Ever read a financial statement only to find yourself wondering what they mean? You’re not alone.
Human resource professionals may not be accountants, but often they need to read financial statements related to pension expense and how these items affect the financial valuation of a company, many of whom many not understand the technical jargon used in the notes.
The notes to a company’s financial statements disclose a significant amount of information about a company’s pension plan to the reader. Most of the information provided, however meaningful and perhaps even exciting to an actuary, is not often read with a sufficiently critical or informed eye by the end user and stakeholders.
But an elementary knowledge of the impact on accounting for your organization’s pension plan can give an appreciation of how critical the pension expense numbers can be when decisions are being reached on such issues as plan design changes, downsizing, mergers and acquisitions and workforce planning.
Pension expense, like all expenses, impacts the reported profitability of a company and can, depending on the magnitude of the pension plan, have a significant effect on a company’s bottom line.
Pension expense for a defined benefit (DB) plan is calculated by an actuary and depends on the actuarial assumptions chosen. Assumptions are needed for economic factors such as future salary levels, inflation and rates of return, and for demographic factors such as turnover, retirement and mortality. The pension expense recorded by companies with very similar pension plans and assets can be dramatically different depending on the assumptions used by each company to calculate the expense.
HOW IS PENSION EXPENSE CALCULATED FOR A DB PLAN?
Pension expense for a given year is typically equal to the cost of benefits earned during the year plus interest on plan liabilities minus the expected return on plan assets, if any. Also, there may be amortization of various items whose recognition can be deferred to future years. Occasionally one also encounters a one-time hit (or profit) in a particular year, as a result of certain activities taking place in the year.
In reading the notes to the financial statements, it is imperative that the reader understands the impact that various assumptions can have on each of these components of pension expense.
Section 3461 of the Handbook of the Canadian Institute of Chartered Accountants (CICA 3461) was recently adopted as the Canadian standard for determining the accounting cost of pension plans and other post-retirement benefits (such as dental or extended health). These accounting rules apply to most private-sector organizations, but do not apply to many public-sector organizations and some subsidiaries of foreign companies.
One of the drivers behind the imposition of the new standards was to lessen some of the problems associated with the wide range of assumptions used by different companies to estimate pension expense. This makes it easier for readers of financial statements to compare the financial results of different companies by ensuring consistency in the way expense amounts are calculated.
STANDARDIZATION OF DISCOUNT RATE ASSUMPTION
One of the big changes from the previous Canadian pension accounting standard (CICA 3460) is how the discount rate, used to value the plan’s liabilities, is determined. Under CICA 3460, a discount rate was used that represented management’s best estimate of the long-term pension fund rate of return in future years. The discount rate that must now be used to value liabilities under CICA 3461 is tied to current market rates of interest. Thus, pension plans being valued at the same valuation date now employ fairly similar discount rates.
A recent Watson Wyatt Survey, 2001 Survey of DB Pension and Post-Retirement Benefits Accounting Assumptions, Making Numbers Count, reveals that Canadian plan sponsors used a mean discount rate as at Dec. 31, 2000 of 6.9 per cent, with 50 per cent of survey respondents using a rate that fell in the range 6.75 per cent to 7.25 per cent. In general, the lower the discount rate used, the higher the value of liabilities and pension expense, and vice versa. A simple example helps illustrate the impact of changes to the discount rate assumption. Using a discount rate of eight per cent would result in a dollar payable 15 years from now to be valued at about $0.32 today. Lowering the discount rate to six per cent would increase this value to about $0.42, a 30 per cent increase in present value.
MANAGEMENT’S BEST ESTIMATES
While the discount rate to be used is now mandated by CICA 3461, other assumptions are based on management’s “best estimates,” including assumptions for future salary increases, inflation and return on assets. When looking at two sets of financial statements side by side, it is rarely an apples to apples comparison because the management of the two companies may have used very different best estimate assumptions.
•Salary increases: The salary increase assumption is usually comprised of an underlying assumption for inflation and an additional component for productivity improvements and merit/promotional increases.
Where plans promise a benefit based on earnings, the salary scale is a factor in determining the costs of future benefits.
The Watson Wyatt survey results indicate that, on average, companies reported using a salary increase assumption of 4.2 per cent, and an average underlying long-term inflation rate of 2.8 per cent. At the 25th percentile, the reported salary increase and inflation assumptions were 3.5 per cent and 2.25 per cent respectively. These figures may be compared to the 75th percentile results, which reported salary increase and inflation assumptions of five per cent and three per cent respectively.
Changing the salary and inflation assumptions from the 25th percentile levels to the 75th percentile figures could lead to an increase in pension expense. Based on a case study of an actual company, this resulted in the pension expense increasing by as much as 30 per cent, all else being equal.
•Return on assets: The expected rate of return on the plan assets can also have a significant impact on results. Any assumed increase in investment return will directly reduce the reported cost of the plan — the pension expense. How does this impact the comparability of financial statements?
Suppose you have two companies that are basically identical in every way that have similar workforce demographics and pension plan provisions. Further, suppose that the assets of both plans are equal and are invested in the same manner. Company A assumes a seven per cent rate of return on assets for determining pension expense while Company B assumes a more aggressive eight per cent (corresponding to the 25th and 75th percentile results of the Watson Wyatt survey, respectively). Based on case studies of actual companies, Company A could report a pension expense more than 25 per cent higher than the pension expense reported for Company B, all else being equal.
It will be interesting to see how poor performance of the markets that may occur in 2001 could impact the pension expense calculated for 2002. Since gains and losses incurred in a particular year are only recognized in following years, many plans will experience an investment loss, at least relative to their expected returns, in 2001. This investment loss will result in an increased pension expense, all else being equal, unless the plan sponsor takes advantage of the “10-per-cent corridor” which is a technique that can be used to temporarily reduce or eliminate such an increase in expense.
•Other interesting anomalies: An interesting anomaly that may occur is that a company can record income rather than an expense with respect to its pension plan if the plan has a surplus on its accounting valuation basis. Being able to record this income improves a company’s bottom line and may make it appear more profitable than it would otherwise be.
Needless to say, this could affect the stock price. For example, a company can be in a declining industry with little or no profit from operations, yet the pension plan may be contributing significantly to the company’s bottom line. Where this is the case, the reader should be cautious when assessing the true value of the company.
Another interesting anomaly is the interaction between funding results and accounting results. Funding results rely on a separate set of assumptions and methods from those used in accounting and determine the contributions that are actually made by the company to the pension fund. This may result in decisions being made on a funding basis that may result in unexpected changes to the results disclosed in the financial statements. Examples include the following:
•If a large surplus exists on a funding basis, plan improvements may appear “free” by not requiring additional contributions by the company. However, the CFO may oppose any such plan improvements due to the impact on the financial statements resulting from the increase in pension expense.
•Design changes may appear to be more palatable to stakeholders as a result of aggressive assumptions being used as management’s best estimates having a direct impact on the results disclosed in the company’s financial statements.
While the requirements of CICA 3461 should improve both the extent of disclosure about pension plans and the comparability of results among companies reporting under generally accepted Canadian accounting principles, one should still be careful when looking at the pension related aspects of financial statements. A lot of information is presented in these financial statements and it is important that practitioners know how to interpret this information in order to apply it properly for their purposes.
Lori Satov is a Vancouver-based actuary and consultant with Watson Wyatt Canada. Jeff Penner is an actuary and consultant in Watson Wyatt’s Calgary office. They can be reached at 1-866-206-5723.
The notes to a company’s financial statements disclose a significant amount of information about a company’s pension plan to the reader. Most of the information provided, however meaningful and perhaps even exciting to an actuary, is not often read with a sufficiently critical or informed eye by the end user and stakeholders.
But an elementary knowledge of the impact on accounting for your organization’s pension plan can give an appreciation of how critical the pension expense numbers can be when decisions are being reached on such issues as plan design changes, downsizing, mergers and acquisitions and workforce planning.
Pension expense, like all expenses, impacts the reported profitability of a company and can, depending on the magnitude of the pension plan, have a significant effect on a company’s bottom line.
Pension expense for a defined benefit (DB) plan is calculated by an actuary and depends on the actuarial assumptions chosen. Assumptions are needed for economic factors such as future salary levels, inflation and rates of return, and for demographic factors such as turnover, retirement and mortality. The pension expense recorded by companies with very similar pension plans and assets can be dramatically different depending on the assumptions used by each company to calculate the expense.
HOW IS PENSION EXPENSE CALCULATED FOR A DB PLAN?
Pension expense for a given year is typically equal to the cost of benefits earned during the year plus interest on plan liabilities minus the expected return on plan assets, if any. Also, there may be amortization of various items whose recognition can be deferred to future years. Occasionally one also encounters a one-time hit (or profit) in a particular year, as a result of certain activities taking place in the year.
In reading the notes to the financial statements, it is imperative that the reader understands the impact that various assumptions can have on each of these components of pension expense.
Section 3461 of the Handbook of the Canadian Institute of Chartered Accountants (CICA 3461) was recently adopted as the Canadian standard for determining the accounting cost of pension plans and other post-retirement benefits (such as dental or extended health). These accounting rules apply to most private-sector organizations, but do not apply to many public-sector organizations and some subsidiaries of foreign companies.
One of the drivers behind the imposition of the new standards was to lessen some of the problems associated with the wide range of assumptions used by different companies to estimate pension expense. This makes it easier for readers of financial statements to compare the financial results of different companies by ensuring consistency in the way expense amounts are calculated.
STANDARDIZATION OF DISCOUNT RATE ASSUMPTION
One of the big changes from the previous Canadian pension accounting standard (CICA 3460) is how the discount rate, used to value the plan’s liabilities, is determined. Under CICA 3460, a discount rate was used that represented management’s best estimate of the long-term pension fund rate of return in future years. The discount rate that must now be used to value liabilities under CICA 3461 is tied to current market rates of interest. Thus, pension plans being valued at the same valuation date now employ fairly similar discount rates.
A recent Watson Wyatt Survey, 2001 Survey of DB Pension and Post-Retirement Benefits Accounting Assumptions, Making Numbers Count, reveals that Canadian plan sponsors used a mean discount rate as at Dec. 31, 2000 of 6.9 per cent, with 50 per cent of survey respondents using a rate that fell in the range 6.75 per cent to 7.25 per cent. In general, the lower the discount rate used, the higher the value of liabilities and pension expense, and vice versa. A simple example helps illustrate the impact of changes to the discount rate assumption. Using a discount rate of eight per cent would result in a dollar payable 15 years from now to be valued at about $0.32 today. Lowering the discount rate to six per cent would increase this value to about $0.42, a 30 per cent increase in present value.
MANAGEMENT’S BEST ESTIMATES
While the discount rate to be used is now mandated by CICA 3461, other assumptions are based on management’s “best estimates,” including assumptions for future salary increases, inflation and return on assets. When looking at two sets of financial statements side by side, it is rarely an apples to apples comparison because the management of the two companies may have used very different best estimate assumptions.
•Salary increases: The salary increase assumption is usually comprised of an underlying assumption for inflation and an additional component for productivity improvements and merit/promotional increases.
Where plans promise a benefit based on earnings, the salary scale is a factor in determining the costs of future benefits.
The Watson Wyatt survey results indicate that, on average, companies reported using a salary increase assumption of 4.2 per cent, and an average underlying long-term inflation rate of 2.8 per cent. At the 25th percentile, the reported salary increase and inflation assumptions were 3.5 per cent and 2.25 per cent respectively. These figures may be compared to the 75th percentile results, which reported salary increase and inflation assumptions of five per cent and three per cent respectively.
Changing the salary and inflation assumptions from the 25th percentile levels to the 75th percentile figures could lead to an increase in pension expense. Based on a case study of an actual company, this resulted in the pension expense increasing by as much as 30 per cent, all else being equal.
•Return on assets: The expected rate of return on the plan assets can also have a significant impact on results. Any assumed increase in investment return will directly reduce the reported cost of the plan — the pension expense. How does this impact the comparability of financial statements?
Suppose you have two companies that are basically identical in every way that have similar workforce demographics and pension plan provisions. Further, suppose that the assets of both plans are equal and are invested in the same manner. Company A assumes a seven per cent rate of return on assets for determining pension expense while Company B assumes a more aggressive eight per cent (corresponding to the 25th and 75th percentile results of the Watson Wyatt survey, respectively). Based on case studies of actual companies, Company A could report a pension expense more than 25 per cent higher than the pension expense reported for Company B, all else being equal.
It will be interesting to see how poor performance of the markets that may occur in 2001 could impact the pension expense calculated for 2002. Since gains and losses incurred in a particular year are only recognized in following years, many plans will experience an investment loss, at least relative to their expected returns, in 2001. This investment loss will result in an increased pension expense, all else being equal, unless the plan sponsor takes advantage of the “10-per-cent corridor” which is a technique that can be used to temporarily reduce or eliminate such an increase in expense.
•Other interesting anomalies: An interesting anomaly that may occur is that a company can record income rather than an expense with respect to its pension plan if the plan has a surplus on its accounting valuation basis. Being able to record this income improves a company’s bottom line and may make it appear more profitable than it would otherwise be.
Needless to say, this could affect the stock price. For example, a company can be in a declining industry with little or no profit from operations, yet the pension plan may be contributing significantly to the company’s bottom line. Where this is the case, the reader should be cautious when assessing the true value of the company.
Another interesting anomaly is the interaction between funding results and accounting results. Funding results rely on a separate set of assumptions and methods from those used in accounting and determine the contributions that are actually made by the company to the pension fund. This may result in decisions being made on a funding basis that may result in unexpected changes to the results disclosed in the financial statements. Examples include the following:
•If a large surplus exists on a funding basis, plan improvements may appear “free” by not requiring additional contributions by the company. However, the CFO may oppose any such plan improvements due to the impact on the financial statements resulting from the increase in pension expense.
•Design changes may appear to be more palatable to stakeholders as a result of aggressive assumptions being used as management’s best estimates having a direct impact on the results disclosed in the company’s financial statements.
While the requirements of CICA 3461 should improve both the extent of disclosure about pension plans and the comparability of results among companies reporting under generally accepted Canadian accounting principles, one should still be careful when looking at the pension related aspects of financial statements. A lot of information is presented in these financial statements and it is important that practitioners know how to interpret this information in order to apply it properly for their purposes.
Lori Satov is a Vancouver-based actuary and consultant with Watson Wyatt Canada. Jeff Penner is an actuary and consultant in Watson Wyatt’s Calgary office. They can be reached at 1-866-206-5723.
