04 May 2020
With the impact of coronavirus on markets, mortality and interest rates, net defined benefit pension scheme liabilities under FRS 102 may increase in the short term mainly due to a fall in the value of any plan assets. They may also be impacted, to a less certain degree, by the effects of changes in the principal actuarial assumptions used to measure the defined benefit obligation.
The Pensions Regulator has issued guidance for sponsoring employers relating to their pension scheme and coronavirus.
What does FRS 102 say?
FRS 102 Section 28 Employee benefits addresses the measurement of the net defined benefit liability. The net defined benefit liability is the:
- Present value of the entity’s obligations under defined benefit plans at the reporting date (referred to as ‘the defined benefit obligation’); less
- Fair value at the reporting date of plan assets (if any) out of which the obligations are to be settled.
The discount rate used to determine the present value of the defined benefit obligation should be determined by reference to market yields at the reporting date on high-quality corporate bonds of equivalent currency and term of the benefit obligations (FRS 102.28.17). The reference to high-quality is not defined or explained.
FRS 102.28.20 does not require an entity to engage an independent actuary to perform the comprehensive actuarial valuation needed to calculate its defined benefit obligation. Nor does it require that a comprehensive actuarial valuation be done annually. In the periods between comprehensive actuarial valuations, if the principal actuarial assumptions have not changed significantly the defined benefit obligation can be measured by adjusting the prior period measurement for changes in employee demographics such as number of employees and salary levels.
FRS 102.28.41(k) requires disclosure of the principal actuarial assumptions used to estimate the defined benefit obligation; typically, these include the discount rate, expected rate of salary increases and any other material actuarial assumptions. FRS 102.8.7 also requires information about key assumptions concerning the future that represent a source of estimation uncertainty, which is often the case in measuring the components of the net defined benefit liability and the cost of pension benefits provided by the entity.
Practical impact and interpretation for preparers
The measurement of the defined benefit obligation may be impacted by coronavirus due to changes in actuarial assumptions about:
- Mortality rates – these rates are based on mortality projection models. It is still unclear what the ultimate impact of coronavirus will be for such models, and whether any specific short-term adjustments to the latest models available are necessary.
- Employee turnover and salaries – reductions in work force due to mortality in the accounting period or redundancies could result in a significant change in employee numbers. Reductions in salary as a result of furlough are not anticipated to result in significant changes in long term assumptions such as career average salaries.
- Discount rate – any impact of coronavirus on high-quality corporate bond yields at the reporting date should be considered, and the discount rate updated accordingly. It is possible that high-quality corporate bond yields may escape some of the fluctuations seen by lower-quality, high-yield bonds. High-quality corporate bond yields saw a downward trend during 2019 and into February 2020 before recovering; for March 2020 reporting dates yields are anticipated to have recovered to a not dissimilar level to those used in the assumptions for March 2019 reporting dates for shorter term liabilities (eg 10 years) but are expected to be lower for longer term liabilities (eg 15, 20 and 25 years).
As noted earlier, there is no requirement to obtain a full actuarial valuation annually, nor for it to be performed at the reporting date. Some entities therefore adopt an approach of updating the latest full actuarial valuation for certain other changes if the principal actuarial assumptions (other than the discount rate which is always updated at the reporting date), have not changed significantly. Such an approach is unlikely to be appropriate given the potential impact of coronavirus on the assumptions, even if the full actuarial valuation was relatively recent.
The value of plan assets is likely to have changed significantly due to the adverse effects of coronavirus on the markets and the resulting volatility in those markets. A further and related consequence is that some assets may become harder to value, particularly when markets become inactive or illiquid. It may be relatively easy to obtain valuations for some assets, but where quoted prices are not available, entities will need to ensure that they have obtained an appropriate valuation at their reporting date.
The significant economic uncertainty caused by Coronavirus may make updating valuations more challenging where the pension scheme reporting date is non coterminous with the entity’s year end or where valuations of investments have been prepared based on information at an earlier date to the entity’s reporting date.
Disclosures in respect of the key sources of estimation uncertainty, such as those listed in the bullet points above, may need to be more extensive than in the past in order to provide users of the financial statements with useful information about the judgements management has made in deciding their assumptions and how they may impact the financial statements. For example, in addition to disclosing the nature and amount of the assumptions made, it may be appropriate to also provide sensitivity analysis in respect of those assumptions, including reasons for the sensitivity, and how they differ from prior assumptions.
Movements as a result of the above actuarial assumptions will be reflected in other comprehensive income. There may also be a less material impact on the current service cost reflected in profit or loss as a result of a reduction in employee numbers. It is not anticipated that reductions in salaries as a result of furlough will have a material impact on the current service charge.
Consider whether the principal actuarial assumptions in the valuation of the defined benefit obligation could have changed significantly as a result of coronavirus, in particular those outlined above. If the assumptions are expected to have changed, entities should engage early with their actuary for advice and to obtain a comprehensive actuarial valuation to recognise in their financial statements. Given current volatility in markets and fast changing conditions, consideration should also be given to obtaining the actuarial valuation as at a date as close as practicable to the reporting date to reduce the need to update the actuarial valuation for changes in the intervening period.
Consideration should also be given to whether it would be useful to provide, and the extent of, additional disclosures in respect of those key assumptions that have been particularly impacted by the event of coronavirus. A useful guide in deciding whether additional disclosure is necessary is to consider the degree of difficulty in choosing appropriate assumptions. The actuary should be able to provide the information needed to provide sensitivity disclosures in the financial statements when the conclusion is that such information would be useful. Additional disclosure may also be needed in any strategic report/narrative reporting to explain the impact of coronavirus on the entity’s funding of its pension scheme liabilities.
Speak to the pension scheme trustees to understand how the value of plan assets has been impacted by coronavirus. Many schemes will have a degree of hedging in place within their investment strategy, and whose success need to be understood in relation to wider market movements.
Whilst not impacting on the measurement of the net defined benefit obligation, coronavirus may have impacted an entity’s cash flows. In respect of contributions to defined benefit pension plans it may be appropriate for employers to speak to the pension scheme trustees regarding the deferral of deficit repair contributions.