Should a separate ‘fast track’ due process be developed to deal effectively with urgent issues? Recent events have demonstrated the need to tackle certain issues quickly. But at the same time, a perceived lack of due process can cause its own problems.

It is easy to put a subject such as constitutional review towards the bottom of a personal ‘to do’ list. After all, there will be little impact on the day jobs of most people. But in my view, the questions raised in this review are important and go to the heart of the future of standard setting on the global stage.

As always, I am interested to hear your views, either by commenting here or by email.