Benefit allocation for defined return promises
At its May 2007 meeting, the Board decided that benefit promises should be categorised as defined benefit, defined return, or defined contribution. The Board tentatively decided that a defined return promise had two components:
- (a) A contribution component that obliges the employer to make specified contributions. Those contributions may be funded or unfunded.
- (b) A promised return component that obliges the employer to provide a specified return based on the contribution component. The specified return may be an actual return on contributions or a hypothetical return on notional contributions.
It may be a fixed return, or it may refer to specified assets or an index.
The Board had also decided that the contribution component is measured as the sum of the accumulated unpaid contributions, while the promised return component is measured as the fair value of the promised return less any plan assets available to satisfy that liability. The staff paper recommended continuing to treat unvested benefits under a defined return promise as giving rise to a liability in phase I of the project. This question should only be addressed fundamentally in phase II.
The contribution component of the benefit promise would be allocated to periods of service in line with the benefit formula, even if the benefit formula specifies a materially higher level of contributions in later years. When asked by the Board, the staff clarified that this approach differs from the treatment in the present IAS 19 relating to 'backloaded' defined benefit promises, where the benefits are spread on a straight-line basis. Under the envisaged approach, where benefits are 'skewed' to later service periods, a liability would be recognised in line with the benefit formula. If, for example, the benefit formula stipulated that contribution would be made in twenty years time for 5 per cent of the employee's salary for each of the 20 years of service, a liability would only be recognised in year 20.
One Board member suggested that for defined return promises, the approach in IAS 37 would justify such an approach conceptually. The Board was in agreement that the 'straight-lining' approach relating to 'backloaded' defined benefit promises was an anti-abuse feature built into IAS 19 to prevent entities from not recognising (potentially material) defined benefit obligations in the early years. As such a feature was not part of the accounting for defined contribution plans, the existence or non-existence of a vesting period would lead to different results in the accounting for defined contribution and define benefit promises. The staff argued in favour of preserving the present accounting approach during phase I of the post-employment benefit project but perhaps change it in phase II. After a lengthy discussion, the chairman called for a hands-up vote. Only one Board member indicated disagreement.
Benefit allocation for defined benefit promises
IAS 19 requires that the benefit in defined benefit plans is attributed to periods of service in accordance with the benefit formula, unless the benefit formula would result in a materially higher level of benefit allocated to future years. In that case the benefit is allocated on a straight line basis. In the deliberations leading to IFRIC D9 Employee Benefits with a Promised Return on Contributions or Notional Contributions, the IFRIC considered whether expected increases in salary should be taken into account in determining whether a benefit formula expressed in terms of current salary allocates a materially higher level of benefit in later years. The staff paper recommended that the Board asked the IFRIC to develop a separate Interpretation on whether, for defined benefit promises, expected increases in salary should be taken into account in determining whether a benefit formula expressed in terms of current salary allocates a materially higher level of benefit in later years.
For defined return plans, as outlined above, the Board tentatively agreed not to straight-line backloaded plans but allocate benefits in accordance with the benefit formula. In the interest of sticking to the timeline of phase I, the Board asked whether or not this issue could be dealt with again by the IFRIC, but agreed not to proceed with this issue in phase I and to tentatively recommend to IFRIC not to deal with it either, despite noting the inconsistency between the approach taken for defined return promises and not proceeding to analyse a possible alternative accounting for backloaded for defined benefit promises. One Board member indicated he might be able to provide the staff with an example which could perhaps help solving the issue.
Measurement of the contribution liability
At the May meeting, the Board concluded that defined return promises are comprised of two components: a contribution requirement and a promised return on those contributions. The Board tentatively agreed that the measurement of the balance sheet liability in respect of each component would be as follows:
- (a) contribution requirement - the amount of any unpaid contributions
- (b) promised return - the fair value of the guaranteed return less any plan assets available to satisfy that liability
However, one Board member pointed out that measurement of the two components is inconsistent because it makes no allowance for the time value of money for the contribution requirement but makes an allowance for the time value of money for the promised return on those contributions.
The Board discussed and rejected the possibility of measuring the contribution requirement at fair value. But the staff thinks that discussion did not fully consider the effect of the time value of money on contributions that will not be paid for a long period of time, for example notional contributions to an unfunded plan. By contrast contributions in a defined contribution promise must generally be paid relatively soon after the period to which they relate. As a consequence, the staff had identified two options for taking the time value of money into account:
- (a) specify a discount rate to be used, or
- (b) require measurement of the contribution at fair value.
While the staff acknowledged that option (a) would avoid potentially lengthy debates on what the appropriate discount rate should be, it recommended to the Board measuring both the contribution requirement and the promised return at fair value.
While fair valuing the promised return component was generally accepted, as it constitutes a financial instrument, there was a lengthy discussion between the staff and the Board about the examples in the staff paper on the measurement of the contribution requirement. One Board member argued that requiring fair value measurement of the contribution requirement would lead to unnecessary complexity. Another Board Member remarked that he did not think taking the time value of money into account was really necessary. However, another Board member maintained that while fair valuing the contribution requirement was not required, as otherwise the Board would have to change paragraphs 52 and 53 of IAS 19, taking the time value of money into account could be achieved by discounting the contribution requirement by the discount rate required by IAS 19 for the measurement of defined benefit promises. No decisions were taken on this matter.
Based on the proposed classification of employee benefit promises into defined contribution, defined return and defined benefit promises, the staff had been asked to clarify the classification of benefit promises linked to inflation. The staff recommended that:
- (a) Benefit promises with a promised return on contributions is are linked to wage inflation are classified as defined benefit.
- (b) Benefit promises with a promised return on contributions that is linked to assets or indices, eg. consumer price inflation, are classified as defined return.
The staff had drawn up the following illustrative example:
Plan A: For each year of service, the employee will receive a lump sum benefit equal to 5% of revalued salary. The revalued salary is the salary, in the year in which it is earned, increased in line with the increase in the national average earnings index over the period to retirement.
The staff argued that such a plan should be classified as defined benefit because:
- such a benefit promise is, in substance, a salary-related defined benefit promise, even if the salary to which it is related is national average earnings not the employee's actual salary.
- constituents have not raised problems in measuring benefit promises linked to wage inflation indices using the projected unit credit method in IAS 19.
- classifying these promises as defined return would result in a significant change in the accounting for many salary-related benefit promises. In particular, a defined return classification would require the employer to fair value a salary-related promise.
In the ensuing discussion, two Board members openly disagreed with the staff conclusions, arguing that such plans should be treated as defined return promises. The rest of the Board seemed to be of the same opinion. No decisions were taken on this matter.
Components of the defined return cost
The staff recommended that the change in the liability for the DR promise be disaggregated as follows:
- service cost being the initial recognition of the liability for the contributions payable for the year plus the initial fair value of the promised return on those contributions
- fair value gain/loss arising on the subsequent remeasurement of the liabilities.
- market factors (such as risk-free interest rates),
- cash receipts and payments,
- changes in credit quality,
- the passage of time,
- demographic experience and
- estimation methods or valuation models.
However, the staff argued that further disaggregation of the change in fair value of the liability into separate components would add unnecessary complexity without the benefit of providing additional decision-useful information, as had been shown by research during other projects. The Board by and large agreed with this conclusion although no formal vote was taken.