Accounting for pension costs
The impact of international accounting rules and their national equivalents on Europe’s occupational pension funds could be far-reaching.
One consequence may be that more employers will be persuaded to switch from defined benefit (DB) to defined contribution (DC) schemes to free up their balance sheets from unwanted liabilities.
This was one of the key conclusions of the tenth annual conference of Euracs, the European network of consulting actuaries, which took place in Paris on 28 and 29 January.
Directive 271, the Dutch equivalent of employee benefits standard IAS 19, will force employers to recognise additional pension fund liabilities on their balance sheets, says Evert van Ling, co-founder of ConAct actuarial consultancy in the Netherlands,
Under Directive 271 unfunded pension liabilities must be reflected on the balance sheet of the employer. “The problem is how to calculate this,” says van Ling. “For the two kinds of DB schemes in the Netherlands – final salary and reindexed average pay – calculations are currently based on accrued benefits and actual salary level. Future salary increases are not taken into account, nor are turnover or disability rates. Both the employer and the pension fund work under same assumptions, so there is no impact on the employer.”
However, van Ling says that when Directive 271 comes into force the equation will alter. The employer’s calculations will be based on accrued benefits and projected final salary – including increases. “These will be far bigger than the increases in the interest rate – 6% compared with 3% to 4%.”
Employer and pensions funds will also work on different assumptions. The employer will now have to base the discount rate on AA-rated bonds. However, the pension fund will continue to use a rate of 4% for its own calculations. Total pension costs will be the sum of the current service cost, past service cost and interest cost, minus the expected return on assets, plus or minus any actuarial gains or losses.
“The effect is that most employers will have to recognise an extra liability on the balance sheet. It will give a tremendous boost to DC because DC is so much easier to apply than DB,” says van Ling.
He said another effect of Directive 271 will be that pension costs will become more volatile. “Because the pension fund can do its own asset liability model it can have an effect on the balance sheet of the sponsor,” van Ling warns. “There will need to be discussion between the pension fund and the employer about investment strategy.”
French pension plans face different problems. France does not have its own FRS 17 and FAS87 Accounting for the sponsor company is covered by various French laws and ‘recommendations’. Many of the largest French companies have adopted IAS 19.
The impact of the new accounting rules on book reserve plans will depend on how large the companies are, says Jean-Christophe Ricard, chef de mission at Fixage actuarial consultancy in Paris. “For large French companies, the problems are almost solved. For the most part financial statements are already compliant with IAS and there is no they do not need to make an extra effort to be compliant with IAS or US GAAP. However for middle size companies, problems remain. French GAAP still gives them the opportunity to ignore the issue.”

French pension vehicles are currently regulated by prudential ‘insurance’ texts, he points out. These are having a distorting effect on pension fund accounting. “The main problem is that the prudential text distinguishes between bonds and equities. Accounting for bonds allows smoothing mechanism for revenue and gains and losses. Special reserves are created to make smoother accounting,” he says.
“Accounting for equities is quite the reverse. There is no smoothing mechanism for revenue and effective gains and losses. Pension vehicles are forced to make depreciation reserves for underlying losses. The differences are very significant.”
These prudential rules have led to a move away from investment in equities, he says. “Equities now form only a modest part of companies’ portfolios.”
There is a positive side to this, he adds. “At the end of September 2001 a survey carried out by the insurance supervisory authority showed that solvency was not challenged by the huge collapse in the equity market. So there was no need for a change of regulations in an emergency.”
The main benefit of international accounting standards is the light they shine on pension fund costs, says Colin Pugh, an independent actuary who advises multinationals: “Accountants and analysts believe an enterprise’s annual funding contributions are not an accurate reflection of the employer’s true pensions costs – and they are right. There is too much flexibility in interpreting the funding contributions, which can either be can be consistently exaggerated o consistently underestimated.”
International accounting standards will particularly benefit multinationals with worldwide pension schemes, Pugh suggests. “Pensions fund accounting is important because it enables information gathering by corporate headquarters. It can mean a chance to find out what multinationals pension fund costs really are. “
A company’s true pension costs are rarely understood, he adds. “The numbers can sometimes be very big indeed, and this will have implications for mergers and acquisitions. Some mergers have fallen apart because of hidden pension fund contributions.”
Overall, Pugh believes, international standards will bring much needed transparency to the hitherto opaque business of pension cost accounting in Europe.

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