Quarterly Guide to IAS 19 Assumptions as at 31 March 2014

JLT Employee Benefits

This guide is intended for use by finance directors in discussions with their actuaries and auditors on the actuarial assumptions to be adopted for recognising pension assets and liabilities in financial statements. It is divided into five sections:

❯❯ Markets since 31 March 2013

❯❯ Expected assumptions at 31 March 2014

❯❯ Recent developments

❯❯ Latest information from FTSE 100 company disclosures

❯❯ Simple guide to IAS 19

Markets since 31 March 2013❯❯ The FTSE All-Share Total Return Index has increased

by 8.8%

❯❯ The MSCI World Index (GBP) has increased by 6.3%

❯❯ The iBoxx >15 year AA corporate bond yield index has increased from 4.05% to 4.30%

❯❯ The FTSE 20 year fixed interest gilt yield index has increased from 2.80% to 3.40%

❯❯ The Bank of England 15-year spot inflation rate has decreased from 3.50% to 3.45%

Better than expected returns on growth assets combined with additional funding contributions made by companies have generally resulted in a decrease in pension scheme deficits compared to the position 12 months ago.

The increase in the AA corporate bond yield index would usually feed through to higher discount rates and result in a lower value being placed on liabilities. However, it is important to highlight that the shape of the corporate bond yield curve has changed significantly over the year. It is currently steeply upward sloping until around 15 years and then flattens out whereas at 31 March 2013 the curve was upward sloping at all terms. The change in the shape of the yield curve should be considered carefully when setting discount rates at 31 March 2014. Discount rates for more mature plans are likely to have increased since 31 March 2013. As the yield curve flattens out at longer durations the discount rates used by less mature plans are likely to have stayed at broadly similar levels to those at 31 March 2013.

In association with

Expected assumptions at 31 March 2014The expected range of assumptions at 31 March 2014 is as follows:

Discount rate 4.00% to 4.50%

Price inflation (RPI) 3.20% to 3.70%

Price inflation (CPI) 2.00% to 3.20%

Salary inflation 3.20% to 5.70%

Assumed life expectancy 25 to 29 years for a male now aged 60 (justified by nature of employee population or experience). 1 to 2 years higher for a male retiring 20 years from now.

Recent Developments IAS 19 changes in forceA significant amendment to IAS 19 was issued on 16 June 2011. This is now in place for accounting periods beginning on or after 1 January 2013. The main elements of this amendment are as follows:

❯❯ Elimination of smoothing (“corridor approach”)

❯❯ Change to the expected return on assets (EROA) which will effectively require the EROA to be set equal to the interest rate applied to the pension obligation (the discount rate)

❯❯ Various extra disclosures

Some other points to note on this amendment are as follows:

Implementation and impactsThe changes are effective for periods beginning on or after 1 January 2013. Prior year comparative information will be required except on specified items, e.g. sensitivity analysis.

All entities will require additional disclosures and nearly all entities will end up with worse P&Ls. Most entities’ balance sheets will remain unchanged unless they use the “corridor approach” and have large amounts of unrecognised losses in which case they could be significantly negatively affected.

Administration CostsThe EROA is no longer used. Instead “net interest on the net defined benefit liability (asset)” (NI) is recognised in profit or loss. NI is determined by multiplying the net defined benefit liability (asset) by the rate used to discount post-employment benefit obligations. Administration costs cannot be allowed for within this NI item (previously these costs were typically deducted from EROA). This may further increase P&L charges.

Investment-related administration costs (i.e. the cost of managing the plan assets) and any tax payable by the plan itself should be allowed for within the actual returns on assets item within the remeasurement items (recognised in Other Comprehensive Income; OCI). Other administration costs are not deducted from the return on plan assets; they are recognised in profit or loss when the administration services are provided.

IAS 19 requires the administration costs to be recognised when the administration services are provided. We expect auditors will accept more than one approach on the presentation of the non-investment management administration costs. We are expecting the most common approach to be that they are recognised in the P&L as a separate listed item, below the service cost item, as an operating cost. Some companies presently show them elsewhere in operating costs away from the pensions section, and so may continue with this approach.

IAS 19 Asset Ceilings – IFRIC 14IFRIC 14 clarifies the recognition of surpluses and also the effects of “minimum funding requirements” on balance sheets. Depending on a pension plan’s circumstances, surpluses may have to be reduced or ignored, and “minimum funding requirements” could further reduce surpluses or even increase deficits.

The “minimum funding requirements” are expected to have more impact than seen in previous periods because more companies are being subjected to higher funding requirements.

Under IAS 19, if there is an IFRIC 14 adjustment then there will be a worsening of the P&L because the discount rate will, effectively, be multiplied by a lower balance sheet position.

JLT’s Client Alert: “Pensions accounting – will contributions agreed with the trustees affect your company balance sheet?” provides further detail on this issue.

Financial Reporting Standards (FRS)FRS102 was issued on 14 March 2013 and is mandatory for periods beginning on or after 1 January 2015. Chapter 28 of FRS102 will replace FRS17 and applies an approach consistent with IAS 19 but with reduced disclosure requirements.

JLT’s Client Alert: “Important changes to how companies account for pensions” provides further detail on the changes.

Directors’ remuneration reportsNew Directors’ Remuneration Reporting Regulations for UK incorporated quoted companies came into force on 1 October 2013 and apply to financial years ending on or after 30 September 2013.

The changes introduce a new single figure for total remuneration received by each director in a financial year.

In addition, the pension disclosure is the sum of all relevant pension benefits including any cash paid in lieu of pension.

The pension disclosures will tie in with the tax rules for valuing pension savings. To place a value on defined benefits accrued over the year, you take the difference between the annual pension at the start and the end of the year and multiply it by a factor of 20. The difference between any lump sums at the start and the end of the year is added to this. The disclosure will then simply be the total ‘pension input amount’ across all group plans in which a director builds up benefits.

The remuneration report must also contain:

❯❯ details of the director’s defined benefit pension at the end of the year

❯❯ the director’s normal retirement date

❯❯ any additional benefit that a director might receive in the event that he/she retires early; and

❯❯ where a director has rights under more than one type of plan, separate details relating to each

Historically there have been additional reporting requirements under the Listing Rules for UK-incorporated premium listed companies. The additional reporting requirements are no longer required following changes to the Listing Rules effective on 13 December 2013.

The changes to the Listing Rules apply to all listed companies with a financial year ending on or after 30 September 2013 that have not published their annual financial report on or before 13 December 2013.

Companies will need to carefully consider what their directors’ remuneration reports will look like going forward and not just in relation to pensions.

Discounting (the Vector Approach)More and more plans are moving their funding valuations, and how they view and manage their pension liabilities, to a cash flow based process with the use of a yield curve (a vector approach) rather than using a single average discount rate.

JLT believe that there are strong theoretical attractions of this approach; however, accounting firms (including BDO) do not believe it is acceptable. If the vector approach was allowed under IAS 19, then using the one-year rate for the interest cost will, in current market conditions, see significantly lower figures flow through to the P&L.

Other Developments

Post-implementation reviewA post-implementation review of the recent changes to IAS 19 is expected to start in 2015. The IASB intends for a more fundamental review of pensions and related benefits, which would include further investigations into discount rates. However, they do not plan to issue a discussion paper or research document before 2015.

Remeasurement at a plan amendment or curtailmentIn January 2014 the IFRS Interpretations Committee (“the Committee”) received a request to clarify the accounting treatment for a plan amendment or curtailment. This was a technical question which should, in most practical examples, not have a material impact on how a plan amendment or curtailment is measured and disclosed. The Committee had planned to discuss the matter at their March meeting but did not because of a lack of time. It will be discussed at the next Committee meeting.

IFRIC 14 - Availability of refunds from a defined benefit planThe Committee received a request to clarify whether a trustee’s power to augment benefits or to wind up a plan affect the employer’s unconditional right to a refund and thus restrict the recognition of an asset in accordance with IFRIC 14. There is currently diversity in practice when interpreting IFRIC 14. The response to this question should provide additional guidance on this issue. Depending on the outcome, companies may need to review the current interpretation of the impact of IFRIC 14. The Committee had planned to discuss the matter at their March meeting but did not because of a lack of time. It will be discussed at the next Committee meeting.

Discount rates – Regional MarketsIn June 2013, the Committee received a request to address the issue of determining the discount rate in a regional market consisting of multiple countries sharing the same currency (for example, the Eurozone). The Committee agreed that in determining the discount rate an entity shall include high quality corporate bonds issued by entities operating in other countries, provided that these bonds are issued in the currency in which the benefits are to be paid. The Committee recommended that the IASB should amend paragraph 83 of IAS 19 through the Annual Improvements project.

The IASB agreed with the proposal and published an exposure draft in December 2013 to this effect. The proposed amendments, if adopted, are expected to be effective from 1 January 2016 with earlier application permitted.

However, in their comment letters on the exposure draft, the European Financial Reporting Advisory Group (EFRAG) and the Financial Reporting Council (FRC) raised concerns about the proposal. IAS 19 requires entities to apply mutually compatible assumptions - the most important of which are the discount rate and inflation. The use of a discount rate of a foreign bond in the same currency might be seen to be incompatible with other required inputs such as inflation or might lead to uncertainty as to which inflation rate to apply, e.g. domestic, regional or foreign.

The exposure draft closed for comment on 13 March 2014. Redeliberations on the proposed amendments are expected to start in Q2 2014.

Employee benefit plans with a guaranteed return on contributions or notional contributions and the “higher of” optionThe Interpretations Committee received a request to clarify the accounting for contribution-based promises under IAS 19 Employee Benefits. Contribution-based promises are a post-employment benefit where the amount of benefits to be received by the employee depends on the contributions plus a promised return. The “higher of” option relates to when the employee is guaranteed the higher of two or more possible outcomes; for example, the employee may be guaranteed the higher of a fixed return of, say, four per cent and the actual return on the contributions made by the employer. Accounting for these plans in accordance with IAS 19 is problematic and has resulted in diversity in practice.

The Interpretations Committee has discussed the issue at length but has been unable to arrive at a solution that both improves the accounting for these plans and also limits the potential for any unintended consequences from any changes. Due to the difficulties encountered in progressing the issues, the Interpretations Committee decided to remove the project from its agenda and noted developing accounting requirements for these plans would be better addressed by a broader consideration of accounting for employee benefits.

Latest Information from FTSE 100 Company DisclosuresThis analysis is based on the most recent annual report available at 31 March 2014 for each FTSE 100 company with a defined benefit pension plan.

Discount RateUnder IAS 19, the discount rate used to value liabilities is set by reference to yields available on high-quality (taken to mean AA) corporate bonds of currency and term consistent with the liabilities. Pension liabilities are long-term in nature and market data is sparse at longer durations.

Historically, when setting the discount rate, a corporate bond index has been used to determine a headline rate, which was then adjusted to reflect the difference between the duration of the pension plan liabilities and that of the index. However, there has been a move in recent years towards considering the yield curve implied by the constituents of the index, and using the curve to derive a discount rate appropriate to the cashflows underlying a pension plan with this duration. The resulting assumption can still be illustrated relative to the yield on the index.

The approximate spread of discount rates around the index yield which have been adopted by FTSE 100 companies is shown in the pie chart below.

The duration of pension liabilities is typically greater than the duration of most long-dated bonds. As recently projected yield curves have been upward sloping accounts released over the past year tend to show that most companies have used rates higher than the index yield on long-dated AA corporate bonds.

More recently the projected yield curve has become flatter at longer durations so the additions illustrated in the chart are likely to be higher than would be appropriate at 31 March 2014. Taking a 20-year duration an addition of 0.0% p.a. – 0.2% p.a. may be appropriate at 31 March 2014.

• within 0.2% of the index yield

• Index yield plus 0.2% to 0.4%

• Index yield plus 0.4% to 0.6%

• Index yield plus 0.6% to 0.8%

25%

5%

30%

40%

Significance

+0.1% on discount rate Liabilities

➝

❯~ 2%

Service cost

➝

~ 2.5%

Price Inflation (RPI)A market-implied rate of inflation can be derived from the yield curves of fixed and index-linked gilts. This implied rate will vary according to the duration of the liabilities. The rates of inflation that companies used drifted below the rate implied by the yield curves, possibly to reflect a “risk premium” on index-linked gilts, but also to reflect the shape of the curve when applied more directly to the actual cash outflows. The “risk premium” is due to the relative market supply and demand features of the conventional and index-linked gilt markets. Based on what has been happening to the markets over the last year, we are now expecting these “risk premiums” to reduce, possibly by the order of 10bps.

The Bank of England publishes spot inflation rates implied by the market, with projections up to 25 years. The approximate spread of price inflation assumptions, relative to the annualised 15-year spot rate, is shown in the pie chart below.

• Spot rate less 0.1% to 0.7%

• Within 0.1% of the spot rate

• Spot rate plus 0.1% to 0.3%

• Spot rate plus 0.3% to 0.5%

20%

5%

40%

35%

Significance

+0.1% on rate of inflation Liabilities ➝ ❯~ 2%

Service cost ➝ ~ 2.5%

CPI InflationMarket practice is to apply a deduction to the RPI inflation assumption to arrive at the CPI inflation assumption. The average deduction from RPI for CPI has been 80bps. The spread of deductions is indicated by the pie chart, the range of deductions being from 50bps to 110bps. The expectation for an amendment to the calculation for RPI was partly allowed for in the market but, after the decision not to amend the calculation, this deduction is likely to increase.

15%

5%

40%

40%

• RPI less 0.6% or less

• > RPI less 0.6% to 0.8%

• > RPI less 0.8% to 1%

• RPI plus more than 1%

Salary Inflation There is a generally accepted link between price inflation and salary inflation, which is reflected in the choice of salary inflation assumptions. The approximate spread of salary inflation assumptions, relative to RPI (i.e. assumed price inflation), is shown in the pie chart.

• up to RPI plus 0.5%

• > RPI plus 0.5% and up to RPI plus 1%

• > RPI plus 1% and up to RPI plus 1.5%

• > RPI plus 1.5%

55%

5%

20%

20%

Significance

+0.1% on rate of salary inflation Liabilities ➝ ❯~ 1%

Service cost ➝ ~ 1.5%

Recently, a large number of companies have begun setting salary increases equal to RPI, with others using an addition of 1%. Very few companies used a rate higher than 1.5% above RPI. Marks & Spencer’s most recent disclosure sets salary inflation 2.4% below price inflation. This is based on the salary increase being used for pensionable purposes being capped at 1% per annum. ITV, Royal Bank of Scotland and GlaxoSmithKline have also capped increases in pensionable salary, assuming salary inflation will be 2.0%, 1.1% and 1.0% below price inflation, respectively.

Mortality The increase in the assumed life expectancy of a pensioner has continued, but the rate of change is now slowing. Seventy-six of the FTSE 100 companies have now adequately disclosed their mortality assumptions. Of these, all have disclosed a figure for the previous year. On average, the assumed life expectancy of a male aged 60 increased by 0.3 years from the previous year’s figure. Only two companies increased their assumed life expectancy by more than two years. Most companies also quote a life expectancy for future pensioners – this is, on average, 2.0 years higher than the figure for current pensioners. “Future pensioners” is typically defined as “currently 20 years from retirement.”

There are many different mortality tables used. Recent studies indicate conflicting ideas; therefore we are expecting to see a wider range of assumptions used. Companies most frequently quote the assumed life expectancy for a male currently aged 60; where they have used a different age, we have converted their figure to an age-60 figure.

55%

5%

15%

25% • < 26 years

• 26 to 27.9 years

• 28 to 29.9 years

• > 30 years

Significance

+1 year assumed life expectancy Liabilities ➝ ❯~ 2.5%

Service cost ➝ ~ 2.5%

Simple Guide to IAS19 (for accounting periods commencing after 1 January 2013)IAS 19 is issued by the International Accounting Standards Board (IASB) and gives directions on the accounting treatment of defined benefit assets and liabilities.

Balance SheetThe main balance sheet items are:

❯❯ Fair value of plan assets – Must be the market price (where available) and based on the bid value of quoted securities.

❯❯ Present value of defined benefit obligations – This is the value of the past service liabilities, calculated on service to date but with allowance for pay increases through to retirement (or earlier leaving). This calculation must be carried out using a discount rate based on market yields on high-quality corporate bonds.

Some adjustments are then possible:

❯❯ Impact of asset ceiling – The fair value of plan assets must be limited if there is a surplus in the plan and the surplus assets are greater than the amount which can be recovered either by means of a refund or in the form of a contribution reduction (but note the effect of IFRIC 14).

❯❯ Deferred tax

Income StatementThe main income statement items are:

❯❯ Service cost – This comprises:

❯– Current service cost which is the increase in the present value of the defined benefit obligation resulting from employee service in the current period;

❯– Past service cost, which is the change in present value of the defined benefit obligation for employee service in prior periods, resulting from a plan amendment (the introduction or withdrawal of, or changes to, a defined benefit plan) or a curtailment (a significant reduction by the entity in the number of employees covered by the plan)

❯– Settlement gains or losses

❯– Expenses

❯❯ Net interest on the defined benefit liability (asset) in profit or loss – This is the change during the period in the net defined benefit liability (asset) that arises from the passage of time. It is determined by multiplying the net defined benefit liability (asset) by the discount rate, both as determined at the start of the annual reporting period, taking account of any changes in the net defined benefit liability (asset) during the period as a result of contribution and benefit payments. It can be viewed as

comprising interest income on plan assets, interest cost on the defined benefit obligation and interest on the effect of the asset ceiling.

RemeasurementsRemeasurements are recognised in Other Comprehensive Income and consist of:

❯❯ Actuarial gains and losses from changes in the present value of the defined benefit obligation resulting from:

❯– Experience adjustments

❯– The effects of changes in actuarial assumptions

❯– The return on plan assets, excluding amounts included in net interest

❯– Any change in the effect of the asset ceiling

Disclosure ItemsThe required disclosures in the accounts include:

❯❯ Characteristics of the plan including the nature of the benefits, a description of the regulatory environment in which the plan operates and governance responsibilities.

❯❯ Description of the risks to which the plan exposes the entity including any entity specific, plan specific or concentrations of risk.

❯❯ Description of any plan amendments, curtailments and settlements

❯❯ Reconciliation of opening and closing present value of the defined benefit obligation, including current service cost, interest cost, member contributions, remeasurements, benefits paid, past service costs, curtailments and settlements. Remeasurements must show separately actuarial gains and losses due to plan experience, changes in demographic assumptions and changes in financial assumptions.

❯❯ Reconciliation of opening and closing value of plan assets, including interest income, the return on plan assets excluding interest income, company contributions, member contributions, benefits paid and settlements.

❯❯ Reconciliation of opening and closing effect of the asset ceiling

❯❯ The total expense recognised in the income statement, including current service cost, past service cost, settlements, expenses and net interest cost.

❯❯ Disaggregation of the fair value of plan assets into classes that distinguish the nature and risks of those assets

❯❯ Fair value of the entity’s own transferable financial instruments held as plan investments and the fair value of plan assets that are property occupied by, or other assets used by, the entity

❯❯ The significant actuarial assumptions used, including the discount rates, expected returns on plan assets, pay inflation, and any other material assumptions.

❯❯ Sensitivity analysis for each significant actuarial assumption

❯❯ Description of any asset-liability matching strategies

❯❯ Indication of the effect of the defined benefit plan on the entity’s future cashflows including a description of the funding arrangements, expected contributions payable in the next reporting period and information about the maturity profile of the plan

❯❯ Additional disclosures may be required for multi-employer plans.

Whilst all reasonable care has been taken in the preparation of this publication no liability is accepted under any circumstances by Jardine Lloyd Thompson for any loss or damage occurring as a result of reliance on any statement, opinion, or any error or omission contained herein. Any statement or opinion unless otherwise stated should not be construed as independent research and reflects our understanding of current or proposed legislation and regulation which may change without notice. The content of this document should not be regarded as specific advice in relation to the matters addressed.

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