Smoothing Mechanisms in Defined Benefit Pension Accounting Standards: A Simulation Study*

The accounting for defined benefit (DB) pension plans is complex and varies significantly across jurisdictions despite recent international convergence efforts. Pension costs are significant, and many worry that unfavorable accounting treatment could lead companies to terminate DB plans, a result that would have important social implications. A key difference in accounting standards relates to whether and how the effects of fluctuations in market and demographic variables on reported pension cost are “smoothed". Critics argue that smoothing mechanisms lead to incomprehensible accounting information and induce managers to make dysfunctional decisions. Furthermore, the effectiveness of these mechanisms may vary. We use simulated data to test the volatility, representational faithfulness, and predictive ability of pension accounting numbers under Canadian, British, and international standards (IFRS). We find that smoothed pension expense is less volatile, more predictive of future expense, and more closely associated with contemporaneous funding than is “unsmoothed” pension expense. The corridor method and market‐related value approaches allowed under Canadian GAAP have virtually no smoothing effect incremental to the amortization of actuarial gains and losses. The pension accrual or deferred asset is highly correlated with the pension plan deficit/surplus. Our findings complement existing, primarily archival, pension accounting research and could provide guidance to standard‐setters.     

Allocating Shareholder Capital to Pension Plans

This article discusses the corporate challenge of providing retirement income to employees while limiting the costs and risks of pension plans to the companies themselves by addressing five main questions:

• ? What are the major issues and challenges surrounding pensions? Although the pension shortfalls have been the focus of attention, the author argues that the more serious concern is the risk stemming from the mismatch between pension assets and pension liabilities— that is, the funding of debt‐like liabilities with equity‐heavy asset portfolios.
• ? To what extent do the equity market and equity prices reflect the shortfall in value and the mismatch in risk? While the author describes some evidence of the market's ability to capture pension risk, analysts' P/E multiples and management's assessments of cost of capital may still be distorted by failure to take full account of the risks associated with pension assets.
• ? How should management analyze and formulate strategic solutions? Without offering specific solutions, the author presents a framework for analyzing the problem from a strategic perspective that can be used in formulating a company's pension policy. In particular, the article recommends that companies take an integrated perspective that views pension assets and liabilities as parts of the corporate balance sheet, and the pension asset allocation decision as a critical aspect of a corporate‐wide enterprise risk management program.
• ? If a company chooses to make a major change in its pension policy, such as a partial or complete immunization accomplished by substituting bonds for stocks, how would you communicate the new policy to the rating agencies and investors?
• ? What are the major issues to be thinking about when contemplating a change from a DB plan to a defined contribution, or DC, plan? The author argues that DC plans without some corporate oversight or responsibility for results are not a long‐term solution.

     

Hicksian Income in the Conceptual Framework

In seeking to replace accounting conventions by concepts in the pursuit of principles‐based standards, the FASB/IASB joint project on the conceptual framework has grounded its approach on a well‐known definition of income by Hicks. We welcome the use of theories by accounting standard setters and practitioners, if theories are considered in their entirety. Cherry‐picking parts of a theory to serve the immediate aims of standard setters risks distortion. Misunderstanding and misinterpretation of the selected elements of a theory increase the distortion even more. We argue that the Boards have selectively picked from, misquoted, misunderstood and misapplied Hicksian concepts of income. We explore some alternative approaches to income suggested by Hicks and by other writers, and their relevance to current debates over the Boards' conceptual framework and standards. Our conclusions about how accounting concepts and conventions should be related differ from those of the Boards. Executive stock options (ESOs) provide an illustrative case study.     

Cash-Balance Plan Conversions: Evidence on Excise Taxes and Implicit Contracts

Firms that wish to switch from a traditional defined‐benefit pension plan to a defined‐contribution‐type plan have a choice between converting to a cash‐balance plan or replacing the defined‐benefit plan with a full‐fledged defined‐contribution plan. According to Ippolito and Thompson's (1999; Industrial Relations, 39: 228‐245) excise tax avoidance hypothesis, a number of firms have switched to cash‐balance plans because conversion allows the firm to avoid excise taxes on its excess pension assets. In contrast to existing studies, our evidence supports the excise tax avoidance hypothesis. Cash‐balance plan conversions also have been criticized for imposing pension losses on older employees. The implicit contract theory of pensions predicts that poorly performing firms would be the ones that would impose losses on employees. However, our evidence indicates that firms converting to cash‐balance plans typically are not poor performers.     

Do a firm's equity returns reflect the risk of its pension plan?

This paper examines the empirical question of whether systematic equity risk of US firms as measured by beta from the capital asset pricing model reflects the risk of their pension plans. There are a number of reasons to suspect that it might not. Chief among them is the opaque set of accounting rules used to report pension assets, liabilities, and expenses. Pension plan assets and liabilities are off-balance sheet and are often viewed as segregated from the rest of the firm, with its own trustees. Pension accounting rules are complicated. Furthermore, the role of the Pension Benefit Guaranty Corporation clouds the real relation between pension plan risk and firm equity risk. The empirical findings in this paper are consistent with the hypothesis that equity risk does reflect the risk of the firm's pension plan despite arcane accounting rules for pensions. This finding is consistent with informational efficiency of the capital markets. It also has implications for corporate finance practice in the determination of the cost of capital for capital budgeting. Standard procedure uses de-leveraged equity return betas to infer the cost of capital for operating assets. But the de-leveraged betas are not adjusted for the risk of the pension assets and liabilities. Failure to make this adjustment typically biases upward estimates of the discount rate for capital budgeting. The magnitude of the bias is shown here to be large for a number of well-known US companies. This bias can result in positive net present value projects being rejected.     

Cash balance pension plans: A case of standard-setting inadequacy

Accounting for and ownership of U.S. private employee pensions has long been a controversial and politically contested terrain. The uniqueness in the U.S. of using employers as the principal provider of pensions makes the reporting of pensions more problematic since the corporate employers providing pensions are not strictly accountable to only the pensioners. Over the last quarter century there has been a marked swing in power toward management and away from employees making it possible for increasing numbers of U.S. companies to switch from conventional defined benefit plans to cash balance plans. This paper provides a “case” study of how accounting standard-setters framed the pension reporting problem vis-à-vis how they frame the “reporting problem” in general. Utilizing various sources of commentary about the phenomenon of cash-balance conversions, we triangulate on the pension problem to demonstrate how current FASB disclosure rules fail to satisfy the condition of neutrality and how those rules have facilitated the shifting of economic risk from shareholders to employees.     

Accounting for financial instruments with characteristics of debt and equity: finding a way forward

Accounting for compound financial instruments, that is those with characteristics of both debt and equity, has challenged accounting standard setters for decades. The principles developed to distinguish liabilities and equity and the application of these principles in IAS 32 have been widely criticised. In 2016–2017, the IASB was engaged in a project to improve IAS 32. Our study presents research that is relevant to the issues faced by standard setters, related to improving the definitions and enhancing presentation and disclosure of liabilities and equity. We discuss studies investigating the effects of the accounting classification requirements on firms’ financing choices and on users’ decision‐making, to examine the question, ‘Does the distinction matter?’ We then explore various approaches that may be pursued by the standard setters to improve accounting in this area and identify areas for future research.     

Disharmony in international accounting standards setting: The Chinese approach to accounting for business combinations

The paper addresses two distinct aspects of disharmony in international accounting standards setting. The first aspect relates to the political economic context of financial accounting standards. This is illustrated by the Chinese standards setters’ decision to allow the pooling of interests method of accounting for business combinations despite the prohibition of this method by both the FASB and the IASB. This decision by the Chinese standards setters appears to have been based on political economic factors related to the need for industrial reorganization in China rather than a desire to serve the needs of global capital markets. The second aspect of disharmony relates to the role played by differential understandings of the fundamental objectives of financial reporting in an international context. The IASB's goal of producing one set of global accounting standards to serve the needs of global capital markets has led to a reduction in the number of permissible accounting methods and a move towards the fair value accounting model. In particular, the IASB concluded that the acquisition method of accounting for business combinations should be the only method allowed for business combinations. In contrast, the Chinese standards setters have recognized the existence of both mergers and acquisitions, and in response they created two different methods of accounting for business combinations. Effectively, the Chinese standards setters developed an alternative approach to accounting for business combinations which challenges the IASB's goal of achieving international accounting convergence through the fair value model.     

Valuation-based accounting research: Implications for financial reporting and opportunities for future research

This paper discusses the relation between financial reporting research and practice, particularly standard setters. Many studies addressing financial reporting issues use a valuation approach. The paper describes alternative approaches to valuation research and summarises the findings relating to four major current issues: fair value accounting for financial, tangible, and intangible assets, cash flows versus accruals, recognition versus disclosure, and international harmonisation of accounting standards. The summaries include identifying what standard setters and others would like to learn from research, what we have learned, and what is left to learn. The paper concludes with observations about future financial reporting academic research.     

Pensions and poverty traps: Is saving worthwhile for women?

Present policy means that a private pension, unless it is substantial, may fail to bring financial gain in retirement due to means testing: the pensions poverty trap. This paper examines women's acquisition of private (occupational and personal) pensions and their risk of facing this trap. Because of the loosening link between marriage and motherhood, previous patterns of pension advantage according to marital status are shifting. The employment and pension impact of motherhood varies with socio-economic status but the pension prospects of the majority of women are poor. It is concluded that women's need for financial advice to avoid the pensions poverty trap is greater than men's. An improved basic pension, indexed to national income, would reduce the risk of mis-selling and restore confidence that saving for a pension is worthwhile.     

Pension Funding Regulations and Actuarial Gains and Losses

With pervasive pension funding deficits, Korean firms have been under pressure to improve their funding levels. We examine whether firms have incentives to set obligation‐decreasing pension assumptions when they have large pension deficits (pension obligations in excess of plan assets) and when they make insufficient contributions to external pension funds. We find that firms report larger actuarial gains (or smaller actuarial losses) associated with the remeasurement of pension liabilities when their pension funding ratio (the ratio of the fair value of plan assets to defined benefit obligations) is lower and when contributions to plan assets relative to pension service costs are smaller. Next, upon the introduction of a minimum pension funding guideline, we find that the effect of the funding ratio and contributions to pension funds on actuarial gains and losses is more pronounced for firms whose funding ratios are slightly below the minimum funding ratio than it is for firms whose funding ratios exceed or fall short of the minimum by a large margin. Our results indicate that firms opportunistically exercise discretion regarding corporate pension accounting under International Financial Reporting Standards to comply with pension funding regulations, thereby reducing perceived pension deficits.     

英国养老金金融化改革的经验和启示

文章梳理了英国养老金制度改革历程,归纳了三个支柱改革的金融化导向及表现,分析了金融化改革对第二、三支柱养老金覆盖率、缴费率、投资收益和基金积累的影响,以及生命周期化投资、养老金债券等金融创新在应对低利率风险、金融危机冲击风险中的作用.基于英国养老金金融化改革经验,结合我国企业年金和个人养老金发展的实际,总结了引入"自动加入"制度、发展集合年金计划、完善税收优惠、推行审慎监管、鼓励养老金生命周期投资创新以及改革基础养老金制度为职业年金和个人养老金金融化改革创造条件等结论和启示.     

An analysis of risk-taking behavior for public defined benefit pension plans

This paper presents the first comprehensive study on the determinants of public pension fund investment risk and reports several new important findings. Unlike private pension plans, public funds undertake more risk if they are underfunded and have lower investment returns in the previous years, consistent with the risk transfer hypothesis. Furthermore, pension funds in states facing fiscal constraints allocate more assets to equity and have higher betas. There also appears to be a herding effect in that CalPERS equity allocation or beta is mimicked by other pension funds. Finally, our results suggest that government accounting standards strongly affect pension fund risk, as higher return assumptions (used to discount pension liabilities) are associated with higher equity allocation and portfolio beta.     

Research horizons for public and private not‐for‐profit sector reporting: moving the bar in the right direction

The examination of public and private not‐for‐profit sector financial reporting has been a topic of interest on a cyclical basis in Australia over the last 30 years. Traditional topics have included examinations of the intended and unintended consequences of specific standards, the accountability value of financial reports, transaction neutrality, compliance with the accounting standards, and more recently, the prospective implications of new, differently focused reporting standards considering such issues as income measurement and outcomes reporting. With increased recent attention from standard setters and regulators, and greater data availability, the opportunities for undertaking impactful research in these and related areas are increasing. In this paper, we focus on research that has examined the following questions: (i) Which private and public NFPOs lodge financial reports and what is reported; (ii) Who are the users and what are their information needs? (iii) Which private and public NFPs should lodge financial reports and what should be included in them; and (iv) How should the accounting frameworks for NFP sector reporting be set? For each of these issues, we identify the research gaps and opportunities for further research.     

Design of employee pension benefits model and China's pension gender gap

The pension gender gap is a universal concern, and policymakers worldwide strive to address the factors leading to gender inequality. This study examines the pension gender gap problem and its causes and effects in China, conducting micro-empirical simulations on China's employee pension benefits model. We propose solutions to this gender inequality and suggest an intra-family pension benefits transfer for women in a family framework. For family units headed by a single woman, we recommend enhanced tax-deductible contributions by prior employers to strengthen the equality of pensions between genders throughout retirement. This additional support and enhancement of female pensions can effectively narrow the pension gap between male and female beneficiaries while maintaining the system's long-term sustainability. More importantly, these proposed enhancements minimize acute poverty while improving the living standards of female pensioners.     

Banks’ Financial Reporting and Financial System Stability

The use of accounting measures and disclosures in banks’ contracts and regulation suggests that the quality of banks’ financial reporting is central to the efficacy of market discipline and nonmarket mechanisms in limiting banks’ development of debt and risk overhangs in economic good times and in mitigating the adverse consequences of those overhangs for the stability of the financial system in downturns. This essay examines how research on banks’ financial reporting, informed by the financial economics literature on banking, can generate insights about how to enhance the stability of the financial system. We begin with a foundational discussion of how aspects of banks’ accounting and disclosures may affect stability. We then evaluate representative papers in the empirical literature on banks’ financial reporting and stability, pointing out the research design issues that empirical accounting researchers need to confront to develop well‐specified tests able to generate reliably interpretable findings. To this end, we provide examples of settings amenable to addressing these issues. We conclude with considerations for accounting standard setters and financial system policy makers.     

Post-Implementation Reviews for IASB and FASB Standards: A Comparison of the Process and Findings for the Operating Segments Standards

Abstract

The International Accounting Standards Board (IASB) and the Financial Accounting Foundation (FAF) have recently completed post-implementation reviews (PIRs) for their converged standards on operating segments IFRS 8 and SFAS 131. The two accounting bodies use PIRs as an additional standard assessment mechanism. This paper (1) provides an overview of the main differences and similarities between the two PIR processes and (2) compares the findings of the PIRs on the operating segment standards supplemented with insights from a survey of the segment information notes of a sample of STOXX Europe 600 companies. The IASB and the FAF set the specific PIR objectives and conduct the information gathering phase differently. For the IFRS 8 and SFAS 131 PIRs, these differences meant that the FAF focused more narrowly on how SFAS 131 performs compared to the previous standard, while the IASB is aimed to more broadly assess constituents' views on whether IFRS 8 works well in practice. Comparing the PIR findings for the operating segments standards is warranted given that the standards are converged and that the standard setters re-expressed their commitment to keep them substantially converged. Uniform PIR processes could have eased the cooperation in maintaining convergence. Given the different scope of the reviews, standard setters will need to find a common ground on how to proceed and which issues to address further.     

An examination of state and local government pension underfunding – Implications and guidance for governance and regulation

State and local government pension underfunding has become a major focus of public policy debate due in large part to recent Governmental Accounting Standards Board (GASB) actions that have brought national attention to the issue. The extent of these plans underfunding has been debated, along with the necessity for state government intervention and the level of regulatory actions that should be enacted by state legislatures. State and local public pension plans do not fall under the enumerated powers of the federal government in the Constitution and are therefore left to each individual state to regulate. The amount of plan underfunding and enacted public policy by state varies greatly. Additionally, in contrast to numerous state balanced-budget laws, legal directives for fully funding public pensions are virtually non-existent. This paper analyzes the state and local public pension crisis, examines current and long-term risk, studies public employee fiscal conditions, considers the societal impacts of these plans, considers the strengths and weakness of pension plan types, recommends public policy and regulation, and offers strategies for managers, board members, and public officials to adopt.     

Modelling the pension system

This paper argues that pensions modelling should be a parsimonious process using different methodologies for different purposes. A range of methodologies exists and is being extensively used in different countries and quarters. Very simple aggregate accounting models can yield robust results as for the sustainability of pension systems, an issue that worries most analysts and governments. While more sophisticated formally derived models have the advantage of yielding results that take into account general equilibrium effects, ad hoc models have the advantage of being better able to cope with the fine structure of pensions programmes and formulae. Focusing on the Spanish pension system to illustrate the output of an ad hoc model, several applications are briefly presented: sustainability indicators up to the horizon 2050, effects of increased migratory flows and an evaluation of recent pension reform legislation. Some attention is paid to the fact that societal issues and behaviours are intertwined with pensions in a way difficult to be captured by standard modelling methodologies.     

Credible Pensions*

One of the main problems in pension policy is to develop an institutional framework that guarantees that public and private pensions promises are kept. This paper discusses how the governance of public and private pensions is key to making such promises credible. It argues that credibility concerns undermine the case for earnings‐related pensions run by the state and private defined benefit plans.