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Many Canadian entities are starting to consider or implement derisking strategies that strike an appropriate balance between managing the costs of a benefit arrangement and addressing the needs of the workforce

Landscape

Posted on April 9, 2015

Against the backdrop of the current economic environment, the cost of funding employee benefits is a significant issue for entities in all sectors. While the accounting for employee benefits varies by financial reporting framework, concerns around potential cost and uncertainty are areas of collective interest to all entities. This is particularly true for those that offer one or more defined benefit plans to employees. The accounting rules in some frameworks have made the cost of defined benefit plans more transparent in recent years due to the elimination of prior options, which allowed an entity to defer and amortize certain cost components

So what are some of the reasons for the increased focus in this area? Improvements in expected mortality have been reported in the most recent mortality studies and, while this is good news for us all, it does translate into an increase in the cost of funding retirement. The longer we live, the more years there are to fund. For defined benefit plans, this increases both the magnitude of the reported obligation on the statement of financial position as well as the periodic costs that are recorded in income. Lower interest rates also reduce the impact of discounting the obligation and result in a higher obligation (since the amount recorded is a present value measurement). In some cases, defined benefit plans established decades ago are now reaching a stage of maturity where it has become difficult to ignore a rising deficit, given that a reversal of the deficit through strong and sustained investment performance is unlikely.

In response to the real economic issues at play, many Canadian entities are starting to consider or implement derisking strategies that strike an appropriate balance between managing the costs of a benefit arrangement and addressing the needs of the workforce. I’ll consider some of these strategies in the balance of this article.

Establishment of new defined contribution plans: While an entity may have historically provided defined benefit plans, it is not uncommon for a defined benefit plan to become closed to new employees joining an entity. Existing members under the defined benefit plan retain the benefits they are entitled to, while new employees joining the entity are permitted only to join the defined contribution plan. This strategy enables an entity to honour promises made to the existing workforce and eliminate the risk (and manage the cost) associated with new entrants. The accounting is clean and not subject to interpretation. The disadvantage is of course that this does not reduce the costs and risks associated with the existing plan. As a result, this route in isolation may not be a solution for all entities.

Shared-risk and target benefit plans: In a defined benefit plan, the risks reside with the entity. In a defined contribution plan, the risks reside with the employee. In a shared-risk plan, the risks are shared between the entity and the employees. How does this work? Well, the benefits are targeted, rather than guaranteed, and the plan is set up so as to create a very high probability that the targets will be met. This isn’t done by guesswork or an optimistic outlook but through a combination of actuarial modelling, a focused investment strategy and a funding mechanism that manages contributions from employers and employees. Contributions are generally set at an initial level but increased or decreased depending on the deficit or surplus position of the benefit plan in question. The ability to implement or convert to a shared-risk plan depends on the nature of the entity and the Provincial or Federal legislation that the plan must comply with. Right now, we have seen more of these plans in the public sector but changes in federal legislation may open the door to other entities in the future.

The accounting frameworks do not currently explicitly address these types of benefit plans, which has resulted in much discussion about how such plans should be accounted for within the practice of accounting. Both the IFRS discussion group and PSAS discussion group have formally discussed shared-risk plans (the IFRS meeting minutes can be accessed through this link and the PSAS link is accessible here). As legislation changes, we can expect to see progression in the accounting frameworks over time. The IASB has recently embarked on a research project where the accounting for shared-risk plans will be addressed and PSAB has announced the establishment of a taskforce designed to tackle, amongst other issues, the subject of shared-risk plans.

Annuity purchases: In an annuity transaction, an entity locks in the cost and risk associated with a defined benefit plan through a contract with an insurer who, for a premium, takes on the risk associated with providing benefits for all or some portion of the plan members. Such transactions are most common in the private sector and we see them under both IFRS and ASPE. For example, Entity A may have an estimated obligation for $200 million for the retired members of its defined benefit pension plan. Setting aside the time value of money, the actual amount paid could be more or less than this. Entity A may therefore decide to transfer this obligation to a third party in return for an agreed-upon premium. The actual extent of the risk transfer will vary depending on the insuring entity and the nature of the annuity contract. Of course, the ability of an entity to enter into such a transaction will depend on applicable pension regulations and the approval of the Trustees in their oversight responsibility as it relates to the protection of plan members. The accounting requires a careful assessment of the nature of the annuity contract, the extent to which risk is transferred to the insuring entity and any restrictions applicable to the pension regulations that govern the plan in question. In some cases, the transaction may meet the definition of a plan settlement, thereby extinguishing the obligation and generating an income statement entry. In other cases, the annuity is not considered to be a settlement but the acquisition of a plan asset – the valuation of which depends on some of the detail in the specific accounting rules that apply as well as the terms of the annuity contract itself.

Longevity swaps: Longevity swaps are a more recent product on the market but are starting to attract interest in Canada (following more than a handful of multi-billion dollar transactions in Europe). These contracts have some similarities with annuity contracts in that they transfer risk to an insuring entity. The risk in this case is focused on longevity and the risk of increased costs due to a member population living longer than expected is transferred (wholly or in part) to the insuring entity. The actual pattern of cash flows associated with a longevity swap differs from an annuity contract. In the latter, there is generally a lump-sum payment made to the insurance entity. With a longevity swap, there is typically no cash paid by an entity at inception of the contract. Instead, there will be a net cash flow made each month (or other agreed upon time interval) based on the difference between an agreed upon fixed amount (plus a risk premium) and the actual benefits due. Effectively, the entity is locked into paying the fixed amount and receiving (paying) the differential from (to) the insuring entity.

These instruments are not specifically addressed in the accounting literature of any of our Canadian frameworks. At the time of writing, however, the IFRIC have issued a tentative agenda decision that states, in part: “predominant practice is to account for a longevity swap as a single instrument, and measure it at fair value as part of plan assets.” The agenda decision is expected to be finalized later this month.

Derisking benefit arrangements is a common interest area to many entities across all frameworks and there are a variety of strategies that can be adopted to manage them – some of which are outlined above. The financial reporting for these transactions is evolving and is not always clear cut. In working with entities on derisking transactions we typically use a team combined of a professional with financial reporting expertise in this area and an actuarial professional from our Deloitte practice. As always, if you want to know more, don’t hesitate to reach out and we’ll be happy to discuss with you.

Clair Grindley Clair Grindley
Partner, National Services

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