The International Accounting Standards Board's revised pension accounting rule eliminating the use of a long-term assumed rate of return on investments could cause companies that follow the international standards to lower the risk in their pension plan's asset allocation.
The change, adopted by the IASB June 16, also could lead U.S. companies to consider shifting more assets, upward of 70%, into fixed income as a sign of possible changes to come to U.S. accounting standards.
The revision will mean companies under the international standards no longer will get a boost in their corporate earnings from pension plan investment gains, or a decrease from investment losses.
The amendments to International Accounting Standard 19 require that companies use the same rate for expected pension asset returns as they use to discount pension plan liabilities. That rate, generally based on corporate fixed-income yields, will invariably be lower than the current long-term investment return assumption, based in large part on equities and other risky assets, consultants said. As a result, pension expense could rise, dampening corporate earnings.
A similar revision eventually could be adopted by the Financial Accounting Standards Board, which governs accounting for U.S. corporations, accounting consultants said.
The FASB and the IASB have been working together on convergence of accounting standards, said Peter Proestakes, FASB assistant director. The FASB has previously indicated it would examine the IASB pension accounting changes “to consider whether those improvements would be good to include” in U.S. accounting principles, a decision FASB's board would have to make to add to its accounting projects, Mr. Proestakes said.
No timeframe for a decision has been set, Mr. Proestakes said.
The Securities and Exchange Commission has projects under way to encourage convergence of U.S. accounting standards and International Financial Reporting Standards. By next year, the SEC could decide whether to incorporate international accounting standards into the U.S. financial reporting system, according to an SEC statement Feb. 24.
Ken Stoler, partner in the New York office of human resources accounting advisory firm PricewaterhouseCoopers, said he believes the revision could cause “a fairly major shift in investment strategy by pension funds” of companies that come under the IASB standards.
Jim Verlautz, Minneapolis-based principal at Mercer Inc., agreed. “For companies complying with IASB, the (new rule) will certainly give companies pause on how they should allocate their assets.”
“There is no doubt an incentive” under current FASB and existing IASB rules for companies to “assume a higher rate of return” in their financial reporting, Mr. Verlautz said. But the revisions “might cause companies to derisk (pension) plans because there is no gain” that can be reported any longer in corporate income statements from that long-term assumed investment return, he said.
“If I am not even going to get credit for investing in risky assets like equities, maybe it is better to focus most of my investments in fixed income because that is all I am going to get credit for on the income statement,” Mr. Stoler said. Companies might be “thinking of changing their investment mix and reducing volatility of investments.”
Mr. Stoler said more companies might move to liability-driven investing. With most pension funds probably in the 30% to 40% range for fixed income, “I think it is a realistic possibility” allocations “will be very high in fixed-income securities,” he said. “They could start pushing those percentages in the 70% range” or higher, he added.
Stewart D. Lawrence, senior vice president and the national retirement practice leader in the New York office of Sibson Consulting, also has heard industry buzzthat pension plans will shift more assets to fixed income if “companies are not going to get credit in the pension expense calculation for holding risky assets.”
“I'm not saying I believe that, but that is the wisdom out there,” Mr. Lawrence added.
Allocating more to fixed income would lower expected investment returns, causing pension plan contributions to rise, Mr. Lawrence noted. Still, companies might continue tilting their asset allocation to equities and other risky assets, regardless of the new rule, to try to raise their pension plan's funded status while keeping contributions lower, Mr. Lawrence said.
Messrs. Stoler and Lawrence agreed that under the IASB's new rule, companies will likely have higher pension expense because the bond rate means a lower returns on assets. For Standard & Poor's 500 companies, such a rule, if adopted by the Financial Accounting Standards Board, would lower corporate earnings about 2% to 4%, Mr. Lawrence said.
Under a scenario Mr. Lawrence developed using S&P data for fiscal 2010 reporting, the S&P 500 companies, which have a combined $1.3 trillion in defined benefit assets worldwide, on average use an assumed rate of return on pension plan investments of 7.7%, while they use an average 5.3% rate, based on corporate bond yields, for discounting pension liabilities.
If the IASB rule were adopted by FASB, companies would use the 5.3% assumed rate rather than the 7.7% rate. That change would reduce pension earnings and corporate earnings by around 200 basis points, he said. With S&P 500 companies reporting $700 billion in earnings in fiscal 2010, the change would lower earnings by an estimated $25 billion, or 3.5%, Mr. Lawrence said.
“Does it make sense for companies to stay in risky investments (such as equities), if they are not getting the higher income?” said Michael Marks, vice president and consulting actuary in Sibson's New York office. “Some will say they want the higher return ... but others will say it is not worth the risk.”
“It's not clear to me that if your accounting calculation changes that you will (want to) change your investment policy,” Mr. Lawrence said.
In addition, the IASB revision eliminates amortizing pension plans' gains and losses over an extended period of years and instead requires that companies report them in corporate financial statements in the same year they occur, a mark-to-market type of valuation that could raise volatility. However, the revision likely will reduce volatility in the corporate income statement, Mr. Marks said. That is because the income statement under IASB will include only generally more stable components of pension costs and exclude the volatility of plan gains and losses, moving them permanently into a separate category of other comprehensive income statement, never to appear in the income statement, accounting consultants noted.
Under the FASB, items reported in other comprehensive income eventually are reported in the income statement, Mr. Stoler said.
In recent months, AT&T Inc., Verizon Communications Inc. and PolyOne Corp. announced moves to a mark-to-market basis for all their pension accounting, immediately recognizing actuarial gains or losses on its pension plan in the year they occur instead of the FASB current method of amortizing them over many years. Honeywell International Inc. moved to a modified approach.
In a way, the moves anticipate adoption of an IASB-type revision, requiring immediate recognition of pension plan gains and losses and ending the current approach of amortizing valuation changes over a number of years, Messrs. Lawrence and Marks noted.
The U.S. companies' mark-to-market adoption is “in the spirit of IASB but conforming to the requirements of” U.S. generally accepted accounting principles,” Mr. Marks said.
The IASB revised its pension accounting rules in part to improve the disclosure of risk and comparability.