Historically many companies have set the interest credit rate assumption equal to the IAS 19 discount rate, unless the legal minimum interest credits are expected to apply or there are already accrued assets in the fund that are expected to be credited via interest to members imminently. We understand this approach is now being challenged by the Expert Suisse auditor group. WTW provides in the following memo additional justification and evidence for the approach.
For the typical Swiss cash balance plan, each eligible member has an account balance that accumulates with “savings” contributions and credited interest at the end of every year. The amount of interest granted is usually dependent on many factors, including the funded status of the pension fund, the actual return during the year, and legal requirements but is essentially a smoothed interest credit rate based on the available assets of the pension fund subject to legal minimums. The fund must provide at least 0% interest on the total account balance, and the BVG/LPP legal minimum rate (currently 1.25%) on the BVG/LPP legal minimum account balance, which is a shadow or underpin account balance. Any additional interest is funded through the fund’s asset returns.
Pension obligations in Swiss Pension Funds are considered a Defined Benefit liability according to IAS 19. Many assumptions are required to determine the balance of such a pension obligation at each measurement date. Assumptions “are an entity’s best estimate of the variables that will determine the ultimate cost of providing post-employment benefits” (Para 76 of IAS19).
To set valuation assumptions, IAS 19 requires that companies use:
[…] unbiased and mutually compatible actuarial assumptions about demographic variables (such as employee turnover and mortality) and financial variables (such as future increases in salaries, changes in medical costs and particular changes in state benefits). Financial assumptions should be based on market expectations, at the end of the reporting period, for the period over which the obligations are to be settled […]
The interest credit rate is required to project how notional member accounts in the pension fund will grow to the ultimate future retirement benefit, which will be then discounted to reflect the present value of the employer obligation (= defined benefit obligation, DBO).
In the case of future benefits being dependent on future financial and other parameters (e.g. in Swiss cash balance case asset performance and interest credit underpins), the benefit projection assumptions must be based on “unbiased and mutually compatible” best-estimate assumptions. We believe that two approaches are acceptable in this context:
We understand approach (1) is currently favored by Expert Suisse, approach (2) has been current market practice in Switzerland and still is in other countries in case of similar plan designs. In the following we’ll share arguments why Option (2) leads to consistent recognition of pension expense over time in a corporate P&L and balance sheet.
Expected return on plan assets = discount rate
Pension Fund assets under discussion qualify as plan assets. The return on plan assets is in essence passed on to insured members over time (considering some timing effects because of risk management measures, the smoothed interest credit approach). For that reason, we consider the discount rate to be a reasonable assumption for future asset returns when setting other assumptions about future benefits that depend on these returns (e.g. the interest credit rate).
Evidence from discussions within IASB, IFRIC, EFRAG
Swiss pension plans are in the international actuarial profession typically classified as “cash balance plans”. Such plan types exist in multiple versions in different countries. As the IFRS standard aims to provide a consistent view on comparable topics across countries, we would like to share international reference points which support our reasoning regarding the proposed assumptions. Our starting point is the IFRS Interpretations Committee (IFRIC), which looked into cash balance plans previously.
IFRIC D9 describes the International Accounting Standards Board view on the valuation of cash balance plans. The draft interpretation IFRIC D9 was never formally adopted but still provides views that are helpful as a reference point. An example of a cash balance plan that falls under the scope of this proposed guidance is as follows:
A plan in which a contribution is made each year based on the employee’s current salary and the employee receives a benefit (a lump sum or an annuity) equal to the contributions plus the higher of (i) the actual return generated on the contributions and (ii) a minimum fixed return on the contributions over the period to when the benefit is paid [1]
This D9 proposed interpretation is relevant for Swiss cash balance plans because the “savings” component of these plans is consistent with the underlying structure as described above: contributions are made to separate notional accounts for each active plan member based on the employee’s pensionable salary. The account accumulates interest credits until the member retires or leaves the plan and receives their benefits. Swiss cash balance accounts are not credited with the exact return generated on the underlying plan assets, but rather receive interest credits based on a rate set annually by the plan’s board of trustees. However, the objective of the Swiss cash balance plans is to award interest to members’ account balances based on the actual return on the underlying plan assets over the long term, subject to minimum interest credits defined by law. [2]
IFRIC D9 offers guidance on how the liability for benefits should be valued given that these benefits are subject to a guaranteed fixed return, future returns on assets, or both. The proposed guidance is as follows:
D9 proposes that the liability for a benefit of a guarantee of a fixed return should be determined by projecting forward the contributions at the guaranteed fixed return to estimate the amount that will ultimately be paid. That amount should be discounted back to a present value using the high-quality corporate bond rate required by IAS 19. In contrast, for benefits that depend on future asset returns, D9 proposes that an estimate of the amount that will ultimately be paid should not be made. Instead, the liability should be determined by the value of the assets at the balance sheet date. Lastly, D9 proposes that the liability for a benefit that combines a guaranteed fixed return and the returns on future assets should be the higher of the liabilities for each separate element. [3]
The D9 guidance therefore provides support for the approach for setting the interest credit rate for Swiss cash balance plans by using the discount rate as an estimate of future asset returns:
Guaranteed fixed return: there is a legal requirement that members receive a minimum of 0% interest on their overall account balance. The BVG/LPP minimum interest credit rate determined by the government applies a higher rate to the mandatory BVG/LPP “shadow” account, but this is a short-term rate (i.e. it only applies for one year) and in any case, the BVG/LPP “shadow” account is significantly lower than the total account balance for the vast majority of client IAS19 valuations we discuss (therefore not going to affect the total account balance).
Returns on future assets: when benefits depend on future asset returns, the IFRIC D9 guidance states that the liability should be determined by the fair value of the assets at the balance sheet date. Setting the cash balance liability equal to the fair value of the assets is equivalent to projecting and discounting the account balance amounts using exactly the same rate. The IFRIC D9 approach is therefore equivalent to projecting the cash balance accounts forward using an interest credit rate equal to the discount rate.
In March 2020, European Financial Reporting Advisory Group (EFRAG) Technical Expert Group (TEG) noted that the IASB was considering the issues described in the discussion paper and the proposed solution generally favoured by constituents. Accordingly, as a next step EFRAG would contribute to the IASB due process and would therefore not do further activities in relation to its own pro-active project on the issue. [4]
In 2022, the IASB considered introducing a cap on promises on returns on assets in defined benefit plans. [5] For such promises, the IASB looked into capping the expected return to the rate of high quality corporate bonds. As before, the IASB has been considering the issue of hybrid plan designs but has found it difficult to define an appropriate scope that would result in improvements for a sufficiently wide range of plans without creating unintended consequences.
It's fair to conclude, that in official statements, IASB, IFRIC, EFRAG concluded that projecting benefits using the expected rate of return and discounting the resulting total benefit to the balance sheet date using the rate of high quality corporate bonds in plan designs where the benefits are linked to the return of the plan assets does not appropriately value the DBO and would result in an accounting mismatch.
Although such cash balance plans are not yet common in countries with traditionally large DB plan benefits (e.g. the US or UK), in Germany there are pension plans that are also considered cash balance plans, the so-called “wertpapiergebundende Pensionszusagen”. These plans provide benefits based on the value of the underlying account at the time the benefit falls due. The accounts are subject to minimum guaranteed interest rates, so the liabilities are valued as defined benefit plans under IAS 19.
The German Actuarial Association (DAV) has published guidance on the valuation of such plans that is consistent with the D9 guidance from the IFRIC. The approach of using an interest credit rate assumption that is higher than the discount rate is explicitly rejected in DAV guidance:
If the contributions are invested, for example, in equity funds and are projected with a return of 4% p.a., but the benefits are discounted with an interest rate of 2% p.a., each new contribution results in fictitious losses. [6]
The key idea is that when benefits are dependent on investment returns, the projection and discounting of the benefits should be done on a consistent basis, i.e. using the IAS 19 discount rate, unless a higher guaranteed minimum interest rate applies. Using a higher rate to project benefits than for discounting results in the appearance of a greater company obligation and generates “fictitious losses” and therefore a false representation of the net liability to the company due to the inconsistency of assumptions, because the company does not finance investment returns and will not be required to make additional contributions to the plan in order to meet this higher obligation.
Finally, to conclude our view: IAS1 generally talks about a “fair presentation of liabilities” as a fundamental part of IFRS and we believe that the approach of interest credit rate greater than the discount rate is artificially increasing the liability (except in certain specific circumstances/market conditions when the interest credit underpin is expected to bite). This effect is displayed in the following example.
Approach results in "windfall losses"; in the long-term systematic gains to be expected
| Interest Crediting Rate | Discount Rate | |
|---|---|---|
| Scenario 1 | Discount Rate | 0.50% |
| Scenario 2 | 1.00% | 0.50% |
| Assets 100k | Start | Interest | Expected | Actual | G/(L) |
|---|---|---|---|---|---|
| DBO | (100,000) | (500) | (100,500) | (100,750) | (250) |
| Assets | 100,000 | 500 | 100,500 | 100,750 | 250 |
| Net | - | - | - | - | - |
| Assets 100k | Start | Interest | Expected | Actual | G/(L) |
|---|---|---|---|---|---|
| DBO | (100,498) | (502) | (101,000) | (100,750) | 250 |
| Assets | 100,000 | 500 | 100,500 | 100,750 | 250 |
| Net | (498) | (2) | (500) | - | 500 |
The simplified example above shows that when the actual return in the future is above the discount rate there will always be systematic gains being recognized in OCI solely due to asset returns which are impacting both the ultimate liability and the assets identically. This is equivalent to the situation with Swiss cash balance plans whereby the interest credits driving the ultimate liabilities will be directly correlated to the long-term actual returns from assets (unless the legal minimum interest credit underpins bite).
Given the IAS19 conceptual framework, we believe that the discount rate is an unbiased and conceptually consistent best-estimate assumption of investment returns for the purpose of setting the interest credit rate assumption in order to avoid overstating the plan obligations.
Accounting standards are conventions that are based on fundamental principles. IFRS have the objective to provide a fair & consistent view of a corporate financial position and reflect the total cost to the employer resulting from the Swiss pension obligation appropriately. If the rates used to discount liabilities were directly linked to the investment returns resulting from the plan’s specific diversified portfolio, an expected asset return reference point as proposed by auditors in Switzerland could systematically be appropriate. However, in the IAS19 conceptual framework, this is explicitly not the case because the discount rate must be set based on high quality corporate bonds and the interest income on assets reflected in the IAS19 P&L costs also based on the discount rate – no matter what the plan’s actual portfolio structure and population growth is.
In addition, we would note that it has been market practice to use the discount rate approach and that results on this basis have been included in audited financial statements of companies for a number of years including in the period when discount rates were below 0.5%.
Please note that we are not experts in accounting. Clients should review any accounting policy position with their auditors.
This position paper was prepared in the context of setting IAS 19 valuation interest crediting rate assumptions for typical Swiss cash balance plan benefits. It may not be suitable for use in any other context or for any other purpose and we accept no responsibility for any such use.
We do not assume any responsibility or accept any duty of care or liability to any third party who may obtain a copy of this paper and any reliance placed by such party on it is entirely at their own risk.
WTW’s Pension Index decreased by 0.5% during Q3/2023.
