Darren Redmayne and Paul Houghton look into upcoming changes to how IAS19 is to be applied.
While there are many ways of measuring pension deficits, the IAS19 accounting measure is the one most visible to external commentators and analysts and there are about to be some big changes to how it is applied.
The International Accounting Standards Board is expected to finalise new guidance on applying IAS19 which will recognise that while it provides a broadly consistent measurement approach, the disclosures can often bear little resemblance to the obligation sponsors have to their defined benefit (DB) pension plans.
How will these changes affect the sponsor-trustee dynamic, and the future funding and investment strategies of DB schemes?
What is changing?
Currently, where employers have a "right" to recover a surplus from their DB scheme (which is not the case for all schemes) they may recognise a pension accounting surplus as an asset even if they actually have a liability to make further payments to their scheme.
The updated guidance will narrow the definition of this right to recover a surplus to exclude, for instance, schemes where the trustees have the power to unilaterally use the surplus in scheme assets to buyout liabilities. Even where a scheme is not currently in surplus on an accounting basis, the sponsor will still need to reduce the value of the scheme's assets to reflect future committed contributions.
This will mean that many more schemes will need to recognise a deficit equal to their minimum funding requirement (usually interpreted as their Schedule of Contributions, "SoC") if it is greater than their IAS19 liability.
Although the changes may improve transparency by bringing the accounting disclosure closer to the reality of pension scheme obligations, which may lead to potentially massive increases in on-balance sheet liabilities, their impact may vary significantly based on small technicalities in the scheme's trust deed and rules.
When does it happen?
The new guidance has not yet been finalised but it is expected to be confirmed in the second half of this year. While it will only become effective for accounting periods commencing 1 January 2019, trustees and sponsors should begin to plan for it now.
How will it affect sponsors?
Companies that recognise their SoC will experience an immediate increase in their deficit, recorded as a charge in Other Comprehensive Income (i.e. not against profit). This will worsen some key ratios (e.g. leverage) but improve others (e.g. return on capital employed).
In entity accounts this will reduce distributable reserves and so may restrict dividends. This is likely to be more pronounced for sponsors with weaker covenants that are more reliant on funding from their sponsor.
The accounting dynamics of the scheme will fundamentally change. The accounting deficit will be less affected by annual changes in IAS19 assumptions but may change materially following agreement of a new schedule of contributions following triennial valuation negotiations with trustees.
As an unintended consequence, sponsors may target a greater level of investment return from their scheme's investments to justify a higher discount rate on the liabilities as this would imply a lower requirement for cash contributions and therefore a smaller balance sheet liability.
How will it affect trustees?
Trustees will need to be aware that these changes could alter the approach their sponsor takes. Before choosing to target higher investment returns, trustees will need to know that their covenant is sufficiently strong and durable to support the increase in risk. Formal commitment to fund a scheme to a lower-risk secondary funding target could become less desirable for sponsors if they result in a higher funding requirement.
As such, accounting based on the SoC may become associated with underfunding and driving risk-taking behaviour and trustees and sponsors will need to behave carefully.
Trustees may also be approached by sponsors to request changing the wording of scheme rules to produce a better accounting outcome. As with any such request they should be sure that any change is in their members' (rather than just their sponsor's) best interests. Greater transparency of sponsors' pension positions may incentivise management to repay the deficit sooner, as they might with ‘normal' debt.
What can sponsors and trustees do now?
Trustees and sponsors would be well advised to review the wording of the scheme's trust deed and rules to understand whether the new guidance will apply to them. If so the sponsor will assess how the revised accounting treatment will affect the presentation of their financial position and performance.
If the sponsor wishes to reduce the impact of the changes by reducing committed contributions, the trustees and sponsor will need to work together to improve the covenant and its potential to underwrite increased risk.
They should also explore whether security, contingent assets, or non-cash contributions are possible to reduce the funding requirements or to justify an increased length of recovery plan.
Darren Redmayne is CEO of Lincoln Pensions and Paul Houghton is founder of Adze Structuring Limited
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