The International Accounting Standard Board's (IASB) newly-updated IAS19 accounting standards look likely to bring the UK's defined benefit pension schemes closer to extinction, drag some healthy pension schemes into deficit and hit company profits by a couple of percentage points, Pension Funds Insider has been told by various sources.

In turn, however, these pessimistic predictions have been slated as 'foolish' by others who welcome the changes for ending "Mickey Mouse" accounting practices, creating an interesting debate surrounding the new standards.

While accounting experts are keen to stress that the new standards on pensions accounting will produce both winners and losers and improve overall consistency and transparency, the biggest losers are likely to be sponsors who run large pension schemes with substantial equity investments - as was feared throughout the draft stage .The UK's declining number of private sector defined benefit (DB) pension funds most closely fit this description.

Nick Griggs, head of corporate consulting at Barnett Waddingham, told Pension Funds Insider that "anything that increases the cost to the company, even if it is just an accounting cost, has to push that company one step further to closing the scheme and, when it can afford to, wind up that scheme". Pensions consultant John Ralfe, however, has said that this "should come as no surprise to anyone" given that the changes were first proposed some 18 months ago.

Barnett Waddingham's consultations with finance and manufacturing companies in the FTSE 350 have found that the two sectors will face a combined £525m hit to profits when the new standards are fully operational in January 2013, amounting to 2.7% and 2.4% of total profits respectively. Lane Clark & Peacock partner Tim Marklew meanwhile has said that BT's latest annual profits would have been reduced by a huge £350m alone if the new accounting regime had been introduced this year instead.

The fears over the effects on profits stem mainly from the ending of accounting rules that have allowed sponsors to include their expected returns on pension fund investments on company balance sheets.

While future returns from pension fund assets will still be included in sponsors' profits, they will be set equivalent to the very modest rate of returns on AA-rated corporate bonds, meaning that sponsors of funds heavy on risky equities will not be able to claim the significant future returns they had hoped for.

Warren Singer, principal of Mercer's global accounting standards group, has told Pension Funds Insider that switching out of high-risk assets like equities and alternatives would be incentivised in the new order. Singer said that "schemes that have a strong focus on profit and loss as a performance indicator and are taking on a lot of equity risk as well as schemes that use deferred recognition, but worried about the consequences of moving to immediate recognition, are most likely to consider reducing risk".

IASB estimates suggest that 50% of companies worldwide who report using IAS19 principals are likely to be effected by the need to change their use of expected asset returns in corporate accounting.

Deferred recognition of returns was a norm 15 to 20 years ago but the new accounting standards continue a trend of making mark-to-market the overriding principal in pension accounting. It was the intention of the creators of the first international accounting standard FRS17 (introduced in 2000) to move progressively closer to full mark-to-market accounting on a step-by-step basis in order to improve transparency. Some commentators now suggest that the latest revision marks an end to this process.

Another important change for pension funds in the forthcoming IAS19 standards will be the removal of the 'corridor' method that has allowed sponsors to present a smoother picture of volatile scheme funding figures. Griggs said: "we are going to see a number of companies suddenly having to declare a massive pension scheme deficit on their balance sheet whereas they had not done so previously."

According to Deloitte's head of global IFRS leadership team the loss of the ability to 'smooth' the effect of pensions on a company's accounts will mean more transparency and comparability, though it will also have a big impact in countries, particularly in continental Europe, where use of the corridor is a much more common practice.

Cards on the table

Enhanced transparency and consistency are being heralded as the major advantages of the changing standards, although from the point of view of protecting DB schemes these could also be worries.

Griggs conceded that well-intentioned changes would be useful for accountants but would make it more difficult for sponsors to hide the consequences of large pension fund deficits. He said: "If you're an investor or an accountant you do want consistency but that might not be the best for a scheme looking to recover a deficit."

For the majority of DB schemes that are not open to new members, increased disclosure rules that make accounting of scheme funding more consistent will be the most notable change once the new rules enter into force.

Independent pensions consultant John Ralfe said that these disclosure rules will help shareholders and bondholders greatly, saying: "the new disclosures will give a much better understanding to shareholders and investors of the details of individual pension schemes and the impact on their sponsors, especially where the scheme is large in relation to the company." The required disclosures include expected cash contributions, duration of liabilities, sensitivities and any unusual features of the scheme.

Marklew said: "The new disclosure rules are principal-based rather than rules based. Instead of companies having a detailed set of rules of what they have to write, the idea is that companies will write more or less depending on how important they consider the pension scheme to be."

So what?

Those warning of the added costs to sponsors concede that figures of the likely impact on corporate profits can exaggerate the overall severity of the changes to the international accounting standards. Griggs says that while many firms will face a one-off blip in disclosed figures, it's not an extra real cost, it's an extra accounting cost. "Operating costs aren't going to change and you have to remember that when people look at company accounts they often strip out all of the pension disclosures and look at the underlying business."

Ralfe says companies and investors should have been fully aware of the planned changes to the standards for some time. He told Pension Funds Insider: "The changes should come as no surprise and are already largely reflected in the share prices. Investors by now distinguish between real operation income in the profit and loss figures and the current made-up expected return on asset income."

He concedes the new standards will do little to preserve the dwindling numbers of generous DB schemes but adds that "the defined benefit genie is already out of the bottle, and the only people who are in denial are those with vested interest in preserving the defined benefit status quo, including actuarial consultants and fund managers."

On the removal of the corridor method, Ralfe points out that he is aware of only two major UK companies, British Airways and Barclays, who currently use this in their accounting and would therefore find their pension funding figures more volatile from 2013 onwards. "More continental companies use the corridor to smooth" says Ralfe, "so having to recognise gains and losses immediately is a bigger issue for those with defined benefit schemes, although they are less common in continental countries".

Ralfe also deems it "a bit of an insult to finance directors" to suggest they are deliberately encouraging their pension funds to hold equities in order to gain a boost to their corporate profits via the deferred recognition principal that is to be abolished. Both him and Marklew agree that the new standard's changes on the practice of deferred return recognition are more moderate could have been.

Singer agrees that the removal of an incentive to invest in equities and other more risky assets would not necessarily dictate a sudden change of investment course. He said that "going beyond accounting consideration, there are of course circumstances in which sponsors may believe that taking risk is appropriate and that they have sufficient covenants to keep the scheme viable in the event that the risk taking isn't successful"

Nonetheless Griggs says that each plan sponsor will need to consider risk management in the light of the changes. "They will vary based on the specific policies of each sponsor but the changes to IAS19 will refocus them on risk management due to the enhanced disclosure requirements."

The trend of de-risking in defined benefit pensions may therefore have long since gained great momentum, but IAS19 seems set to give it another boost.

First published: 28.06.2011

dbillingham@wilmington.co.uk