Some people wonder why companies present pension liabilities net of the related plan assets. They suggest that instead companies should consolidate their pension plans. People making that suggestion think it would lead to companies presenting pension liabilities (gross) separately from the plan assets. This post explains why introducing a requirement to consolidate pension plans would not lead to gross presentation.
How companies report pension liabilities
Companies report their pension liabilities in the balance sheet on a net basis. For example, suppose Company A has a funded pension plan and measures its defined benefit obligation (DBO) at £1,000 and the related plan assets at £990. Company A’s balance sheet presents a (net) pension liability of £10. Also, Company A discloses the gross carrying amounts of the DBO (£1,000) and of the plan assets (£990) in the notes.
Now consider Company B. Company B has an identical work force, identical with Company A’s work force in all respects. Both companies provide exactly the same pension benefits, but Company B’s pensions are unfunded. Thus, the 2 companies’ pension plans differ in 2 ways:
- Company A pays contributions into the pension fund and the pension fund pays the benefits. In contrast, Company B pays pensions directly.
- Company A’s pension fund holds plan assets and will pay the benefits out of those assets. On the other hand, Company B holds assets itself.
Comparing companies with funded and unfunded plans
For a simple comparison between Companies A and B, let’s suppose that Company B’s assets include assets identical to Company A’s plan assets. In this case, Company A’s DBOs and plan assets expose it to largely the same risks—and offer largely the same rewards—as is the case for Company B. (Though Company A is typically less able to benefit from the rewards).
Yet although both companies face largely the same risks and rewards:
- Company A’s balance sheet presents a pension liability of only £10 (with note disclosure of the gross carrying amounts).
- Company B’s balance sheet presents (gross) assets of £990 and a (gross) pension liability of £1,000.
Some people suggest that companies should consolidate their pension funds. They argue that this would make it easier to compare balance sheets between companies with funded pension plans and companies with unfunded pension plans. Those people say that pension funds are just a type of special purpose entity (SPE) and they point out that companies have to consolidate many SPEs.
Why didn’t IASC make companies consolidate pension plans?
IASC (the IASB’s predecessor) deliberately defined plan assets in IAS 19 Employee Benefits in a way that mirrors closely the offsetting criteria in IAS 32 Financial Instruments: Presentation. In effect, the definition of plan assets functions as a set of offsetting criteria. As a result, even if companies were to consolidate their pension funds, offsetting would still occur, so consolidating the pension funds would make no difference.
Anchoring the definition of plan assets in normal offsetting criteria has an important advantage. Anchoring the definition in this way makes it unnecessary to consider whether companies should consolidate their pension plans. Trying to answer that consolidation question would probably have led to vigorous and forceful debates about who really controls pension plans.
Looking at the definitions
Let’s look at the criteria in more detail.
Criteria in IAS 32 for financial instruments
Paragraph 42 of IAS 32 sets 2 criteria for offsetting a financial asset against a financial liability. The entity must:
- currently have a legally enforceable right to set off the recognised amounts; and
- intend either to settle on a net basis or to realise the asset and settle the liability simultaneously.
Criteria in IAS 19 for pension plan assets
IAS 19 defines plan assets and 2 categories of plan assets:
- most plan assets are what IAS 19 labels as ‘assets held by a long-term employee benefit fund’. Until 2000, this was the only category of plan assets. For simplicity, I use below the short label ‘plan assets’ for this category, because I don’t need to say much below about the other category.
- IASC created in 2000 a specialised category of ‘qualifying insurance policies’. The definition of ‘qualifying insurance policies’ largely parallels the definition of ‘assets held by a long-term employee benefit fund’.
The definitions in paragraph 8 of IAS 19 set the following main criteria defining plan assets:
- the assets must be held by an entity (a fund) that is legally separate from the reporting entity and exists solely to pay or fund employee benefits;
- the assets must be available to be used only to pay or fund employee benefits;
- the assets must not be available to the reporting entity’s own creditors (even in bankruptcy); and
- the assets cannot be returned to the reporting entity unless the fund’s remaining assets are sufficient to meet all the related employee benefit obligations.
Comparing the criteria in IAS 19 and IAS 32
Comparing those main IAS 19 criteria with the IAS 32 criteria:
- in effect, the company has a legally enforceable right to force employees set off their benefit claims against the plan assets. Employees must first claim their benefits from the fund. They have no claim against the company itself if sufficient assets are in the fund.
- the main IAS 19 criteria mean that the company must settle the DBO and realise the plan assets simultaneously because the fund pays the benefits directly out of the plan assets. And none of the plan assets can leak back to the company (or to its creditors) unless the fund has sufficient plan assets to meet all the related employee benefit obligations.
Thus, the main IAS 19 criteria are broadly consistent with the IAS 32 criteria.
Minor criteria in IAS 19
The definition in IAS 19 includes 2 other less pervasive criteria:
- the assets must not be non-transferable financial instruments issued by the reporting entity. I do not discuss this detailed criterion further.
- in one other case, the fund can return assets to the reporting entity—when returning those assets reimburses the entity for employee benefits already paid. I discuss this specialised case next as the ‘Swedish amendment’.
The ‘Swedish amendment’
I have already said that the definition of plan assets functions as a set of offsetting criteria. The definition serves one other function: it determines which items are illegible for inclusion in the measurement model used for pension liabilities and the related plan assets.
Soon after IASC issued IAS 19 in 1998, it learnt about some funded pension plans common in Sweden. In those plans, the employer pays benefits to employees and then receives reimbursement from the fund. In all other respects, the plans behave like plans whose assets meet the 1998 definition of plan assets. Thus, some interested parties felt that it was unreasonable to treat the Swedish plans differently.
Cases newly addressed in 2000
Having considered those concerns, IASC amended IAS 19 in 2000 by:
- as mentioned above, adding one other permitted use of plan assets: to reimburse the company for employee benefits already paid. This is the Swedish case.
- creating a new category of ‘qualifying insurance policies’, defined using criteria that parallel the definition of ‘assets held by a long-term employee benefit fund’.
- creating requirements covering ‘reimbursements’—cases when it is virtually certain that another party will reimburse part of the expenditure required to settle a DBO.
In the 2000 amendments, to deal with those 3 newly addressed cases, IASC:
- broadened the defining criteria of plan assets to include both the Swedish cases and qualifying insurance policies. Following that broadening, companies now present these items on a net basis—even though they do not quite meet the offsetting criteria in IAS 32 and in the 1998 version of IAS 19.
- created an explicit requirement to present reimbursement rights gross (ie not netted against the DBO). The company measures that asset at fair value (like a plan asset) and presents changes in that fair value in the same way as changes in the fair value of plan assets.
Footnote on the ‘Swedish amendment’
I was the project manager on the 1998 version of IAS 19 and on the ‘Swedish amendment’ made in 2000. Not long after IASC issued the 2000 version of IAS 19 including the ‘Swedish amendment’, I took a phone call from the Swedish representative on the Board of IASC. He said people had been looking at the Swedish plans even more closely once IASC issued the 2000 version of IAS 19. He told me people were starting to doubt whether Swedish plans did, in fact, meet the new criteria.
On a small scale, this story illustrates a common problem that standard setters face. However much effort people put into testing proposals during a comment period, people often cannot really dig into the full detail until they have to implement the final standard for real. The information people give to standard setters about real-life implications (both positive and negative) is often based on an incomplete understanding.
The definition of plan assets in IAS 19 is broadly in line with offsetting criteria in IAS 32 for financial instruments. Thus, introducing a requirement to consolidate pension plans would not lead to separate (gross) presentation of the defined benefit obligation and the related plan assets.