Actuarial gains and losses: To defer or not to defer?
Deferral and amortization no longer common practice
Recognizing the differences between actual experience from assumed, and any changes in actuarial assumptions over an extended period, was once a common practice in pension accounting.
Many accounting standard-setters have moved away from this practice in the past 10 years or so for the following reasons:
- Actuarial gains and losses arising from pensions are no different from changes in other accounting estimates. They should be recognized when the changes arise.
- When some gains and losses are not recognized, the net pension liability or asset reported in the balance sheet does not represent the obligation or asset of an entity. In some circumstances, a net pension asset may be reported even when the plan obligations exceed its assets.
- The pension expense, consisting of amounts arising from current period activities and the amortization of amounts deferred in prior periods, can be difficult to understand.
To defer or not to defer
While others have come to their conclusions, whether actuarial gains and losses should continue to be deferred and amortized is a subject of debate in the Canadian public sector.
Potential consequences of not deferring
Many worry about the potential consequences if actuarial gains and losses are recognized in annual surplus/deficit when they arise. The differences in compensation between public and private sector employees, primarily due to the promise of a defined benefit pension, has been highlighted in the media in recent years. Removal of the deferral and amortization treatment for actuarial gains and losses may result in higher pension liability and cost reported in bad years, and more fluctuations in the bottom line of public sector entities. This could create further public pressure on public sector entities to move away from providing defined benefit pensions to their employees.
Arguments for deferring
Some argue that the presumption of perpetuity of governments and their power to tax suggest that there is less need to reflect all the changes as they arise. After all, pension obligations are settled over a long period and plan assets are invested for the long term.
Many changes are tentative. Gains and losses may be reversed or offset in subsequent periods. Reflecting them when they arise as if they were “real” may create unrealistic expectation and pressure for new spending in the good years and suboptimal decisions in the bad years.
Arguments against deferring
Others believe that smoothing the effects of actuarial gains and losses over an extended period does not provide taxpayers with relevant information about the affordability of defined benefit pensions and sustainability of public service.
Governments are not immune to the challenges facing private sector employers. They operate in the same economic and general environment, such as historically low interest rates, market volatility, increasing life expectancy and aging membership.
Reporting volatility as it arises, even if some may be of a tentative nature, provides transparent information about the cost and risk related to the benefit promised to public sector employees. This information is needed to hold public sector entities accountable for their decisions.
Components approach informs deferral debate
To facilitate an evidence-based debate on this highly controversial topic, PSAB took a components-approach to look at the actuarial gains and losses in its Invitation to Comment, Employment Benefits: Deferral Provisions in Sections PS 3250 and PS 3255.
The components of actuarial gains and losses include changes in the actuarial assumptions (such as demographic, discount rate and other economic assumptions) as well as adjustments to reflect the actual experience. The Invitation to Comment discusses the nature of each component of the actuarial gains and losses and the reasons for their changes. The objective is to inform a meaningful discussion on whether the deferral and amortization treatment for each component of the actuarial gains and losses remain appropriate and justified.
Assumptions tend to be stable
Given the inherent nature of any forecast, actual experience usually differs from assumed. However, except for the discount rate assumption that can change from year to year depending on the economic and market condition, demographic and other economic assumptions usually do not change significantly from year to year.
People tend to live longer. Such expectation based on historical pattern is usually incorporated into the mortality assumption. Other employee behaviours are more stable. The retirement pattern of employees of an entity generally does not change unless the entity, for example, introduces changes in the eligibility to early retirement.
Other economic assumptions can be affected by general economic conditions but long-term inflation, a common element of all economic assumptions, has been quite stable. Inflation in the Canadian economy has mostly been within the Bank of Canada’s one to three per cent target range in the past 20 years.
Defer or not — which way to go?
The Invitation to Comment identifies the following three possible ways to recognize each component of the actuarial gains and losses:
- recognize in annual surplus/deficit when gains and losses arise
- do not recognize in annual surplus/deficit at all
- recognize in annual surplus/deficit in subsequent periods
What do you think?
You can participate in this debate and influence PSAB’s deliberations on this issue by responding to the Invitation to Comment by March 3, 2017.