London Market Monitor – 31 August 2022
Our August review of the markets and Solvency II discount rates.
In July 2020, the Dutch government agreed with representatives of Dutch trade unions and employers’ associations on a drastic change of the Dutch structure for second-pillar (that is, company-agreed) pension arrangements. In December 2020, the government cast this in proposed new pension legislation. Implementation of the proposed legal changes will force almost all companies to revise the benefit promises in their pension plans. For companies with a company pension fund, the proposed legislation may even affect vested benefits.
Especially for companies that use international or American accounting standards, the impact of such pension plan changes on their pension liabilities in the balance sheet and on the pension cost in their profit or loss statements can be huge.
This article first addresses the proposed legal changes. After that it will evaluate the accounting consequences for companies, reporting under International Accounting Standards—International Financial Reporting Standard (IFRS); IAS19—and for companies reporting under US Accounting Standards Codification (ASC); ASC 715.
For accounting purposes, the main issue is how the proposed legal changes affect future benefits and how they affect past service pension benefits.
The plan change occurs when social partners agree to the change. Social partners select a plan administrator to execute the plan. The plan administrator does not determine the plan. If a plan administrator accepts execution of the plan, it should make sure that the plan complies with legal requirements and that it fits within its own administrative processes.
A conversion occurs when a decision by the pension fund makes the conversion irrevocable. The pension fund should base its decision to convert (or not to convert) on a request from social partners.
The implementation of the proposed new pension rules will affect the plan definitions for future service benefits and could even affect past service plan benefits. Under the proposed law, future benefits will be based on a defined contribution plan definition.
The legislation expresses a strong preference for conversion of past service benefits. This does not mean that conversion is required. It means that much stronger justification is needed for not converting than for converting.
For pension plans that are administrated by industry-wide pension funds we do not expect major accounting consequences. Accounting consequences can be expected for companies that have their plans administrated by a company pension fund or an insurance company.
Conversion of past service benefits in a company pension fund, in line with the preference of the legislation, effectively settles these benefits. This can have significant accounting consequences. The pension liability in the balance sheet is likely to come down, resulting in large gains in the profit or loss under IFRS accounting. Under ASC accounting, the pension liability is also likely to come down. The impact on the profit or loss, however, is very much company-specific: the implementation of the new pension rules is likely to trigger the recognition of unrecognised results. If there are large unrecognised losses the impact on the profit or loss can be very substantial. Careful consideration will especially be needed for companies using ASC accounting rules.
We note that the final decision on whether to convert past service benefits lies with the pension fund board, based on a request by social partners. This means that the company does not have full control over a decision, with possibly very large accounting consequences, and that a good picture of the pension fund board’s intentions is essential to avoid accounting surprises. We advise that the company stays in close contact with the pension fund board of the company pension fund to avoid such surprises.
More detailed explanations of the accounting consequences under IFRS and under ASC are found below.
The pension accounting rules under IFRS are determined by IAS19.
Under IAS19, conversion of a plan with defined future benefit accruals into a plan with (age-related or non-age-related) defined future contributions will, most likely, also trigger defined contribution accounting for this part of the plan. Defined contribution accounting implies that the pension cost will be equal to the premiums charged. This part of the plan can be excluded from an actuarial defined benefit valuation. This also means that the company should remove any liability allocated to the past but resulting from increasing future accruals (e.g., due to expected future wage increases). Under IFRS the company recognises this curtailment in its profit or loss as a past service gain.
From the perspective of the company, conversion of past service benefits into individually allocated pension amounts effectively settles the plan. It removes the company’s past service liabilities and past service risks. This also means that the company should remove the liability for pensions from its balance sheet.
Partial settlement may occur if parties agree to remove the company risks and liabilities for only part of the benefits, either by actually transferring this part of the benefits out of the company pension fund or by sufficiently separating these (converted) benefits within the company pension fund.
The settled pension liabilities and the settled pension assets can also be removed from the company pension disclosures. Under IFRS the resulting reduction of the balance sheet liability is a past service gain in the profit or loss.
The conversion of defined benefits into individual amounts results in the transfer of risk from the company to the participants. The company may agree to compensate the participants for the additional risk. Amounts paid into the company pension fund for this purpose are recognised in the profit or loss (and effectively reduce the past service gain).
If the company pension fund does not convert the past service benefits, and no further arrangements are made between social partners, then the related company liabilities and company risks remain unaffected. The current regulatory provisions (the supervisory framework) remain applicable for these benefits. This means that company contributions for past service benefit increases (e.g., resulting from wage increases or indexation) will still be allowed. Additional contributions (or repayments), due to low (or high) investment results, will also still be possible. Benefit cuts would also be subject to the same regulatory provisions as currently apply.
Of course, as the company pension fund and social partners discuss the implementation of the proposed legal changes, social partners may agree on plan changes. What happens, for instance, with final pay benefit increases, if future benefits are based on a defined contribution plan? If parties agree that those increases lapse, or if the increases are replaced by a (lower) price or wage index, then this reduces the liability of the company. Such a reduction would be a past service benefit. Under IFRS the company recognises this impact in the profit or loss.
Under IFRS the recognition of plan changes, resulting from the implementation of the proposed legal changes, is straightforward. The impact is fully recognised in the profit or loss. The proposed legal changes do not result in amounts recognised in other comprehensive income. Because actuarial results are the main source for the amounts in other comprehensive income, any reduction of actuarial risks under the new law will also reduce future amounts in other comprehensive income.
The pension accounting rules under ASC are determined by ASC 715.
Obviously, the economic reality under ASC will not be different from the economic reality under IFRS. The impact on the company’s balance sheet (the pension liability) under ASC is also the same as, or very much comparable to, what we observe under IFRS. For the profit or loss, however, the accounting consequences can be substantially different. This difference is mainly due to the fact that ASC 715 separately administrates unrecognised amounts (i.e., unrecognised actuarial results and unrecognised prior service cost) in accumulated other comprehensive income (AOCI) and recognises these amounts in the future via amortisations or with special events (i.e., curtailments and plan amendments).
As with IFRS, the conversion of defined future benefits accruals to defined future contribution is likely to result in defined contributions accounting and a curtailment gain.
Under ASC 715, the impact of a curtailment on the profit or loss strongly depends on whether there are unrecognised actuarial gains or unrecognised actuarial losses. If there are unrecognised actuarial gains, then the curtailment gain is fully recognised in the profit or loss. However, if there are unrecognised actuarial losses, then the curtailment gain should first be offset against those unrecognised losses. A gain in the profit or loss would only occur if (and to the extent that) the curtailment gain exceeds the unrecognised actuarial losses.
A curtailment generally does not affect the unrecognised prior service costs.
If the company pension fund decides to convert all accrued defined benefits into individual amounts, this removes the related actuarial and investment risk for the company. As with IFRS, this represents a settlement under ASC. However, under ASC, full settlement triggers the full recognition of all unrecognised actuarial results and all unrecognised prior service costs (benefits). For companies with large unrecognised losses, the conversion of the benefits would result in substantial losses to be recognised in the company’s profit or loss. And, similarly, substantial profits would come into the profit or loss if there are large unrecognised gains.
Partial settlement may occur. Partial settlement will result in partial recognition of unrecognised actuarial results and partial recognition of unrecognised prior service cost (benefit).
If no conversion occurs, and the existing liabilities and risks remain with the company, then the unrecognised amounts also remain unaffected and there is no additional impact on the profit or loss.
If no conversion occurs, there may still be a plan amendment, e.g., due to removal of final pay benefit increases, or changes to the applicable index. Under ASC the impact of a plan amendment is added to the unrecognised prior service cost with no immediate impact on the profit or loss. The amount (i.e., a prior service benefit) should then be amortised over the expected remaining service of those affected by the amendment.
Dutch pension reform: How does it impact your accounts?
Learn more on the proposed pension reform in the Netherlands, as we evaluate the accounting consequences for companies, reporting under the International Accounting Standards or under the U.S. Accounting Standards Codification.