Mark-to-Market Accounting for Corporate Pension Plans

Institutional Asset Management September 2005 Mark-to-Market Accounting for Corporate Pension Plans By John Stone, CFA and Paul Sweeting, FIA The British are coming! The British are coming! n a clear night in April 1775, Paul Revere rode a borrowed horse from Boston to Lexington, Massachusetts to warn John Hancock and Samuel Adams that British forces were advancing. Two hundred and thirty years later, the same cry may be heard from U.S. corporate defined benefit plan sponsors. In the United Kingdom, the Accounting Standards Board (ASB) released Financial Reporting Standard 17 (FRS 17), which, as of January 2005, requires pension plans to fully recognize any gains or losses on a market value basis on the corporation s balance sheet. The concern is that mark-to-market accounting will introduce significant volatility into a corporation s financial statements. The U.K. is not alone; the International Accounting Standards Board (IASB), which sets the accounting standards for most of continental Europe, as well as other parts of the world, is redrafting their pension accounting standard to be more like FRS 17. The U.S. accounting standard setter, the Financial Accounting Standards Board (FASB), has agreed to work with IASB on global accounting standards. It is not clear how this will affect defined benefit accounting, but there is concern that it will move toward FRS 17. FASB controls the accounting rules on corporations that have pension plans, and these rules are enforced by the Securities and Exchange Commission. The impact of new accounting rules may alter companies financial reports through increased pension expense and potential charges to shareholders equity. As a result, it may affect the valuation of the company, but it does not directly require funding contributions to a pension. Pension funding guidelines are a separate set of rules, set by the U.S. Congress, under enforcement by the Internal Revenue Service. So, if mark-to-market accounting does not have any impact on companies being required to fund their pension plans, do they really care? They do. In a 2004 study by Fidelity Investments and PLANSPNSR magazine, corporate plan sponsors reported that mark-to-market accounting was the second biggest threat for defined benefit plans. It is currently perceived as a bigger threat than changes in PBGC requirements or even a further decline on interest rates. 1 Similar studies by the Committee on Investment of Employee Benefit Assets (CIEBA) and the American Benefits Council have also raised concern about U.S. accounting standards moving toward a mark-to-market approach. 2 This paper will compare and contrast the current U.S. accounting standards on employee benefits (FAS 87 and FAS 132) with FRS 17 and the international standard, IAS 19. In addition, it will look at the effect of FRS 17 on defined benefit plans in the U.K. and discuss the potential impact of a similar standard on U.S. defined benefit plans. FIDELITY MANAGEMENT TRUST CMPANY

The Convergence of Accounting Standards Each country has the option of establishing its own accounting standards, yet one of the hottest topics in accounting circles today is the global convergence of accounting standards. Convergence of standards has gained momentum as the world moves toward a more global economy and there is more interest in comparing companies across geographic boundaries. Convergence began in September 2002 when the FASB and IASB issued a Memorandum of Understanding where they acknowledged their commitment to the development of high-quality, compatible accounting standards that could be used for both domestic and cross-border financial reporting. At that meeting, both the FASB and IASB pledged to use their best efforts to make their existing financial reporting standards fully compatible as soon as is practicable. 3 While initial work has focused on other areas, in June 2005, FASB Chairman Robert Herz announced that FASB will begin looking into pension accounting with a decision on whether to move forward with an overhaul by early fall. 4 While the requirement to mark-to-market is the biggest difference between U.S. and U.K. standards, there are several differences that plan sponsors should understand. There are differences in the way assets are measured, as well as how they are treated on the income statement and the balance sheet. We will review each of the major differences between U.S., U.K., and International accounting standards. Comparing of Accounting Standards Treatment of Actuarial Gains and Losses: Mark-to-Market for Gains and Losses (U.K. nly) U.S.: FAS 87 only requires a corporation to recognize actuarial gains or losses that are outside a corridor of up to 10% around the greater of assets or a plan s projected benefit obligation. In addition, these gains or losses are further smoothed by recognizing them in the corporation s income statement on a straight line basis across the expected working lifetime of the employees in the plan. U.K.: FRS 17 takes a radically different approach, requiring immediate recognition of investment gains and losses, liability gains and losses from actuarial assumption changes, and the impact of benefit changes. These gains and losses are shown in a statement unique to U.K. accounting called the Statement of Total Recognized Gains and Losses, rather than in operating income statement. The effect of this immediate recognition is significant swings in shareholders equity on the corporation's balance sheet. Furthermore, gains and losses are not known until after the end of the fiscal year, thereby increasing uncertainty and making budgeting more difficult. International: IAS 19 is hedging between the U.S. and the U.K. standards. Under IAS 19 s current provisions, it allows for a corporation to choose one of three approaches. Under the first option, corporations immediately recognize actuarial gains or losses in the Statement of Recognized Income and Expense, with no impact on the operating income statement, but direct impact on shareholders equity (similar to FRS 17). Under the second option, corporations immediately recognize all actuarial gains and losses in the income statement. This would, in turn, lead to recognition in the balance sheet through retained earnings. The third option is similar to FAS 87 s corridor approach where gains and losses are recognized to the extent that they exceed 10% of assets or liabilities, and are recognized across the working lifetime of the employees in the plan. The unrecognized portion would be on the balance sheet as an adjustment to the net pension asset or liability. Asset Valuation: Elimination of Smoothing U.S.: FAS 87 requires the use of fair market valuation of assets for the determination of funding status. However, for determining the return on assets component of net periodic benefit costs, FAS 87 allows for the systematic smoothing of asset gains or losses for a period of up to 5 years. U.K.: FRS 17 requires the use of fair market valuation of assets for the determination of funding status, as well as for determining the return on assets component of net periodic benefits costs. Treatment of Past Service Costs: Elimination of Smoothing U.S.: Similar to the treatment of actuarial gains and losses, FAS 87 allows past service costs to be recognized on the income statement across the working lifetime of the employee in the plan. 2

U.K.: FRS 17 requires that past service costs be recognized across the period that they become vested (often immediately). Net Pension Assets on Balance Sheet: Limitation on Prepaid Pension Cost U.S.: FAS 87 allows for corporations with plans that are generating pension income to build up prepaid pension costs as assets on their balance sheet. These assets can then be used to reduce pension expense in future years. U.K.: FRS 17 limits the net asset on the balance sheet to the amount of refund or reduction in future contribution due to the surplus. Expected Return on Assets: Current Yield for Bonds (U.K. nly) U.S.: FAS 87 allows for a long-term estimate to be used for the expected return of plan assets. FASB recently revised FAS 132, which now requires plan sponsors to provide more disclosure around how long-term expected returns are calculated, as well as the plan s asset allocation. U.K.: FRS 17 also allows for a long-term estimate of expected return for equities, but requires that bond s expected return be the current market yield. International: IAS 19 allows for a long-term estimate to be used for the expected return of plan assets. Additional Disclosures U.S.: FAS 87 requires that plans also disclose the accumulated benefit obligation (AB) if underfunded, and show a minimum liability on the balance sheet for an underfunded AB with a resulting charge to equity. U.K.: None. International: None. In 1998, IAS 19 was very similar to FAS 87, (exceptions included the treatment of past service costs and pension assets on the balance sheet). Recent changes by the IASB have moved IAS 19 closer in line with FRS 17, and there is discussion by IASB to bring the two even further in line. ne of the key people responsible for IASB change is its chairman, Sir David Tweedie. Tweedie s prior role was head of the U.K. s ASB, where he was one of the principal architects of FRS 17. ne driving force of the recent change to IAS 19 was to allow companies who had adopted FRS 17 to more easily apply the IAS 19 standards as well. Given a convergence in global accounting standards, is it only a matter of time before FAS 87 begins to look like IAS 19 and FRS 17? And, perhaps more importantly, what does that mean to corporations with defined benefit plans? Impact of FRS 17 on U.K. Pension System U.K. firms have had to disclose numbers according to FRS 17 (in their footnotes) since June 2001. The FRS 17 numbers changed from being disclosures to figures that actually appear in the P&L and balance sheet, as of January 2005. In practice, what this means is that analysts will no longer need to adjust the accounting figures manually to allow for FRS 17. As with FAS 87, FRS 17 is a reporting standard and merely determines the numbers that go into a company s financial statements; it has no direct impact on the contribution rate, which must be paid into the plan, or on the asset allocation within the plan. Nevertheless, FRS 17 has brought into sharp focus the volatility of a funded ratio (the ratio of a pension plan s assets to its liabilities) calculated on a mark-to-market basis, particularly when compared with the ill-fated Minimum Funding Requirement, a statutory funding basis that effectively valued the majority of active and deferred member benefits using a discounted dividend approach. This added focus has led to an increase in bond weightings in the U.K. over the past five years, even greater than would be expected if the change was due only to the poor relative performance of equity markets (bonds have significantly out-performed equities in the U.K. over the period since June 2001). This has also coincided with an increased interest in Sterlingdenominated corporate bonds as an alternative to U.K. Treasuries, and greater scrutiny of bond managers ability to add value against their benchmarks. A study by Greenwich Associates found that U.K. pension fund allocations to equity have dropped dramatically, from 70% of assets in 2000, to 63% in 2004. In addition, the study found that almost half of U.K. companies with existing DB plans have closed them to new entrants. 5 There has also been an increase in Liability Driven Investing (LDI), which uses the interest rate sensitivity of the liabilities to drive the investment strategy through the use of interest rate and inflation swaps, in effect immunizing plans from swings in funded status. The development of this approach is a direct result of 3

mark-to-market accounting for post-retirement benefits. Potential Impact of Mark-to- Market Accounting on U.S. Pension System The potential impact of mark-tomarket accounting on U.S. corporations will depend on multiple factors, including modifications made by the FASB and any changes Congress makes to funding rules, i.e., PBGC premiums, etc. It is difficult to look at each in isolation, but collectively they are pointing to similar results in the U.K. In the Fidelity/PLANSPNSR study, 50% of corporations responded that they would decrease equity and increase fixed income allocations in response to a change to mark-tomarket accounting. Also, 22% said that they would increase the duration of their fixed income plan, and 30% said that they would consider freezing or terminating their plan. 6 In CIEBA s study, 75% of plan sponsors who responded indicated that they would decrease equity and increase fixed income, with 47% saying that they would consider lengthening their duration of their portfolio. In addition, 50% of plans indicated that they would consider freezing their plan to either current or new entrants. 7 Looking at asset allocations, a recent study by Goldman Sachs estimated that corporate pension plans could shift $290 billion from equities to fixed income. 8 Another study by Merrill Lynch suggested that the amount would be between $215 billion and $270 billion. 9 Greenwich Associates expects around $300 billion. 10 Assuming $1.5 trillion in corporate pension plan assets, this translates to a 15% 20% asset allocation shift from equities to fixed income. A $200 $300 billion shift in asset allocation among corporate plan sponsors will have a measurable impact on overall markets and the investing public. While the shift would likely happen gradually, it would amount to a 2% outflow of domestic equity markets and a 1.5% inflow into domestic fixed income markets. Perhaps the biggest impact could come at the long end of the yield curve. If plan sponsors choose to reallocate into long duration fixed income as a hedge against changes in their liabilities, an inflow of $200- $300 billion into a market of $1.1 trillion is significant and would lead to further flattening of the yield curve and lower discount rates for liabilities. This, in turn may further inflate pension liabilities and exacerbate the current pension funding crisis. Greater financial transparency and cross-border accounting consistency are worthy aspirations with which few would argue. It is the transition from concept to implementation that raises controversy. Change must be managed to minimize financial market disruption and unintended consequences. Clearly the actions of FASB bear watching over the coming years.o John Stone is a Senior Investment Analyst with Strategic Services at Fidelity Management Trust Company (FMTC). In this role, he is responsible for performing asset allocation studies and conducting portfolio construction analysis. John is a CFA charterholder and a member of the Boston Security Analysts Society. Paul Sweeting is a Director in the Portfolio Strategies Group at Fidelity Investments in London. He works on a wide range of strategic asset allocation issues, particularly in relation to institutional pension plans. He is a Fellow of the Institute of Actuaries. Endnotes 1 Funding Drives, PLANSPNSR Magazine, February 2005, http://www.plansponsor.com/magazine_type 3/?RECRD_ID=28323. 2 The U.S. Pension Crisis: Evaluation and Analysis of Emerging Defined Benefit Pension Issues, the Committee on Investment of Employee Benefit Assets of the Association for Financial Professionals (CIEBA of AFP), March 2004, http://www.afponline.org/pub/pdf/0304 ciebapension_crisis_full.pdf and Pensions at the Precipice: The Multiple Threats Facing ur Nation s Defined Benefit Pension System, American Benefits Council, May 2004, http://www.american benefitscouncil.org/documents/defined benefits_paper.pdf. 3 The Norwalk Agreement, September 18, 2002, http://www.fasb.org/intl/ convergence_iasb.shtml. 4 New Scrutiny on Auditing of Pensions, The New York Times, June 23, 2005. 5 The Twilight of the Defined Benefit? Greenwich Associates, February 2005. 6 Is Rome Burning? PLANSPNSR Magazine, November 2004. 7 The U.S. Pension Crisis: Evaluation and Analysis of Emerging Defined Benefit Pension Issues, the Committee on Investment of Employee Benefit Assets of the Association for Financial Professionals (CIEBA of AFP), March 2004, http://www.afponline.org/pub/pdf/0304_ ciebapension_crisis_full.pdf. 8 Pension reform: Implications for Plan Sponsors and the Capital Markets, Goldman Sachs, April 6, 2005. 9 Pension Reform Spells $200B Fixed Income Shift, Fundfire, April 21, 2005, http://www.fundfire.com/home/members/art icle.html?navmode=archive&id=974225611. 10 The Twilight of the Defined Benefit? Greenwich Associates, February 2005. 4

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