The current state of many company’s defined benefit pension plans may be parlous, but you would never know it from the balance sheets. The reason is that current accounting standards allow for the extensive smoothing of gains or losses. Will the elimination of smoothing present a true picture of a company’s defined benefit plan? Or, will it force firms to reconsider the benefits that they pay out to retirees? These accounting professors shed new light on these questions.
The United Kingdom’s controversial accounting standard for defined pension (DB) plans, Financial Reporting Standard (FRS) 17 “Retirement Benefits,” became mandatory for accounting periods after January 1, 2005. The standard removes companies’ ability to smooth the reporting of gains and losses on defined benefit plans and requires that firms report the funded status of their pension plans on the face of the balance sheet. The standard also contains new requirements for the reporting of pension expense on the face of the income statement. Based on responses from other national and international accounting standard bodies, this approach could become the required method in the future. In this article, we explore the possible implications of these changes for Canadian companies with DB pension plans.
Rules under attack
Accounting rules for DB plans have been criticized because they allow extensive smoothing of gains and losses, typically over 10 to 15 years. Proponents of the current approach argue that DB pension plan obligations represent long-term liabilities and that immediate recognition of gains and losses to the liabilities or plan assets introduces unnecessary volatility to income-when, in fact, many of these changes offset one another over time. The critics argue that the volatility is a financial reality, and ignoring it misrepresents the financial status of the pension plan and the company. Concern has increased in recent years as a prolonged bear market has resulted in significant accumulation of unrecognized losses.
We analyzed the 100 Canadian companies with the largest DB pension plans from 2000 through 2003 and found evidence of mounting losses (ranked by the value of their pension assets in 2003 on Canadian Compustat). As indicated in Exhibit 1 (all Exhibits at end of article), the aggregate funded status (i.e., the fair value of the pension assets less the accrued benefit obligation, or pension liability) of these 100 companies deteriorated markedly over this time period. While the aggregate funded status was a positive $19.6 billion in 2000 (only 24 per cent of firms were underfunded), that amount decreased to a negative $19.0 billion by 2003 (76 per cent were underfunded.) Notable, however, is the amount of this decline that remained unrecognized on the balance sheets of these companies because of the smoothing provisions. In 2000, the companies had an aggregate positive total of $13.7 billion in unrecognized amounts. By 2003, even after improvements in the stock market, the same companies had an aggregate negative $28.3 billion in unrecognized amounts (primarily accumulated losses) off-balance sheet. In 2003, 47 per cent of the companies in our sample reported net pension assets on their balance sheets when their pensions were in fact underfunded. These statistics highlight the extent of smoothing permitted under current accounting rules, and support critics’ claims.
Changes under way
The U.K. introduced FRS 17 in 2000, but the standard did not come into effect until 2005. In December of 2004, the International Accounting Standards Board (IASB) issued an amendment to IAS 19, giving companies the option of immediate recognition of actuarial gains and losses in the statement of recognized income and expense, similar to the provisions of FRS 17. The IASB chairman, Sir David Tweedie, noted that, “The amendment issued today allows entities to choose a simpler, more transparent method of accounting than is commonly accepted at present. I hope that many entities will take advantage of improving their financial reporting in this way.”
Robert Hertz, chairman of the U.S. Financial Accounting Standards Board, recently reiterated his concern about current pension rules and voiced his support for harmonization with international accounting standards (Financial Times, Jan. 24, 2005). And Ian Hague, from the Canadian Accounting Standards Board (AcSB), indicated that Canada is also considering a full re-evaluation of its pension accounting rules. “It is probably unlikely that this will start for another year or so, but when it does I think it highly likely that AcSB will also participate and consider changing Canadian pension standards.”
Balance Sheet Effects
The swings in funded status from 2000 through 2003 highlight how significantly the status of a DB pension plan can change, often because of factors outside of the corporation’s control, such as interest rate movements and equity market volatility. Under current rules, a corporation’s financial statements are largely cushioned from these swings by the smoothing provisions within the rules, but this will change if Canada follows the U.K.’s lead.
Under FRS 17, pension deficits and surpluses (to the extent recoverable) must be fully reflected on the balance sheet. To assess how such a rule change might impact Canadian companies, we measured how full removal of smoothing would impact the balance sheets of our sample firms. To do this, we calculated the 2003 balance sheet impact as the difference between the net pension asset/liability currently reported in the balance sheet compared to the funded status of the plan. We measured the change as a percentage of total assets.
Overall, the average change for the 100 companies in our sample is a decrease of 3.3 per cent of total assets. However, for some firms the change is more dramatic. Twenty-one firms would see a decrease greater than five per cent of total assets. The 10 companies impacted most significantly are reported in Exhibit 2. For these companies the average reduction in total assets is 16.7 per cent, and together they have $9.5 billion of unrecognized amounts, $8.3 billion of which relates to accumulated losses. Most dramatic is Stelco, with a reduction of 42.0 per cent of total assets. While the funded status of Stelco’s pension plan deteriorated to a deficit of $752 million, the company continued to report a net asset on the balance sheet as $1.0 billion of losses, and past service costs were not recognized in the financial statements.
Of note, six out of the 10 companies computed expected return on assets using market-related value of those assets rather than current market value, an additional smoothing element permitted under the Canadian rules. (Market-related values are computed as the market value of the plan assets averaged over three to five years.) This suggests that this additional smoothing device, in addition to the use of expected return on assets in the computation of pension expense, and delayed recognition of gains and losses through a corridor, allows balance sheet values to diverge even further from the economic status of the plan.
Timing is everything
The four-year perspective highlights how pension plan status moves in cycles. In contrast to the negative effect that a rule change would have produced in 2003, the effect of the change would have been positive, on average, in 2000. At that time, the average effect would have been a 1.4 per cent increase, rather than a decrease. Further, the average impact for the 10 companies in Exhibit 2 in 2000 is negligible. This suggests that U.S. and Canadian rule makers may be warranted in waiting to introduce changes when the effects would be less dramatic and the change may be more palatable to companies. When and if the change comes, however, it will carry with it the potential for significant year-to-year changes in the reported financial statement numbers.
Income Statement Effects
We also examined the effects of the possible rule change on the income statement. Canadian companies report six components of pension expense: service cost, interest cost on the pension liability, expected return on plan assets, amortization of past service costs, amortization of unrecognized gains and losses, and amortization of transition assets and liabilities. Under FRS 17, these components are broken apart and reported in different sections of the income statement. Current service costs, and past service costs vesting in the year, are the only components of pension expense reported in operating income. Interest expense, net of expected return on plan assets, is reported with other finance expenses, and annual actuarial gains and losses on plan assets and liabilities are fully charged through the statement of total recognized gains and losses – the equivalent of the North American comprehensive income calculation — rather than amortized over 10-15 years.
To estimate the impact on Canadian companies, we reorganized the presentation of pension cost components according to FRS 17 for 2003. (Since we did not have information as to which past service costs reported in Canadian annual reports had vested and which had not, we made the simplifying assumption that 2003 amortization of past service costs was a reasonable approximation of past service costs that vested in 2003.) We reported both average estimated effects for the 100 Canadian firms with the largest defined benefit plans in 2003, and details of the 10 firms whose operating income would be most affected by the application of a standard similar to FRS 17. Details for these 10 companies are summarized in Exhibit 3.
We first focus on operating income. Overall, the average effect on operating income for the 100 companies in our sample is negligible. In 2003, the average operating income reported was $963 million, compared to $965 million estimated under FRS 17. There is a significant variation, however. Thirteen firms would see a decrease of greater than five per cent in operating income, with an average decrease of 14.7 per cent. The 10 most extremely affected companies highlighted in Exhibit 3 show an average decrease in operating income of 17.2 per cent. In the most extreme case, Canfor Corp., the application of FRS 17 would reduce operating income in excess of 60 per cent.
Changes in operating income depend on the relative magnitude of the components of current pension expense. All of the firms on our “top 10” list have an expected return on pension assets that exceeds the interest calculated on the plan liability. For a number of these firms, this reflects how well funded they are. Three of the top 10 firms –Maple Leaf Foods, Hudson’s Bay and Canada Life Financial Corp -are among the firms with the highest funding ratios (pension assets divided by pension liabilities) of the 100 company sample. The return on assets portion of pension expense provides a significant offset to pension expense under current rules. Under FRS 17, these firms would report net finance income rather than expense from their pensions; however, operating income would suffer from this reclassification. Additionally, eight of the 10 companies reported positive amounts in pension expense arising from the amortization of a “transitional asset.” (A transitional asset or obligation is the unrecognized portion of the funded status of the plan when the company first implemented current requirements in 2000.) Under FRS 17, this amortization is no longer included in operating income.
For some companies, these reductions in operating income are offset by increases to financing costs, resulting in very little change to net income overall. As indicated in Exhibit 3, Canfor Corp. Exhibits a net income calculated under FRS 17 that is virtually identical to that calculated under current standards. On the other hand, for companies with significant transition assets or unrecognized gains, income decreases as the amortization of these amounts is removed. The average decrease in net income for the 10 companies in Exhibit 3 is 15.3 per cent. Changes to comprehensive income under FRS 17 are reported in the last column of Exhibit 3. The U.K. statement of total recognized gains and losses is comparable to the North American comprehensive income calculation. American firms are currently required to report comprehensive income, and Canadian firms will be required to do so for fiscal years beginning on or after Oct. 1, 2006. In the case of pension accounting, were Canada to adopt an equivalent standard to FRS 17, the most significant items flowing through the comprehensive income calculation would be the gains or losses on plan assets (that is, the difference between the actual and expected returns) and actuarial gains and losses on pension liabilities (due to changes in interest rates, for example). Expected return on plan assets would still be included in income as an offset to the interest expense on the pension liability.
As shown in Exhibit 3, half of the 10 companies would see a positive charge to comprehensive income, and half would see a negative charge. The five companies with the positive charges all exhibit actual return on plan assets exceeding expected return in 2003. The five companies with the negative charges all have an actuarial loss on the plan liability in 2003. Annual charges to comprehensive income resulting from pension accounting may be volatile from year to year, and often reverse in sign as market conditions shift. It is this volatility in reporting that current pension accounting, with its emphasis on smoothing, seeks to avoid.
DB pension accounting is complex and has been debated for years (see for example, Ole-Kristian Hope, “Provocative Pension Accounting,” Strategic Finance, August 2003, 41-43). While analysts and regulators want a transparent method that reflects the financial status of the plan and does not allow for manipulation of operating income through optimistic assumptions, others argue that current smoothing mechanisms appropriately reflect the separate and long-term nature of pension plans.
Some, however, fear that changes to the accounting rules for DB pension plans may alter the real economic decisions that firms make with regard to post-retirement benefits. Rules that introduce the volatility of stock market conditions onto the balance sheet through the fair value of pension assets will highlight what financial economists have termed a mismatch between the nature of pension assets and pension liabilities. One way to remove this volatility is to reduce the equity allocation in the pension asset portfolio. The U.K. chain, Boots, has recently adopted this approach, stirring significant debate when it announced plans to adopt a zero-equity investment strategy for its pension plan assets, selling £2.3 billion sterling in equities and shifting the funds entirely into long term AAA bonds. Several analysts have since endorsed this approach, although it remains controversial. (See, for example, Joel Chernoff, “Pension Funds Turn to Asset, Liability Matching – Again”, Pension & Investments, November 1, 2004.)
On a more extreme level, there are concerns that changes to DB pension accounting could discourage companies from offering DB plans. Trade unions in the U.K. opposed FRS 17 for exactly this reason. Further, the number of members in DB plans has already decreased somewhat in Canada from 2001 to 2003, according to Statistics Canada. The recent ruling on pension surplus entitlement in the Monsanto case is seen as another blow against DB plans.
Company-sponsored pension plans are an important element of the three-legged retirement system in Canada, along with government programs and personal savings. While uncertainty around pension accounting continues, there is still a need to debate other aspects of DB pension plans that could make these plans more palatable to employers, including changes to legislation concerning surplus entitlement and modifications to the Income Tax Act allowing less-restricted deductibility of cash contributions. Perhaps these changes collectively will ensure the continued, transparent and effective use of DB pension plans well into the future.