Historically, Canadian pension accounting standards were viewed as one of the barriers encountered by employers wishing to reduce pension risk. These barriers included the ability to defer and amortize experience gains and losses, the inclusion of expected additional returns from risky assets in the expected return on assets (EROA) calculation, and the ability to use a smoothed value of assets to calculate the EROA.
With the recent revisions to International Accounting Standards Section 19 (IAS 19), which mark pension plans to market in the employer’s financial statements, these barriers to de-risking will be removed and IAS 19 may actually become a catalyst, in some cases, for de-risking.
De-risking barriers
The risks associated with DB pension plans have created financial challenges for many employers. In many cases, financial pension risk is largely due to an investment policy that includes a significant allocation of plan assets to risky assets (e.g., equities), which are generally expected to generate higher investment returns than other investments, such as bonds.
However, the annual investment returns on risky assets can be volatile and may not align with the movement of a pension plan’s liabilities. A financial market environment characterized by decreasing long-term interest rates and equity market volatility has resulted in financial pain and uncertainty for many employers.
Given the concern about the level of financial risk contained in DB plans, employers have been assessing the merits of de-risking their plans.
For example, the risk in most plans can be reduced by increasing the allocation of plan assets to bonds and decreasing the allocation to equities. Another approach to de-risking that may be considered is the purchase of annuities for some or all of the plan’s retirees.
The implementation of a pension de-risking strategy is typically associated with lower expected investment returns and, as a result, an increase in the expected long-term cost of sponsoring the plan. In other words, there are usually risk/return trade-offs that employers must assess when considering whether to de-risk.
However, having experienced the pain associated with pension risk over the past few years, many employers appear to have concluded that it is time to establish and execute a de-risking strategy.
It should be recognized, though, that even when an employer decides that it would be prudent to de-risk, the employer faces a number of barriers.
For publicly traded companies, several barriers to de-risking were previously caused by Canadian accounting rules, but the rules have changed and therefore eliminated some of those issues.
CICA 3461
Prior to 2011, most Canadian publicly traded companies were required to follow the rules of the Canadian Institute of Chartered Accountants Handbook Section 3461 (CICA 3461) for purposes of reflecting their pension plans in their corporate financial statements. CICA 3461 encouraged, or at least did not discourage, assuming DB pension risk for the following reasons.
Deferral and amortization of gains and losses: Instead of requiring immediate recognition of pension experience gains and losses in the employer’s income statement and on the employer’s balance sheet, CICA 3461 permitted recognition of these gains and losses to be deferred and amortized into pension cost and onto the balance sheet over time. The ability to defer and amortize gains and losses resulted in the masking of the true risk that the plan posed to the employer.
The deferral and amortization of gains and losses also resulted in some employers having built up relatively large deferred (i.e., unrecognized) losses in recent years. This resulted in a reluctance to undertake certain de-risking actions such as purchasing annuities, since these actions required a portion of those deferred losses to be recognized immediately in the employer’s income statement.