Pensions Consultant Issues Advance Warning On New Accounting Standard

by Robin Pilgrim, LawAndTax-News.com, London

10 December 2009

Hewitt Associates, a global human resources services company, criticizes the dramatic increase in reported pension costs that it expects will arise from proposed changes to company accounting standards for employee benefits (IAS 19). An exposure draft from the International Accounting Standards Board (IASB) is due, which will address some of the issues raised in their 2008 discussion paper, including the reporting of pension costs in profit and loss (P&L) accounts.

Simon Robinson, pension consultant at Hewitt Associates, said:

"At present, there are three key components of pension cost in P&L. First, is service cost, the cost of benefits accruing to pension scheme members during the year. Second is, interest cost, the increase to the value of previously accrued benefits because retirement is one year closer. Third, is the expected return on assets, which is a P&L credit reflecting that the company has at least partially funded accrued benefits in advance."

"As an example, take a pension scheme which has been closed to new members for a few years:

• Service cost is GBP1m – small because the scheme has relatively few remaining active members;
• The value of accrued pensions (the "defined benefit obligation") is GBP400m, which would suggest an interest cost of GBP20m using a typical discount rate of 5%;
• The pension scheme has assets of GBP340m, which would suggest an expected return on assets of GBP22m using a typical expected rate of return of 6.5%."

"Under IAS 19 as it currently stands, there would be a P&L credit of GBP1m, comprising the service cost plus the interest cost and offsetting the expected return on assets. However, the IASB's current thinking is that the expected return on assets will disappear and, in the future, the actual return on assets is recognized but in 'other comprehensive income', or OCI – that is, outside of P&L. So the P&L charge would change from a GBP1m credit to a GBP21m charge."

"It also means that the treatment of returns on assets held by a pension scheme will be quite different from the returns on any assets held outside of a pension scheme. For assets held directly by a company, the return achieved on these assets is recognized in P&L."

Martin Lowes, principal at Hewitt, explained:

"However, the IASB has also mentioned that it will revisit this idea at its next discussions in December and will consider whether it is more appropriate to calculate the interest cost as the interest on the deficit rather than the interest on the entire pension obligation. In the above example, this would mean that the P&L charge changed from a GBP1m credit to a GBP2m charge – the GBP3m difference calculated as 5% of the deficit of GBP60m. It is still a change from current practice, but not as painful a change."

"Hewitt urges the IASB to consider this point very carefully. Their initial thinking would have a huge negative impact on the P&L of any company which operates a defined benefit pension scheme. It also acts as a significant incentive to underfund company pension schemes in the future."

"The IASB also has a separate project underway which, potentially, will change the composition of income statements in company accounts. At present, OCI is separate from P&L but the IASB's proposals may include OCI as part of a wider income statement going forward. If so, the problem illustrated above largely disappears, although companies would still notice a significant change in the allocation of the pensions charge to different parts of the income statement."

The IASB is expected to issue an exposure draft of changes in the first quarter of 2010, resulting in a new standard in 2011, to be implemented from 2013.

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