German accounting reform will make book reserve pensions less attractive and will give Pensionsfonds the advantage over CTAs
An accounting reform law (BilMoG) is the centrepiece of the German government's project to overhaul existing domestic accounting procedures (HGB) and align them with international standards (IAS). Occupational pension provision is among the areas directly affected, and significant changes were introduced to the bill of 21 May 2008 compared with the first draft.
The first draft proposes the abolition of optional disclosure of the provisions for indirect and direct pension obligations. This option is removed, bringing back the previous wording that the balance sheet disclosure is mandatory except for direct covenants issued before 1987.
Importantly, the previous rule for indirect covenants, such as support funds (Unterstützungskassen), is also retained. This means employers do not have to show these obligations in the balance sheet, as long as the insurance provider is secure. The credit risk and probability of default will probably be taken more seriously in future, particularly after any bankruptcy of a support fund, which would pass liability to the employer. Trade bodies had campaigned vigorously to maintain the status quo, so the indirect forms of pension provision would not be affected.
Whether the government rejected the change because of trade body activism or out of self-interest remains to be seen. As a heavy user of the system, it must have been aware of the fact that VBL (the pension provider for federal and state employees) and other public pension covenants now have to disclose provisions - even though in many cases more than 90% of liabilities are unfunded. The indirect obligations not covered will have to be set out in the notes in future, meaning employers will have to pay greater attention to them. This will affect support funds with one-off lump sum endowments in particular. In view of the current financial crisis, which has seen companies move large financial obligations off balance sheet, this condition seems justified.
But obligations that are transferred to Pensionsfonds with insurance-like guarantees often do not need to be disclosed.
One objective of the reform bill is to value provisions for pension obligations at market rates in future, replacing the old budget-based valuation methods of tax accounting. Adopting the basic principles of a ‘true and fair view' is enough.
It is not yet clear which of the methods under discussion will be adopted. The cash value method aligned to the financial year - a modified version of the fractional value method - and cash value in proportion to future entitlements are all on the cards. The government will leave it to best practice.
The proposed rule to simplify rules surrounding pension reserves, and preventing the requirement to value each obligation individually, is to be welcomed. It is achieved by introducing a single average interest rate, set by the central bank and based on high-grade credit (AA-rating) with a duration of 15 years. The rule is conditional on the pension provisions not being significantly under 15 years in dura-tion. The average interest rate also avoids major interest rate fluctuations and therefore also major fluctuations in the valuation of the pension provisions.
But the concept may not accurately portray the actual state of a fund's finances at a given reporting date. Companies with a good credit rating will also complain that their credit risk is no longer reflected in the interest rate or in the level of their pension obligations. Also, cost and price increases such as salary rises and annual adjustments for inflation are supposed to be included in the calculations, which is against the reporting date principle.
Even conservative estimates suggest pension liabilities will increase by at least 25% under HGB to reveal the full extent of obligations. The widely used lower value arrived at by tax accounting will no longer be acceptable under the new accounting rules. Furthermore, discounting revenues and expenses must by shown in the income statement in future. The government has also proposed a "reserves mirror", in which these revenues and costs are to be displayed separately. This not only increases the employer's workload but also removes any scope for offering an alternative outside the income statement, along the lines of IAS, the SORIE method.
The need to balance pension obligations and the assets set aside for them, such as provision insurance, is new. This is required when it is shown that the assets will be used exclusively to cover the liabilities. There is a need for debate over exactly what security measures are necessary to satisfy this new balancing principle. In the first draft the double trust method is explicitly mentioned, whereas no more examples are given in the final version. The legislature needs to resolve this ambiguity and not leave it to the judiciary, since legal certainty is required. All the possible models for achieving security, such as hypothecation of liability insurance - the most common solution in Germany - should lead to the same result.
The only result of the balancing principle is to show the open obligation. Following criticism of the first draft of the bill, both pension obligations and the corresponding asset values have to be marked to market, unless the latter exceeds the former.
The actuarial valuation method used to calculate pension provisions, the basic assumptions, especially the interest rate, salary increases and mortality tables are to be given in the company notes, to make comparisons between companies easier. If pension provisions and assets are to be balanced, data on acquisition costs and the current market values as well as the value of pension provisions, revenues and costs, must be given.
The move away from the basis of ‘reversed authority' means tax accounts and commercial accounts will diverge in future. Two balance sheets will have to be drawn up and, for company schemes; two different values for pension provisions need to be calculated. Article 6a of the income tax code, which prescribes an interest rate of 6% but does not take future price and cost increases into consideration, is still applicable under tax accounting. The additional costs for companies anticipated in the bill - €50m in the first year and €35m in subsequent years - seem too low.
To avoid any shock to the system the government has proposed a transitional period. The additional allocation to provisions can be made in equal instalments from 2009 to 2023. Alternatively, it can be made all at once immediately, or in varying amounts depending on the annual results. The only option not allowed is to wait until 2023 to pay the difference.
Once the reform bill has been passed, Pensionsfonds will have an advantage over contractual trust arrangements (CTAs): contributions towards the outsourcing of pension obligations continue to be tax deductible, whereas the costs incurred by employers in outsourcing to a CTA are not recognised in tax accounting law.
We will have to wait until the bill is passed into law, as changes may be made during the legislative process. Nonetheless, companies must get to grips with the impact of the accounting reform law and the rough outline of the legislation is already clear from the final draft of the bill. Pension liabilities will increase significantly as a result of the more realistic valuation procedures in HGB and all covenants are affected.
Overall, though, enough commercial accounting loopholes remain to accommodate individual needs. Moreover, having sufficient capital cover for pension covenants will become even more important. The old book reserve method - first issuing a pension covenant and then using cash flow payments to finance it - will only be possible for companies that are completely independent of the capital markets.
Many German pension entities will have to be audited and adapted. It is important to consider strategies for achieving sufficient capital cover and for allocating the pension provisions at the right time (in the transitional period), as well as appropriate outsourcing solutions. But there will be no catch-all solutions. There is no avoiding the significant costs. The legislator is not just achieving greater alignment with international valuation methods with the reform. But it is also making the book reserve method, which is widely seen as an arcane German speciality, even less attractive in Europe.
Our main criticism of the proposal remains the retention of the unrealistic tax treatment of pension obligations, which is no longer market-based. As long as market participants continue to issue pension covenants, competitive disadvantages relative to European players remain firmly in place. Companies should act now to identify alternatives.
Hans Melchiors is managing director of BVG (Beratungs -gesellschaft für Versorgungswerke) in Hamburg
No comments yet