The impact of low interest rates on defined benefit (DB) pension plans not only leads to higher contribution requirements but also to an increased squeeze on corporate earnings. Under current U.S. GAAP guidelines, large losses in the funded status of a pension plan (whether because of asset returns less than expected or liability increases that are due to lower interest rates) accumulate on the balance sheets through other comprehensive income (OCI). In most cases, these losses are slowly realized through earnings over time. Absent significant increases in asset returns or interest rates over the next few years, corporate earnings for DB plan sponsors will continue to drag from the gradual recognition of the losses that led to the current, historically high underfunded statuses.
Another item to keep an eye on in 2012 is the progress between the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) on their goal for convergence. The two boards have stated they share a long-term desire to coordinate accounting standards. The IASB revised its accounting standard for employee benefits (IAS 19) last year, which will require significant changes in reporting requirements in 2013. Of particular importance is the removal of the expected return on assets component of pension cost. That will now be rolled into the net interest charge, which will be calculated by multiplying the net liability or asset by the discount rate. This revised method will likely increase fiscal year pension costs because it replaces the prior calculation of interest on the liability at the discount rate offset by the expected return on plan assets. Most sponsors have been reflecting an expected asset return in excess of the discount rate, in essence assuming asset growth will outpace liability growth. This will no longer be allowed. Also, the annual aggregate gain or loss will be recognized as a change in OCI and will not be subsequently amortized through pension expense in future years. Because of these changes, equity returns will no longer directly generate increased reported profits for sponsors. First, the higher expected return on equities has been removed from the pension cost calculation. Second, the recognition of actual superior equity returns (should they materialize) will also not boost profits because the recycling of asset gains or losses from OCI into profit and loss (P&L) has also been removed. This may urge companies to take a second look at their asset allocations because they no longer benefit in the same way from increased equity risk.
FASB has not yet made similar changes and still allows for differing recognition techniques. It will be interesting to see what progress, if any, is made during 2012. Until that day comes, plan sponsors with U.S.-based defined benefit plans must continue to determine if two sets of plan costs and disclosures may be required.
Next we’ll look at defined benefit plans’ funded status and at-risk.