In the spotlight: occupational pensions
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So it’s no surprise that employee benefits schemes are adjusting their pension plans. The question arises as to how measures related to employee benefits are presented in a company’s financial statements. Significant here is not just the set-up of the measures themselves, but the standard under which an entity reports.
In financial reporting practice in this country, the Swiss Code of Obligations (CO) is relevant for statutory (stand-alone) financial statements, and Swiss GAAP FER, International Financial Reporting Standards (IFRS) and US GAAP for consolidated accounts. Depending on the standard used, there are two different approaches to presenting pension liabilities in the accounts.
a) Financial reporting under CO/FER: this approach primarily presents the legally accrued benefits and their funding. Financial statements under CO/FER therefore work on the basis of cash flows resulting from the legal duty to fully fund pension benefits. The basis for the entity’s potential (pension) liability is the financial statements of the employee benefits scheme (i.e. the pension fund). The main question addressed in the pension fund’s financial statements, which have to be produced in accordance with Swiss GAAP FER 26, is the degree to which legally accrued benefits as shown on the balance sheet date are funded. To this end the assets in the pension fund are recognised in the balance sheet at fair value, while benefits to insured members are recognised in accordance with the actuarial (technical) assumptions set down in the pension fund regulations. The discount rate is calculated on the basis of a long-term average. A pension liability is especially likely to accrue to the entity in cases where the benefits promised in the regulations are currently insufficiently funded and the pension fund is forced to take steps to improve its financial situation. The key question in terms of reporting under CO/FER is how the planned measures affect the funding of the pension fund?
b) Financial reporting under IFRS/US GAAP: this approach revolves around the benefits promised to employees on the basis of the currently valid pension fund regulations. The entity’s net defined benefit liability is calculated as the difference between the pension fund assets measured at fair value and the present value of the accrued prospective entitlements pro-rated on service. The requisite discount rate is calculated on the basis of capital market rates on the balance sheet date. Since all costs accruing to the entity on the basis of the promised benefits have to be considered, the actuarial calculations take account of future-oriented assumptions such as increases in pay and pensions and the anticipated development of life expectancies. Under this approach the degree to which the net defined benefit liability is funded plays only a subordinate role. If measures are resolved to improve the finances of the pension fund, the key question in terms of reporting under IFRS/US-GAAP is how the promised benefits will change?
If it becomes evident that an employee benefits scheme's pension plan is going to be insufficiently funded in the future, it may be necessary for the board of trustees, and particularly the employer representatives, to take action even before compulsory remedial measures are required under employee benefits law. This requirement is closely linked to the actuarial funding ratio. Under the law, compulsory remedial measures have to be taken when the funding ratio falls below 100%. But this doesn’t mean that a scheme that is currently more than 100% funded will be able to fund the promised benefits in the medium to long term. This is reason enough to take appropriate steps in good time. When deciding on what measures to take in such situations, in addition to the legal requirements, a pension fund has to take account of various other factors, including the origins and magnitude of the shortfall, the fund’s risk tolerance, and economic considerations as well as the company’s interests in terms of its reputation as an employer and its ability to offer an attractive overall pay package.
Here is a summary of the most important preventive and remedial measures:
Reduction in the conversion rate: this mechanism is currently the subject of controversy. Reducing the conversion rate usually requires an amendment to the pension fund rules to adapt the plan by reducing the benefits promised. The remedial effect for the pension fund is prospective, as it will require less capital to cover future pensions than it does to cover current pensions. Often a reduction in the conversion rate is accompanied by a reduction in the discount rate see Figure 1.
Promised benefits result in long-term obligations. To take account of the time factor, discounted values are used in the presentation of pension fund obligations. The methods used to calculate the relevant discount rates vary according to the financial reporting standard.
The discount rate for Swiss GAAP FER 26 purposes is calculated on the basis of the technical reference interest rate, which represents the average of the performance of the BVG-Indices 2005 Pictet BVG-25 plus for the last 20 years and the yield on 10-year Swiss Confederation bonds.
These differing calculation methods have led to divergence between discount rates in recent years see Figure 1. This is one of the main reasons why benefit obligations come out significantly higher under IFRS/US GAAP than under CO/FER.
Lower interest on retirement savings: this involves reducing the benefits without adjusting the plan. It is done at the expense of the active members, amounting to a reduction in their benefits in favour of the existing pensioners.
The entity imposes a restriction of use on the funds in the employer contribution reserve account: if such a restriction is imposed, for the period during which there is a shortfall in cover the employer contribution reserve cannot be used to pay employer contributions. While this mechanism does not reduce underfunding, it does give the pension fund time to work out additional measures.
Employers and employees pay remedial contributions: when this mechanism is applied, additional funds accrue to the pension fund without there being an increase in employee benefits. Under the terms of Art. 65 d BVG, the remedial contributions paid by the employer must be at least as high as those paid by the insured members.
Depending on the financial reporting standard applied, the impact on the figure recognised in the company’s accounts for preventive and remedial measures in connection with financial difficulties at the pension fund will vary. Figure 2 summarises the main implications:
|Measures in the event of pension fund underfunding||Swiss Code of Obligations||Swiss GAAP FER||IFRS|
|Reduction in interest on retirement assets (lower pension benefit without adjusting the plan)||Indirect impact of lower reserves required in future resp. lower contingent liability||Indirect impact of lower reserves required in future resp. lower contingent liability||Reduction in DBO on the basis of remeasurement in OCI|
|Reduction in conversion rate (lower pension benefit with an adjustment to the plan)||Indirect impact of lower reserves required in future resp. lower contingent liability||Indirect impact of lower reserves required in future resp. lower contingent liability||Reduction in DBOrecognised in profit and loss|
|Decision to require remedial contributions (approving supplementary funding)||Provisions and/or expense required corresponding to amount of remedial contributions (regardless of when due)||Provisions and/or expense required corresponding to amount of remedial contributions (regardless of when due)||No direct impact|
|Payment of remedial contributions (providing supplementary funding)||Reduction in provisions, with no effect on profit or loss||Reduction in provisions, with no effect on profit or loss||Reduction in net benefit obligation, with no effect on profit or loss as well as lower cost of benefits in subsequent periods because the plan is better funded|
|Entity imposes restriction of use on funds in employer contribution reserve account||Part of net release of hidden reserves (impairment charge if employer contribution reserve was recognised)||Impairment charge on employer contribution reserve||No direct impact|
|Pension fund lowers technical reference interest rate||Increase in provisions required||Increase in provisions required||No direct impact (as long as there is no improvement in benefits for active members in statutory defined benefit plan)|
The following accounting effects deserve special mention:
The accounting approaches under CO/FER and IFRS/US GAAP each have their pros and cons. Those responsible for pension funds, employer representatives and users of financial statements are advised to take account of the various peculiarities and differences when making strategic decisions or assessing the need for action. Neither approach really does justice to the ‘truth’.
Financial statements produced in accordance with CO/FER present cash flows in the relatively near future. This kind of presentation is easier to understand than long-term projections involving complex calculations and assumptions. It’s unproblematic as long as the pension fund has sufficient reserves. However, it does not give any indication on future risks for the entity on the basis of the benefits currently promised, or of the reserves necessary to ensure benefits are adequately funded in the long term.
In current financial reporting practice very few companies reporting under CO/FER provide more extensive information on their pension plans in their financial statements. In this respect, useful information would mean disclosing information on how an entity sets up its pension plans, the actuarial assumptions used (technical discount rate and mortality tables), and what the pension fund’s current financial situation is (for example the entity discloses the technical and the economic funding ratio and details of how they are calculated).
Financial statements under IFRS/US GAAP present extensive actuarial calculations and look far into the future. They present the entity’s risk on the basis of the pension benefits currently promised. This presentation fails to fully reflect the fact that extra-mandatory benefits can be reduced prospectively. When it comes to benefit obligations, both IFRS and US GAAP require very extensive disclosures, but in some cases these disclosures are not very meaningful.
Company directors and pension fund trustees should familiarise themselves with the impact of measures designed to address limitations on a pension fund’s ability to handle risk, not only in terms of the implications for insured members and the scheme’s finances, but also in terms of the associated company’s financial reporting. They should be aware that depending on the financial reporting standards adopted, the same facts may be presented differently. While financial statements under the Code of Obligations or Swiss GAAP FER often contain too little information, IFRS/US GAAP statements contain comprehensive information, some of which is less useful.
It would be fairly easy to make reporting under the Code of Obligations and FER more meaningful by disclosing information on the actuarial principles applied and the actuarial and economic funding ratio for the pension fund, in addition to details of how the company sets up its pension plans. Both the new financial reporting law and Swiss GAAP FER would encourage enhanced disclosure of this sort.