With rising interest rates, you may have a pension surplus and available options
With rising interest rates, companies with defined benefit (DB) pension plans may find themselves in the enviable position of having a large pension surplus. The reason for this, in short, is that DB pension plans have spent the past decade working to offset the impact of low interest rates. Lower interest rates lead DB pension plans to require greater up-front contributions to meet long-term obligations. Now that interest rates are increasing, this means that the DB pension liabilities would also decrease and may lead to an unexpected pension surplus.
It is estimated that if long-term bond yields stay at current levels, there could be an aggregate surplus of $29 billion by the end of 2022 for a basket of companies in the S&P/TSX 60 with DB plans, which represents an increase of about 170% or $18 billion from 2021 when the combined surplus was roughly $11 billion.
Why do rising interest rates lead to surplus positions?
DB pension plans have financial commitments that will be fulfilled many years into the future. Plan sponsors must ensure that the pension fund will have sufficient assets to make benefit payments as they become due.
An actuarial valuation determines the value of all plan assets and liabilities as of a specific date. If the value of the plan assets exceeds the value of the liabilities, the funded ratio will be greater than 100% and the plan will be considered to be in a “surplus” position. If the liabilities exceed the value of the plan assets, the funded ratio will be less than 100% and the plan will be considered to be in a “deficit” position.
In conducting an actuarial valuation, many future events must be assumed or predicted. These assumptions include life expectancy, age of retirement, general salary increases, and interest rates. In general, when calculating the present value of future assets and liabilities, actuaries discount future cash flows by using a discount rate linked to long-term interest rates. An increase in long-term interest rates means that the liabilities, or the discounted value of future cash flows of a pension plan, would decrease. This, in turn, could lead some DB pension plans to have a surplus.
While the overall effect depends on various factors such as the duration of assets and liabilities as well as the allocation of fund assets to equities and bonds, a rise in interest rates may improve the funded status of DB plans, which may lead to significant surplus positions.
What is IFRIC 14 – IAS 19 and what does it mean for defined benefit plans?
In July 2007, the International Accounting Standards Board issued IFRIC 14 IAS 19 – The Limit on a Defined Benefit Asset, Minimum Funding Requirements and their Interaction. The objective of this project was to improve information to investors and to address some diversity in practice related to pension accounting requirements. In particular, IFRIC 14 provides general guidance on the amount of a pension fund surplus that can be recognized as an asset. It also explains how the pension asset or liability may be affected when there is a statutory or contractual minimum funding requirement.
The right to a refund or contribution holiday
Employers that sponsor DB plans must determine the availability of a refund or contribution holiday in accordance with the terms and conditions of the plan text as well as any statutory requirements in the jurisdiction of the plan. An economic benefit, in the form of a refund or a reduction in future contributions, is available if the employer can realize it at some point during the life of the plan or when the liabilities are settled. However, an economic benefit due to the pension surplus will be available to an employer only if the employer has an unconditional right to a refund or contribution holiday. To determine this, a legal opinion is required.
Given the increases in interest rates over the past year, companies with DB pension plans should seek guidance on whether they have a right to a pension surplus refund or contribution holiday. Our Pension & Benefits Department can assist in reviewing plan documents and statutory provisions to determine an employer’s right to a refund or contribution holiday.
If you have any questions about the legal implications of IFRIC on pension plan surpluses, please don’t hesitate to contact a member of our Pensions & Benefits Department.