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Update: pension obligations
Pension Obligations in IAS 19
Stefan Haag
Director, Accounting Consulting Services, PwC Switzerland
Robel Ghebressilasie
Accounting Consulting Services, PwC Switzerland
Swiss pension funds were exposed to various influences in 2019. On the one hand, the positive performance of the stock markets resulted in a significant increase in the returns on plan assets. On the other hand, interest rates, which were already low, fell again, and in autumn 2019 were even negative for certain durations of defined benefit obligations (DBOs). On top of that, pension funds continue to be confronted with rising life expectancy. The effects of these developments on the reporting of pension obligations in IFRS financial statements, as of the end of 2019 and in subsequent periods, are outlined below.
A good stock market performance led to higher-than-expected returns on plan assets. According to IAS 19, such increases must be recognised as part of other comprehensive income (OCI) separately from the income statement. These increases improved the funding status of pension obligations as of 31 December 2019, resulting in lower financing costs in the calculation of the defined benefit cost to be recognised in the income statement for the subsequent period.
The further decline in interest rates has resulted in various concerns for IFRS accounting. The most obvious issue relates to the discounting of the DBO. Here IAS 19 defines that the rate used shall be determined by the reference to market yields at the end of the reporting period on high quality corporate bonds with the same maturity and currency as the pension obligation (see IAS 19 para. 83.). If no such market yields are available, those for government bonds are to be used. This market reference excludes a floor of 0%, which means that negative discount rates may also be applied.
The application of a negative discount rate leads to an increase in the DBO, which is recognised as a remeasurement in OCI. In the subsequent period, this results in higher service costs and interest income as a result of the compounding of the pension obligation.
The low interest rate level also affects the assumption applied to the future interest rate on the retirement savings of insured persons. In the past, this was equated by some users with the discount rate. In the case of very low or even negative discount rates, this practice can no longer be justified, given the minimum threshold imposed under pension law (for 2020: 1% of the mandatory portion of the retirement savings). Moreover, a negative interest rate on retirement savings is not permitted under pension law.
However, very low or negative interest rates also have an impact on the investment side. Pension funds place some of their assets in fixed-interest investments in accordance with the provisions of pension law. If pension funds assume a current target return of around 2% on their total assets, but fixed-interest investments yield significantly lower returns over a prolonged period, (see Figure 1) this results in a fundamental discrepancy. In the medium term, this means that the current benefit level of pension commitments will be insufficiently financed.
Figure 1: Spot interest rate on 10-year Swiss government bonds
Source: Swiss National Bank, statistics, spot interest rates on Swiss government bonds for selected durations.
Figure 2: Life expectancy at birth in years
Source: Swiss Federal Statistical Office, mortality indicators in Switzerland, 1970-2018: life expectancy.
Together with the increase in life expectancy (see Figure 2) that has been observed for some time now, this means that companies must continue to give close consideration to the future benefit level of their pension plans. This has two implications for the recognition of pension liabilities in a company’s IFRS financial statements.
First, pension regulations will continue to be adjusted on an ongoing basis in the future; it can be observed that, in the course of ‘de-risking’ strategies, the prospective benefit commitments in pension plans are being reduced. When the highest governing body of a pension fund adopts new pension regulations, the company must revalue the new benefit plan for its IFRS financial statements using the actuarial assumptions applicable at that time and must recognise any difference between the DBO and the old benefit plan as a past service cost in the income statement.
Second, with regard to IFRS accounting, companies are having to consider what assumptions they can realistically apply to the development of benefit levels for the projection of pension obligations, without the pension regulations having yet been formally adapted. It is very challenging to make realistic assumptions in the context of such risk sharing, e.g. regarding the future development of conversion rates or how future financing gaps are to be split between employees and employers. This involves complex simulations and a meaningful disclosure of the assumptions made, if necessary, supported by sensitivities. The application of risk sharing also means that persons insured under a pension plan must be informed about the company’s pension strategy, thus allowing them to assess the trends that the company anticipates in the recognition of its pension fund obligations.
Summary
In summary, it can be assumed that structural issues in companies’ pension funds in conjunction with low interest rates will lead to a further review of the benefit levels provided by pension plans. IFRS users would do well to monitor these developments actively, so that any impact on IFRS financial statements can be identified in good time.
