EROA: The pension cost that flowed through the employer’s annual income statement was reduced by EROA. The calculation of the EROA was based on the employer’s expected long-term rate of return on the pension plan assets. The more risky assets that the plan holds, the higher the expected long-term rate of return on plan assets. Thus, a higher allocation to risky assets immediately decreased the pension costs flowing through the employer’s annual income statement, even though the anticipated additional investment returns reflected in the EROA were yet to be earned. The manner in which the EROA was calculated provided employers with an incentive to establish investment policies with larger allocations to risky assets.
For example, changing the asset mix of a pension plan with $200 million of assets from an allocation of 60% equities, 40% bonds mix to a lower risk allocation of 30% equities, 70% bonds could result in an immediate increase in the annual pension cost of $2.5 million.
Smoothed value of assets: CICA 3461 permitted the EROA to be calculated using a “smoothed value” of plan assets, under which investment gains and losses were recognized in the smoothed value of assets over time. The ability to use a smoothed value of assets served to further mask the plan’s true investment risk.
IAS 19
Beginning in 2011, Canadian accounting standards adopted international accounting rules for most publicly traded Canadian companies. These companies began reporting under IAS 19 for purposes of reflecting their pension plans in their corporate financial statements.
The adoption of IAS 19 eliminated some of the above-mentioned barriers to de-risking.
- IAS 19 required that the fair value of plan assets be used to calculate the EROA and the use of a smoothed value of plan assets was no longer permitted.
- Employers adopting IAS19 could elect to recognize experience gains and losses immediately on their corporate balance sheet (through other comprehensive income). The balance sheet for these employers better reflected pension financial risk as the pension plans were now marked to market on the balance sheet.
Employers adopting IAS 19 also had the option of continuing to defer and amortize experience gains and losses.
Revisions to IAS 19
Revisions to IAS 19 come into effect on Jan. 1, 2013. These revisions further reduce the barriers to de-risking that have been embedded in accounting standards.
- Revised IAS19 requires the immediate recognition on the balance sheet of all changes to pension plan surpluses or deficits (i.e., deferral and amortization of experience gains and losses will no longer be permitted).
- The annual pension cost will be calculated assuming that the annual expected rate of return on pension plan assets is equal to the liability discount rate, which is based on high quality corporate bond yields (i.e., the pension cost reflected in the employer’s profit and loss statement will no longer anticipate incremental returns from risky assets). Any incremental investment returns due to the investment in risky assets that actually emerge over time will be recognized on the corporate balance sheet (through other comprehensive income) once the incremental returns are actually earned.
In the earlier example, under revised IAS 19 a decision by the employer to change the long-term asset mix from an allocation of 60% equities, 40% bonds to an allocation of 30% equities, 70% bonds will have no immediate effect on the employer’s annual pension cost.
Implications for pension de-risking
Employers that follow IAS 19 for pension reporting would be wise to assess the effect of the recent revisions to IAS 19 on the amount and volatility of their pension cost and any effect that these changes may have on their balance sheet.
Employers should also assess whether these changes provide opportunities, or possibly even create the necessity, to commence the process of de-risking or accelerate the pace of de-risking where a de-risking strategy is already in place.