The transition to IFRS in 2011, and new pension rules coming into effect in 2013 bring increased transparency for Canadian companies with large defined-benefit pension plans. This means that the financial health and related risks will be more openly reflected in sponsoring companies’ financial statements. However, until uniform policies arrive in 2013, financial statement users will need to be aware of the choices companies made upon adopting IFRS and how such choices impact their financial reporting. Readers will learn about the choices and their impact in this article.
Many Canadian companies with large defined-benefit pension plans that adopted International Financial Reporting Standards (IFRS) on January 1, 2011 started the year with a clean slate. In one transition adjustment, they swept large off-balance sheet actuarial losses into equity. The result is a more transparent financial statement presentation. Unfortunately, given that many of these plans remain underfunded, the actual result is higher pension liabilities and lower equity than reported on the balance sheet.
In this article, we analyze the financial health of the 47 Canadian companies with the largest pension plans. We then describe the changes in reporting for defined benefit pension plans of the 25 companies that have already made the transition to IFRS.
Economic health of the largest Canadian pension plans
Our sample includes the 47 Canadian companies with the largest pension liabilities as of the end of fiscal 2010.1 In Table 1, we analyze the financial health of these plans by comparing pension plan assets to liabilities. As reported in column 3 of Table 1, underfunding remains highly prevalent, with 40 of 47 companies reporting pension liabilities that exceed pension assets. In dollar terms, the aggregate shortfall across the 47 companies in our sample is $14.7 billion, with aggregate pension liabilities of over $150 billion exceeding aggregate pension assets of approximately $136 billion. Air Canada has the largest pension deficit with $2.1 billion, followed by Nortel Networks, Bombardier Inc, and BCE Inc., each with deficits of approximately $1.5 billion. Only seven companies in our sample report pension surpluses, which range to a maximum of $346 million for the Bank of Montreal.
In column 4 of Table 1, we rank sponsoring companies by the size of their pension surplus or deficit relative to total shareholders’ equity at the end of fiscal 2010. Reported defined benefit pension plan deficits are sizable for some companies in our sample – 15 companies have pension deficits greater than 5 percent of shareholders’ equity. Not surprisingly, the company with the largest deficit as a percentage of equity is Air Canada, with a deficit equal to 119.4 percent of shareholders’ equity, followed by Essar Steel Algoma Inc (67.2 percent of equity), Tembec Inc (56.4 percent of equity), and Bombardier Inc (40.9 percent of equity).2 In column 5 of Table 1, we also report the funding ratio (pension assets divided by pension liabilities) for each company. The median ratio is 91 percent. Magna International Inc reports the lowest funding ratio, with pension assets of 44 percent of pension liabilities, followed by Canadian Oil Sands Ltd with a ratio of 62 percent, and Nortel Networks with a ratio of 63 percent. Thus, for a number of these companies, pension plan underfunding remains a serious concern.
Market conditions had a mixed effect on pension plans in 2010. Investment returns on pension plans were healthy. Forty-five of 47 firms in our sample reported returns on pension plan assets that exceeded long-run expectations.3 The median actual return was close to 10 percent, compared to a median expected long-run return of 7.0 percent. However, declining interest rates in 2010 had a negative effect on reported pension plan health. The median discount rate used to value pension liabilities decreased from 6.1 percent to 5.4 percent, resulting in significant increases in the valuation of pension liabilities from actuarial losses driven primarily by this rate change. Pension liabilities are measured as the present value of estimated future cash outflows; liabilities therefore increase as the discount rate decreases. For example, Air Canada disclosed that for every 0.25 percent decrease in the discount rate, pension liabilities increase by $411 million. As a result, the increase in pension liabilities caused by lower discount rates more than offset the favorable pension asset returns for most companies. Off-balance sheet losses increased from 2009 to 2010 for 39 of 47 sample firms.
Under Canadian GAAP prior to the implementation of IFRS, these actuarial gains and losses were allowed to remain largely off-balance sheet for extended periods of time. Therefore, while companies in our sample reported an aggregate pension deficit of $14.7 billion, the majority of companies (36 of 47) were still reporting net pension assets on their balance sheets (see column 6, Table 1).4 An aggregate of $27.8 billion in actuarial losses (column 7) remained off-balance sheet. The companies with the largest off-balance sheet losses are BCE Inc. ($4.3 billion), Air Canada ($2.1 billion), and Royal Bank of Canada ($2.1 billion). This disconnect highlights a problem with pension accounting under the old Canadian GAAP. While smoothing mechanisms in the accounting rules mitigate the effect of swings in pension asset and liability values, they also result in balance sheet values that bear little resemblance to the economic status of the pension plans.
Table 1: Pension Funded Status and Balance Sheet Amounts as of end of fiscal 2010
In million of CDN$ (unless otherwise stated), except for percentages
|Company||Pension Obligation||Pension Assets||Pension surplus (deficit)||as a % of shareholders’ equity||Funding Ratio||Net pension asset (liability)||Off-balance sheet gains (losses|
|Nortel Networks Corp (in US$)1,2||3,997.0||2,507.0||(1,490.0)||n.m.||62.7%||(1,490.0)||0.0|
|Essar Steel Algoma Inc||944.1||681.9||(262.2)||-67.2%||72.2%||(135.5)||(119.6)|
|Bombardier Inc (in US$)||6,750.0||5,236.0||(1,514.0)||-40.9%||77.6%||338.0||(1,764.0)|
|Manitoba Telecom Services Inc||2,099.7||1,873.7||(226.0)||-17.6%||89.2%||420.0||(683.7)|
|Canadian Pacific Railway2||8,983.8||8,310.4||(673.4)||-14.0%||92.5%||(673.4)||0.0|
|Imperial Oil Ltd2||5,562.0||4,296.0||(1,266.0)||-11.3%||77.2%||(1,266.0)||0.0|
|Finning International Inc||769.0||661.7||(107.3)||-7.7%||86.0%||152.2||(251.7)|
|Canadian Oil Sands Ltd||717.0||442.0||(275.0)||-6.9%||61.6%||(42.0)||(233.0)|
|Weston (George) Ltd||1,784.0||1,514.0||(270.0)||-4.4%||84.9%||359.0||(622.0)|
|Magna International Inc (in US$)||575.0||253.0||(322.0)||-4.0%||44.0%||(241.0)||(81.0)|
|West Fraser Timber Co||945.3||879.4||(65.9)||-3.7%||93.0%||152.6||(209.6)|
|Power Corp Canada||4,326.0||3,983.0||(343.0)||-3.6%||92.1%||245.0||(726.0)|
|Manulife Financial Corp||3,743.0||2,869.0||(874.0)||-3.3%||76.6%||79.0||(979.0)|
|Sears Canada Inc||1,342.8||1,296.2||(46.6)||-2.8%||96.5%||170.5||(217.1)|
|Suncor Energy Inc||3,219.0||2,335.0||(884.0)||-2.4%||72.5%||(645.0)||(234.0)|
|Yellow Media Inc||551.7||413.8||(138.0)||-2.2%||75.0%||(42.0)||(96.0)|
|Potash Corp Sask Inc (in US$)||892.4||752.3||(140.1)||-2.1%||84.3%||179.1||(311.2)|
|Domtar Corp (in US$)2||1,636.0||1,572.0||(64.0)||-2.0%||96.1%||(64.0)||0.0|
|Sun Life Financial Inc||2,274.0||2,092.0||(182.0)||-1.0%||92.0%||201.0||(391.0)|
|Teck Resources Ltd||1,589.0||1,452.0||(137.0)||-0.8%||91.4%||217.0||(299.0)|
|Toronto Dominion Bank||3,921.0||3,584.0||(337.0)||-0.8%||91.4%||867.0||(1,094.0)|
|Intact Financial Corp||704.6||682.3||(22.3)||-0.7%||96.8%||115.2||(146.5)|
|Bank of Nova Scotia||5,255.0||5,078.0||(177.0)||-0.6%||96.6%||1,377.0||(1,758.0)|
|Royal Bank of Canada||8,084.0||7,897.0||(187.0)||-0.5%||97.7%||1,921.0||(2,082.0)|
|Industrial Alliance Ins & Fin Services||536.0||527.0||(9.0)||-0.4%||98.3%||59.0||(67.0)|
|Bank of Montreal||4,839.0||5,185.0||346.0||1.6%||107.2%||1,877.0||(1,445.0)|
|Canadian National Railway2||14,895.0||15,092.0||197.0||1.7%||101.3%||197.0||0.0|
|National Bank Canada||2,123.0||2,258.0||135.0||1.9%||106.4%||648.0||(483.0)|
|Maple Leaf Foods Inc||1,139.5||1,180.7||41.3||3.4%||103.6%||291.6||(316.9)|
|Median Funded Status||-2.6%||91.0%|
Changes to pension accounting
But pension accounting is about to change. First, as Canadian companies transition to IFRS, they must make a decision regarding off-balance sheet amounts at the transition date. Second, there are several differences in accounting rules going forward between Canadian GAAP and IFRS. And finally, a new pension standard introduced in June 2011 and effective 2013, IAS 19 Employee Benefits, will significantly change the way that defined-benefit pension plan information is reported in the future. In fact, some of the transition choices companies are making today reflect the changes to come under the new standard.
We explore the impact of IFRS for the 25 firms in our sample that adopted IFRS as of January 1, 2011. Excluded are firms that have not yet adopted IFRS, specifically non-December fiscal year-end firms and rate-regulated enterprises (who have a one-year IFRS deferral). We also exclude firms reporting under U.S. GAAP that will not be adopting IFRS.
IFRS adoption: transition provisions
A significant accounting choice available to Canadian companies transitioning to IFRS is the one-time option to recognize all of the accumulated off-balance sheet actuarial gains or losses as of January 1, 2010 directly in retained earnings. This option results in a one-time increase in reported liabilities and a decrease in reported equity. As reported in Table 1, these off-balance sheet amounts can be significant. As of the end of 2010, unrecognized actuarial losses exceeded $27 billion in aggregate for the 47 sample companies, with nine companies reporting unrecognized losses exceeding $1 billion.
Since all of the 25 IFRS adopters in our sample have accumulated actuarial losses, such an election would decrease shareholders’ equity and increase reported liabilities for all of these companies, bringing reported balance sheet amounts much more in line with the funded status of the pension plans. However, for some firms, the magnitude of unrecognized losses is sizable, and the resulting change to the reported financial position could affect contracts based on balance- sheet information, such as accounting-based debt covenants. Further, some firms, notably financial service firms, have minimum regulatory capital requirements that are affected by the decrease in equity. For example, Sun Life Financial Inc expects that the adoption of IFRS will reduce regulatory capital by approximately 5 percent by the end of the transition period. Twenty-four of the 25 sample companies did choose to recognize actuarial losses upon IFRS adoption, decreasing opening equity under IFRS for those 24 firms. Manulife Financial Corp, the one company that did not choose to recognize actuarial losses upon IFRS adoption, avoided a reduction of approximately $680 million in shareholders’ equity or 2.5 percent (assuming a tax rate of 30 percent). The impact on regulatory capital may have influenced Manulife Financial Corp’s decision.
Although the balance-sheet impact of this election can be dramatic, there is an offsetting benefit to future income – those accumulated actuarial losses never pass through the income statement. Under the corridor method prior to IFRS, off-balance sheet actuarial losses were eventually recorded as a pension expense through amortization. By recording accumulated actuarial losses directly in equity upon adopting IFRS, companies avoid recognizing such losses on their 2011 income statements, and in subsequent periods so long as the losses have not been reversed.
In Table 2, we estimate the amount of 2011 pension expense avoided by recording accumulated losses directly in equity. We also report 2010 pre-tax income to demonstrate the significance of savings. Pension expense avoided ranges from no effect for Suncor Energy Inc, a company with relatively small off-balance losses, to $271.6 million for BCE Inc. For some companies, the effect relative to pre-tax income is sizable. As reported in column 3 of Table 2, pension expense avoided as a percentage of net income is 41.1 percent for Air Canada, 36.3 percent for Maple Leaf Foods Inc., and 27.4 percent for Manitoba Telecom Services Inc. Manulife Financial Corp’s pension expense is unaffected due to its choice to not recognize actuarial losses on adoption, as discussed above.
Financial statement users, especially financial analysts, need to take note of this change. With higher reported net income and lower reported equity, profitability and return on equity appear higher under this change. However, pension plan funding requirements are not affected by this accounting choice. Therefore, future cash contributions to pension plans may exceed reported pension expense, as funding will continue to reflect additional payments driven by actuarial losses and underfunding.
Table 2: Reduction of 2011 pension expense due to recognition of accumulated actuarial losses directly in equity
In million of CDN$ (unless otherwise stated), except for percentages
|Company||2011 Estimated reduction of pension expense||2010 Pre-tax income||Pension expense avoided as % of 2010 income|
|Note – Employees’ average remaining service life was estimated as 11 years if not disclosed.|
|Maple Leaf Foods Inc||18.1||49.8||36.3%|
|Manitoba Telecom Services Inc||43.1||157.4||27.4%|
|Finning International Inc||14.6||216.3||6.7%|
|West Fraser Timber Co||10.5||238.6||4.4%|
|Weston (George) Ltd||40.3||1,095.0||3.7%|
|Canadian Oil Sands Ltd||13.4||857.0||1.6%|
|Intact Financial Corp||6.9||524.8||1.3%|
|Power Corp Canada||26.7||2,870.0||0.9%|
|Yellow Media Inc||3.1||375.7||0.8%|
|Potash Corp Sask Inc (in US$)||19.1||2,449.0||0.8%|
|Sun Life Financial Inc||14.9||2,079.0||0.7%|
|Teck Resources Ltd||17.5||2,915.0||0.6%|
|Industrial Alliance Ins & Fin Services||1.2||348.0||0.4%|
|Suncor Energy Inc||0.0||4,247.0||0.0%|
|Manulife Financial Corp||n/a||-1,172.0||n/a|
IFRS adoption – New accounting rules – and choices
Going forward, Canadian companies will potentially be impacted by at least four differences between Canadian GAAP and IFRS.
- They will be able to choose how to report ongoing actuarial gains/losses. They can recognize these directly in equity through other comprehensive income (OCI) or continue to use the corridor method.
- They will no longer be able to use market-related value when computing expected return on assets.
- Under IFRS, Canadian companies will be required to record past service costs stemming from vested plan amendments directly in net income, rather than spread these costs out over employees’ service lives.
- More stringent limits on the recognition of pension assets on the balance sheet will apply, resulting in lower pension assets and higher pension liabilities recorded on the balance sheet for some companies.
1. Ongoing actuarial gains/losses
A key difference between Canadian GAAP and IFRS is the choices available for actuarial gains and losses. Independent of the choice companies made for existing actuarial gains and losses upon adopting IFRS, companies must make a further choice of how to handle these gains and losses going forward. Under Canadian GAAP, companies use the so-called ‘corridor’ method, which gradually amortizes actuarial gains and losses to pension expense when they become large. As seen in column 7 of Table 1, significant actuarial gains and losses are generally not reflected on the balance sheet under this method. Conversely, recognition of actuarial gains and losses through OCI avoids any impact on pension expense, but causes greater volatility in balance sheet equity. Of the 25 sample firms, only four firms (Industrial Alliance Ins & Fin Services, Manulife Financial Corp, Power Corp Canada, and Sun Life Financial Inc.) elected to continue applying the corridor method after adopting IFRS. These four firms represent the only financial service firms in our sample. Such firms must meet regulatory capital requirements. Due to such requirements, these firms may be hesitant to accept the resulting equity volatility that stems from directly recognizing gains and losses in OCI.
2. Discontinuing market-related value for pension expense
Companies can no longer use market-related value rather than market value for calculating pension expense. Under Canadian GAAP, companies could use a smoothed value (usually averaged over three to five years) of pension assets for calculating expected return on assets, which reduces pension expense. Using a smoothed value reduces the impact of significant changes in the value of pension assets and impacts pension expense only gradually. Companies with larger pension plans tended to use market-related value, specifically BCE Inc., Air Canada, Manulife Financial, Sun Life Financial, Manitoba Telecom, and ATCO Ltd. These firms will no longer have this option under IFRS. To illustrate the impact, consider BCE Inc as an example. As of January 1, 2010, market-related value of pension assets was $14.2 billion, while market value was only $13.1 billion. If BCE Inc had used market value rather than market-related value in 2010, pension expense would have been approximately $80 million higher (over 70 percent of reported pension expense for 2010.)
3. Recording of past service costs
Under IFRS, companies must record past service costs stemming from vested plan amendments directly in net income. Under Canadian GAAP, such costs were spread out over employees’ service lives. Consequently, the cost of pension improvements is reflected in pension expense immediately, which may increase the volatility of pension expense. For example, BCE Inc. completed a pension plan amendment in 2006 that increased its pension liability by $38 million. Under IFRS, the $38 million would have been recorded as pension expense in 2006, while under Canadian GAAP the $38 million would be expensed over eleven years at $3.5 million per year.
4. Calculation of pension asset limits.
Under IFRS, pension asset limits are more likely to apply, which can lead to higher recorded pension deficits. Air Canada was significantly affected by such asset limits and recorded an additional pension deficit of $1.9 billion when it adopted IFRS.
Companies were required to quantify the impact of these changes on 2010 net income and on 2010 OCI in their first quarter 2011 filings. In Table 3 below, we summarize the estimated impact as disclosed by our sample companies. The effect on net income depends on which of the above four changes dominates. As reflected in column 1, pre-tax income would have been higher for 15 companies. For these firms, the increase is largely due to the elimination of actuarial loss amortization, as described above. Pre-tax income would have been lower for seven companies, caused primarily by the elimination of market-related value and differences in treatment of past service costs. Overall, reporting under IFRS would have changed pre-tax earnings from between -61.0 percent to +12.9 percent, thus suggesting that the impact of IFRS accounting changes is significant for companies with large pension obligations. The impact, however, is not uniform.
The impact on OCI is reflected in column 3 of Table 3. For firms electing to record all actuarial losses in OCI (firms continuing to use the corridor method are not affected), 2010 OCI under IFRS would be lower than under Canadian GAAP, except for Air Canada. The general negative effect is attributable to falling discount rates in 2010, while the positive effect for Air Canada likely stems from pension asset limit reversals that were discussed above. In column 4, we provide the impact on 2010 OCI as a percentage of opening 2010 equity. The impact is largest for Air Canada (increase in OCI of 40.1 percent of originally reported equity), Manitoba Telecom Services Inc (decrease in OCI of 11.4 percent of originally reported equity), and Atco Ltd (decrease in OCI of 10.1 percent of originally reported equity). Such large changes in equity are demonstrative of the increased volatility caused by not using the corridor method, particularly during periods of large interest rate changes.
Table 3: Impact of IFRS on 2010 reported pre-tax income and other comprehensive income
In million of CDN$ (unless otherwise stated), except for percentages
|Company||Impact on 2010 pre-tax income||Impact as % of original 2010 pre-tax income||Impact on 2010 OCI||Impact as % of original 2010 equity|
|Note – Impact on income and OCI includes the effect of other post-employee benefits.
1 – Manulife Financial Corp had negative pre-tax income so the impact as % is not meaningful.
|Maple Leaf Foods Inc||-8.1||-16.2%||-33.7||-2.8%|
|Intact Financial Corp||-6.0||-1.1%||-41.0||-1.4%|
|Manitoba Telecom Services Inc||-1.7||-1.1%||-149.8||-11.4%|
|Power Corp Canada||-18.0||-0.6%||–||–|
|Yellow Media Inc||-1.2||-0.3%||-75.7||-1.3%|
|Suncor Energy Inc||4.0||0.1%||-201.0||-0.6%|
|Sun Life Financial Inc||6.0||0.3%||–||–|
|Potash Corp Sask Inc (in US$)||24.0||1.0%||-36.0||-0.6%|
|Canadian Oil Sands Ltd||9.0||1.1%||-62.0||-1.6%|
|Industrial Alliance Ins & Fin Services||4.0||1.1%||–||–|
|Teck Resources Ltd||37.0||1.3%||-119.0||-0.8%|
|West Fraser Timber Co||4.5||1.9%||-77.6||-4.8%|
|Weston (George) Ltd||29.0||2.6%||-98.0||-1.4%|
|Finning International Inc||7.2||3.3%||-21.8||-1.4%|
|Manulife Financial Corp1||-75.0||n.m.||–||–|
|Onex Corp||not disclosed||-64.0||-3.9%|
More changes ahead
Many of the decisions made by Canadian companies in our sample may reflect their anticipation of further changes to pension accounting. In June 2011, the IASB (International Accounting Standards Bureau) issued a new accounting standard for pension plans, IAS 19 Employee Benefits. It will become effective in 2013 and aims to improve the transparency and comparability of pension reporting.5 These changes should help financial statement users more fully incorporate pension information into investment and credit assessments. Further, comparability is improved by eliminating the choices allowed by the existing standard. Specifically, the new standard eliminates the corridor method and requires pension-funded status to appear directly on the balance sheet. Twenty-one of the 25 sample companies have already elected to do so after adopting IFRS; however, this will represent a change for the four financial services firms in our sample that elected to continue applying the corridor method. In addition, to provide better characterization of the various cost components, the new standard requires that the pension expense be split into service cost (reported in operating income), net interest income or expense (reported as a component of financing costs), and re-measurements (reported in OCI).
The transition to IFRS in 2011, and new pension rules coming into effect in 2013 bring increased transparency for Canadian companies with large defined benefit pension plans. This means that the financial health and related risks will be more openly reflected in sponsoring companies’ financial statements. However, until uniform policies arrive in 2013, financial statement users will need to be aware of the choices companies made upon adopting IFRS and how such choices impact their financial reporting. In particular, firms have the option to erase unrecognized pension losses upon adopting IFRS, which will reduce pension expense going forward. However, reported liabilities will be significantly higher and reported equity will be significantly lower. These changes could negatively impact contracts that are based on balance sheet information, such as accounting-based debt covenants.
Defined benefit pension plans are already contentious, with many companies converting their defined benefit pension plans into the more predictable defined contribution plans.6 At the same time, a new study by Aon Hewitt, 2011 Global Pension Risk Survey,reports that many Canadian companies remain committed to maintaining their defined benefit plans. Regardless of the accounting rules, there are numerous risks associated with these plans, and Canadian companies will continue to need effective, long-term, risk management strategies if they plan to maintain their defined benefit pension plans.
- We exclude companies that are subsidiaries of other companies in our sample (Power Financial Corp, Loblaw Companies Ltd, Enbridge Gas Distribution, Canadian Utilities, and Great-West Lifeco).
- Nortel Networks has negative shareholders’ equity, so discussing its pension deficit in terms of shareholders’ equity is not meaningful.
- The expected rate of return on plan assets is based on expectations for returns over the entire life of the related pension obligations.
- Five sample firms (Nortel Networks, Canadian Pacific Railway, Imperial Oil Ltd, Domtar Corp, and Canadian National Railway) report under US GAAP, which requires firms to recognize pension funded status directly on the balance sheet. Thus, funded status is the same as the net pension asset (liability) for these firms.
- For a complete discussion of the new standard, see D. Henderson and C. Wiedman, “Will Changes Bring Transparency?, CA Magazine, June/July 2011.
- T. Keller, “The battle over pension plans”, The Globe and Mail, June 24, 2011. Towers Watson surveyed Canadian companies and found 51% of firms have converted their defined benefit pension plans into defined contribution plans.