© Copyright 2006 Rogers Publishing Ltd. The following article first appeared in the September 2005 edition of BENEFITS CANADA magazine.
A call to account
There is a need for a more transparent yet practical way to measure pension plan costs and obligations in Canada.
By Steve Bonnar and Ken Choi

Recent pension shortfalls have put corporate pension plan accounting on the front pages of business publications. But as pension plans sank into the red, many corporations continued to report pension income. How could this be?

Some observers pointed to the confounding “expected return on assets”(EROA)assumption, saying that companies tend to inflate expectations for future investment returns. Others questioned the underlying investments: should a corporate pension plan hold much in equities?

Financial statement transparency is a laudable objective, but it must be balanced with consistency and comparability in order to be meaningful. Accounting standards allow for significant smoothing—the accounting process which reduces the swings in annual pension costs driven by a highly volatile stock market—and deferred recognition of plan experience. A market-based approach to measuring pension costs and liabilities, which would eliminate all of this smoothing and deferral, promises a more accurate snapshot, but would also create significant financial statement volatility.

The challenge: to find a more transparent yet practical way to measure pension plan costs and obligations in Canada. Towers believes one exists, and so does the International Accounting Standards Board(IASB), which has proposed eliminating all smoothing inherent in the current rules and that the pension expense calculation separate operating costs from financing costs.

The following were among the recommendations in Towers Perrin’s recent White Paper, Renovate to Rejuvenate: Canadians Need a 21st Century Pension Plan:
• use economic assumptions that are “marked to market”;
• measure assets at fair market value;
• measure investment gains and losses relative to the discount rate—not the EROA;
• amortize all unrecognized experience gains or losses over five years;
• reflect service cost and the value of plan amendments as part of operating costs, and reflect the remaining elements of pension expense under the company’s other financing costs;
• recognize the impact of benefit changes over five years, or the length of any applicable collective agreement if shorter.

However, Towers’ proposals diverge from the IASB’s in two key areas: one technical and one practical.

The technical divergence is the mark-to-market approach. Towers believes that all of the economic assumptions should be marked to market at each measurement date. The practical divergence is the time allowed to reflect experience gains or losses and plan changes. Under current standards, experience gains or losses are recognized over a very long period, in many cases in excess of 15 years. This approach is no longer acceptable to investors, but immediate recognition is not fully consistent with the treatment of most other financial statement items. It’s important to consider that the plan’s obligation is at best a rough estimate and defies accurate calculation until the obligation is crystallized.

A compromise could be the answer. Recognize experience gains and losses over five years, but with asset gains and losses determined relative to the discount rate used to determine the obligations instead of the expected rate of return on assets. This way, the additional expected returns on “risky” assets—the equity risk premium— get recognized only as they are earned. Towers also suggests amortizing each year’s experience gains and losses independently, made practical by the shorter five-year amortization. This would avoid the potentially indefinite deferral that occurs under current rules when gains and losses are pooled with only a portion recognized each year.

Finally, the cost of plan improvements can also be recognized over five years unless covered under a collective bargaining agreement with a shorter term. These accounting changes need to be part of the broader changes needed in the system. Only then will we see a 21st century system designed to meet the needs of Canadians in a new era.

Steve Bonnar and Ken Choi are both principals with Towers Perrin in Toronto.steve.bonnar@towersperrin.com, ken.choi@towersperrin.com.