Accounting for employee benefits: Revisions to discount rate assumption
Accounting standards require that corporations report in their financial statements the cost and value of their employee benefit programs, including pension plans, based on discount rates that reflect current yields on high quality corporate bonds. But this presents a challenge in the Canadian market since there are very few long-term bonds in that category.
CIA approach (Fiera Capital)
In September 2011, the Canadian Institute of Actuaries (“CIA”) published the Educational Note Accounting Discount Rate Assumption for Pension and Post-employment Benefit Plans, in which an approach was proposed by the Task Force on Pension and Post-retirement Benefit Accounting Discount Rates (“Task Force”) to help plan sponsors select an appropriate discount rate to value their benefit plan liabilities in their financial statements. In addition, the CIA retained the services of Fiera Capital to produce the monthly discount rate curve. Due to the scarcity of high quality Canadian corporate bonds (rated AA) with maturities beyond 10 years, the approach used provincial bonds (adjusted for credit spread) to extrapolate the long end of the yield curve.
Since then, the number of high quality corporate bonds with maturities beyond 10 years has decreased to only two (mainly due to bond rating downgrades and no new issuance of long-term bonds), bringing the CIA approach into question. As a result, the members of the Task Force met again in early 2016 to explore ways to adapt the approach to the current bond market conditions. In October 2016, the Task Force presented its new proposed approach to the actuarial community. The following month, the Task Force confirmed the proposed approach would be in effect starting November 30, 2016.
The revised approach still uses provincial bonds to extrapolate the long end of the yield curve, but the credit spread adjustment is now based on the ratio of average yield spreads of corporate bonds (rated AA) and provincial bonds over the Canada bond yields. The discount rates resulting from the new yield curve are very similar to those of the previous approach.
Morneau Shepell’s approach
Following the announcement of the revised approach by the CIA Task Force, Morneau Shepell updated its own discount rate methodology as well, in effect starting on December 31, 2016. The revised methodology uses provincial bonds as well as corporate bonds rated A to extrapolate the long end of the yield curve. As with the CIA revised approach, ratios of average spreads are used to determine the credit spread adjustments to provincial and corporate bonds.
As a result, the discount rates from the updated Morneau Shepell methodology have increased slightly (compared to the previous methodology), but are very close to those from the revised CIA approach.
The following table summarizes the differences between the approaches:
The revised approaches will be less dependent on the breadth of the Canadian high quality corporate bond market, even if the number of bond issues were to decrease even further. It is important to note that auditors generally consider such revisions as changes in accounting estimates (as opposed to changes in accounting policies), so there should be no need to restate prior financial statements to reflect the revised discount rate estimate.