Accounting standards : significant increase in costs expected for 2006LinkedIn
There, in black and white
NB Bulletin Vol. 8 N. 13, November 2005
For private sector companies whose fiscal year ends on December 31, fall marks the time of the year when budgets are determined. Among other things, your budget will include costs for defined benefit pension plans and group insurance plans offered to retirees.
As a result of the decline in long-term bond yields in 2005 (used to determine the discount rate), a significant increase in these costs is expected for 2006. This increase could vary from 20% to 40%, or even more, based on the demographic profile of active members, the maturity of the plan (large number of retirees) and the financial position, or owing to special circumstances (amendments, settlements or curtailments).
The annual discount rate used for the purpose of disclosing the accrued benefit obligation as at December 31, 2004 and for calculating the cost for 2005 was around 5.75%. Since the beginning of 2005, this rate has fallen to around 5.00%, for a reduction of 0.75%. By comparison, the rate reduction for 2004 was around 0.25%.
To give you a better understanding of this increase in the cost for future employee benefits, we are providing you with a few «rules of thumb» (applicable for 2005 and to forecast for 2006) for each of the components that make up the cost:
Each 1% reduction in the discount rate results in an increase of around 20% in the current service cost for the employer. The increase will be greater for contributory pension plans and group insurance plans for which the cost assumed by the retirees has a set dollar amount. Conversely, the increase will not be as great for plans for which the average age of the active members is high (over 45 years of age).
Since the interest on the average obligation results from the multiplication of the average obligation by the discount rate, little impact is expected from this component. In fact, the increase in the average obligation will be offset by a lower discount rate.
For funded pension plans, the expected return on average assets results from the multiplication of the average assets by the expected long term return. Any gain in relation to the expected long-term return assumption on plan assets will directly reduce the cost. The more mature the plan, the more significant the reduction in the cost. The good returns in 2004 (SEI median for balanced funds of 10.4%) lessened the impact of the 0.25% reduction in the discount rate. For 2005, it is less likely that the returns will entirely eliminate the impact of the 0.75% reduction in the discount rate.
Many companies have incurred actuarial losses over the last years. When the balance is sufficient (greater than the 10% margin), the excess is amortized. Then, for many companies, around 5% (20-year amortization period) to 10% (10-year amortization period) of the loss recorded in 2005 will be recognized in 2006. The magnitude of the loss on the accrued benefit obligation will depend on the maturity of the plan. As a general rule, a 1% reduction in the discount rate will increase the obligation linked to retirees by around 10% and the obligation linked to active members by around 20%. For health care plans offered to retirees, the high inflation expected on health care costs will add to this increase.
Other factors such as amendments, settlements and curtailments pertaining to the plan can also impact the cost.
Please feel free to contact us for additional information.
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