Defined benefit pension liabilities arising from participation in multi-employer plans may not be recognised on the balance sheet. Under IFRS, companies can avoid recognition by simply asserting that “information is not available”. Disclosures in the footnotes help, but these may be measured on an ‘actuarial’ basis which is not relevant for investors.
We use retailer Ahold-Delhaize to illustrate the challenge for investors. It participates in several US multi-employer schemes and discloses an unrecognised actuarial liability of €1.1bn as per year end 2018. We estimate the more relevant IAS 19 liability, which we think should be recognised on-balance sheet, to be €2.2bn.
Multi-employer defined benefit pension plans are common in many countries, often set up jointly by worker unions and industry employers. Their advantage is that employees may change employers within an industry without having to change pension arrangements. In addition, there is, supposedly, greater security of pensions, considering that if one employer fails then the remaining employers participating in the scheme can be called upon to provide funding.
However, such arrangements do not come without added problems. For employers there is additional risk due to the guarantee related to other participating employers. For employees there is potentially less, rather than more, security because there is an incentive for employers to minimise contributions and leave such schemes underfunded. In addition, in the USA (which we focus on below, given its relevance to Ahold-Delhaize), there is further risk for employees due to the guarantee provided by the PBGC protection fund in respect of multi-employer schemes being less generous and more uncertain than that related to single-employer plans.
Investors must deal with unrecognised liabilities and a cash-based expense that may not reflect the true economic cost
The problem for investors, and our main focus in this article, is that the information that most companies provide about multi-employer pension obligations in their financial statements is insufficient to obtain a full understanding of the economic value of the obligation or the related expense. Liabilities are not recognised as such in the balance sheet and the income statement reflects cash payments and not the more relevant economic expense actually accruing in the period. In the case of Ahold-Delhaize we estimate an unrecognised liability of approximately €2.2bn. For context, the company has a market capitalisation of €27.3bn and shareholder’s equity of €14.8bn.
More on Ahold-Delhaize later; first let’s consider the accounting for multi-employer pensions. In our view, the failure to properly account for multi-employer plans is largely a failure of accounting standards and enforcement.
IFRS accounting for multi-employer pensions
Most of you should be relatively comfortable dealing with defined benefit pension liabilities and the related expense in equity analysis and valuation – the service cost is an operating expense, any net deficit is a liability that should be included in enterprise value and invested capital, and the net interest expense is the financing cost of that liability (under IFRS, US GAAP is more complicated). The IFRS numbers are generally adequate and you probably do not need to make any adjustments, unless a company participates in multi-employer plans.
DB multi-employer pensions should be subject to DB accounting – often they are not
Under IFRS accounting multi-employer defined benefit pension plans are, by default, subject to the same defined benefit (DB) accounting as single-employer schemes. This means that the service cost, net interest expense and surplus or deficit is included with the other DB pension obligations. If this is the case, there is no particular reason to focus separately on multi-employer pensions. The only potential complication is the unrecognised implicit guarantee that is present in respect of other participating employers.
However, you will frequently find the liability is not recognised in this way. Under certain circumstances defined contribution (DC) accounting may be applied instead of the appropriate DB accounting. This means only recognising the contributions to the fund during the period as an expense and, generally, not recognising any liability in respect of a scheme deficit, however badly underfunded the scheme might be.
In IFRS the DB accounting ‘get-out’ is provided in IAS 19 paragraph 36. Given its importance to this subject we reproduce it below. Essentially, it applies when it is difficult to measure the liability on a defined benefit basis, either because it is not possible to identify a “consistent and reliable basis to allocate the obligation” between participating employers or because the entity does not “have access to sufficient information” to produce IAS 19 compliant valuations.
The objective of paragraph 36 is to avoid presenting unreliable and potentially inconsistent figures in the financial statements. This may be well intentioned, but we think some companies may be using this as an easy way to avoid DB accounting and hence avoid recognising the resulting deficits on the balance sheet (we do not necessarily include Ahold-Delhaize in this assessment – we have no evidence one way or the other). It seems to us that, in most cases, if a company wanted to obtain the necessary information on an IAS 19 basis, it could do so and that a reasonable basis for allocation of that deficit between scheme members is possible. There may be some estimation required but we think that reporting in the balance sheet an approximate deficit on an IAS 19 basis, with appropriate disclosures about the uncertainties, is preferable to reporting no deficit at all. Approximately right (with explanation) is definitely better than precisely wrong.
Sometimes a liability may be recognised in respect of multi-employer pensions, even though defined contribution accounting is used. This can happen if certain contractual arrangements are in place or if a so-called ‘withdrawal liability’ is triggered. A withdrawal liability arises when an entity has, or intends to, cease being a member of the multi-employer plan and is required to make contributions to cover its share of any deficit.
In spite of these exceptions, if DC accounting is used for a DB multi-employer scheme, the entity’s share of any deficit will likely not be recognised in the balance sheet. If these off-balance sheet obligations are material, then analysis and valuation based on reported metrics will be incomplete and potentially incorrect.
Disclosing actuarial funding valuations does not compensate for the lack of DB accounting
IAS 19 requires companies to disclose the surplus or deficit of a multi-employer pension scheme and its level of participation. This should give investors some insight into the extent of any unrecognised liability. However, the problem is that the measurement of the disclosed funding position does not have to be in accordance with IFRS. Unfortunately, the most likely non-IFRS measure presented (and that used by Ahold-Delhaize) is an actuarial funding valuation.
We do not think actuarial valuations of pension liabilities are relevant for investors and they should not be included in equity valuations. In effect, actuarial valuations present future risky investment returns as though they are risk free and have already been earned. While actuarial valuations may have some merit in planning scheme funding, they do not appropriately measure, and can significantly understate, the economic obligation and the ongoing cost.
For a more detailed explanation of why you should not use actuarial valuations of pension liabilities see our article ‘Pension liabilities: Not so prudent actuarial values’.
What about US GAAP?
US GAAP is even less investor friendly when it comes to multi-employer pension liabilities. While IAS 19 requires DB accounting where the information is available, US GAAP does not; it mandates that all multi-employer plans be accounted for using DC accounting. Like IAS 19, there is a requirement to recognise the withdrawal liability, but this also only applies if a withdrawal is likely. In addition, there is no requirement under US GAAP to provide any disclosure of the surplus or deficit of a multi-employer plan, making it even more difficult to get a sense of the underlying obligation.
Why is the accounting problematic for investors?
Applying defined contribution accounting to defined benefit pension liabilities misrepresents the economics. Potential liabilities are not recognised, and the income statement will only, by chance, reflect the correct expense. IFRS is more helpful than US GAAP, considering the additional disclosures, but both are deficient in practice.
If you analyse companies where DB multi-employer pension liabilities are material and DB accounting has not been applied, then you should try and make adjustments. The only way to do this is to review the financial statements of the multi-employer plans themselves, which is what we did for Ahold-Delhaize.
Analysing Ahold-Delhaize multi-employer pensions
So how does all of this affect Ahold-Delhaize? The company participates in several defined benefit multi-employer plans, predominantly in the US through its Giant Foods subsidiary. These plans are not included in the group balance sheet. The reason given reflects the paragraph 36 requirements we describe above … “Ahold-Delhaize does not have sufficient information to accurately determine its ratable share of the plan obligations and assets following defined benefit accounting principles and the financial statements of the multi-employer plans are drawn up on the basis of other accounting policies than those applied by Ahold-Delhaize”.
Just to be clear, we use Ahold-Delhaize as an illustration of the problem of applying DC accounting to multi-employer plans; it is an issue for many companies. The disclosures by Ahold-Delhaize about the schemes and the risks and uncertainties involved are comprehensive and, as far as we can tell, comply with the disclosure and reporting requirements of IAS 19.
As required by IAS 19, the company provides disclosure about the deficit or surplus of each of its significant DB multi-employer plans and its proportionate share.
Ahold-Delhaize multi-employer pension plans
This disclosure would seem to provide investors with the headline liability measure that is needed – €1,073m Unfortunately, this is not so. The main problem is that the plan deficits are measured on an actuarial basis which, as we have explained, is not a realistic representation of the economic liability. The precise methodology for actuarial values can vary but, typically, the discount rate is based on the expected asset return rather than reflecting the characteristics of the liability. In addition, the asset value included in the overall deficit may incorporate an element of smoothing and not be a fully up to date measure. We think such a smoothed average is useless for investors.
Actuarial values … the wrong discount rate and (often) the wrong asset values
The reported deficit also depends on identifying the percentage participation the group has in each scheme. This can be difficult, and a precise measure may not be possible. Ahold-Delhaize observes that the measure given in the disclosure above is just an “indication” of their proportionate share and so may not necessarily produce an accurate reflection of the liability.
It is not possible for investors to accurately adjust an actuarial valuation of a multi-employer pension liability to an estimate based on a more realistic financial reporting basis. Despite the challenges, we have made an attempt for Ahold-Delhaize by reviewing the relevant regulatory filings.
We note that our estimate is somewhat out of date as, even though the latest annual financials for Ahold-Delhaize are for 31 December 2018, we are only able to give an IAS 19 estimate for one year earlier. The data provided by US multi-employer pension plans is generally filed late and includes actuarial valuations at the start, not the end, of the accounting period (which also applies to the company disclosures). You will only be able to get 2018 figures when the 2019 data is filed later in 2020. This is another reason why we think DB accounting needs to be mandated for multi-employer DB plans.
Estimating an IAS 19 liability for US multi-employer pension plans
To estimate IAS 19 amounts, you need to identify the underlying gross liabilities and assets for each scheme and adjust these to obtain the revised funding position. For US plans this data is available through the regulatory ‘Form 5500’ filings.
To obtain an IAS 19 estimate we need to make sure that the scheme assets are measured at an up to date fair value and not a smoothed average value that could be used for actuarial purposes. For US plans the current value must be reported in Form 5500, so we can simply use that.
Actuarial discount rates 7% to 8.5%; IAS 19 discount rate 4.3%
For the gross liability, the problem is primarily the discount rate applied to the forecast pension payments for scheme members. In Form 5500 the actuarial value and the discount rate applied are both disclosed. For the seven individual schemes we analyse, the discount rate ranges from 7% to 8.5%. The average IAS 19 rate the company uses for its single employer DB plans in the US is 4.3%. To restate the liability using a rate of 4.3% we need to know the liability duration and hence the sensitivity of the present value calculation to changes in discount rate. The duration of pension liabilities can vary significantly depending on the maturity of the scheme and type of benefits. However, for US plans we have some further information that helps.
In Form 5500 you will find a so-called RPA 94 valuation of a multi-employer pension fund. This is a regulatory ‘health-check’ using a stricter approach which derives a much higher liability that is similar to a buy-out valuation (the amount that would be demanded by, say, an insurance company to take on the liability). The discount rate applied in this approach is much lower, at around 3%.
Having two liability measures at different discount rates make it much easier to estimate the liability on an IAS 19 basis. We simply interpolated between the two liability measures provided for each scheme and then allowed for an estimated impact of the non-linearity due to the convexity effect.
After restatement onto an IAS 19 basis, we estimate that the aggregate deficit related to the Ahold-Delhaize participation in multi-employer plans to be €2.2bn. This compares with zero in the balance sheet and a €1.1bn actuarial liability reported in the notes.
Ahold-Delhaize multi-employer pensions: Adjusted balance sheet liability
Adjusting profit and loss
The lack of DB accounting for multi-employer pension plans can also affect profit and loss. Under DC accounting the reported operating expense is the cash contribution in the period. Under DB accounting the value of the benefit provided in the period is reported as an operating expense and a financial expense is recognised in respect of the interest accretion on the balance sheet deficit.
The cash contribution is, of course, important for cash flow and solvency purposes, but it is not a good measure of the economic cost of DB pensions. For this we need to adjust to DB accounting. The challenge with this is estimating the value of the pension benefit accrual in the year. Fortunately, for US plans, we have the Form 5500 data, which includes a measure of benefit accrual based on the RPA 94 measurement basis. On an IAS 19 basis the cost would be lower, but we can obtain an estimate using the same adjustment factor as applied to the liability. The interest accretion can be estimated by simply applying the IAS 19 discount rate to the opening liability.
Ahold-Delhaize multi-employer pensions: Adjusted profit and loss expense
One of the risks related to multi-employer pensions you should look out for is the potential for contributions to rise considering the current underfunding. An increase in contributions would result in a higher expense if the accounting is based on defined contribution principles.
Ironically, the opposite would happen under our preferred defined benefit accounting. An increase in cash payments would be regarded as an earlier repayment of an existing liability. The expense would already have been recognised in prior periods when the liability arose, and the economic cost was accrued. The only impact on current profit would be a reduction in the net interest accretion due to the lower liability.
Pension risk and risk sharing
Your analysis of defined benefit pensions should go beyond simply including an appropriate liability and expense in the financial statements. Pension related risks and the impact of these on potential changes to funding and cash contributions are also important.
For multi-employer plans, many of these risks should be explained in the financial statements. However, due to the lack of DB accounting, you may also need to refer to underlying scheme data, such as identifying fund asset allocation, which is necessary to assess group investment risk exposures. We note that the asset allocation of the Ahold-Delhaize DB multi-employer plans is more weighted towards risky assets compared with the single-employer plans, for which asset allocation is closer to asset-liability matching. The asset allocation also provides information about the exposure of the fund to credit risk related to receivables arising from past withdrawal liabilities. A default by former employer participants can have a significant impact on those that remain.
The IAS 19 liability assumes companies honour their obligations – that may not always be the case
Some pension risks may be shared with employees. Pension schemes, including the multi-employer plans of Ahold-Delhaize, can have so-called adjustable benefits, such as healthcare or disability cover, that may be withdrawn by the scheme trustees if deemed unaffordable. Doing so would reduce the liability and reported deficit. The ability to reduce deficits may, in practice, go even further than this because the pension accrual could itself be amended (with the agreement of members) if doing so were thought necessary to ensure the survival of the company and to preserve employment.
Many members (the pensioners and employees) of US multi-employer pension schemes are in danger of losing some of their benefit entitlements due to the poor funding of many schemes.
More about the US multi-employer pension crisis …
The multi-employer pension crisis in the USA is well acknowledged. Many defined benefit plans are severely underfunded and, without action, will simply run out of cash and be unable to continue to pay those pensions already in payment, let alone the future pensions of current active employees. This affects some of the plans in which Ahold-Delhaize participates. For example, the FELRA & UFCW Food Pension Fund is in such bad shape that, unless more funding is provided, it is projected to run out of assets in Q4 this year.
FELRA & UFCW Food Pension Fund solvency projection disclosure
Out of the seven multi-employer plans separately described by Ahold-Delhaize, three are given the regulatory classification of ‘Red (Critical and Declining)’ which means they are projected to be insolvent within 14 (or for some 19) years.
It is difficult to say how this chronic underfunding may impact the participating employers in the coming years. One possibility is a significant increase in cash contributions, but one cannot rule out more drastic action affecting the scheme members. Ahold-Delhaize provides extensive disclosures about these uncertainties.
Someone will lose – either employers, scheme members or the taxpayer
One thing we can be sure is that someone is going to lose out. Either the participating employers meet their obligations and increase contributions, the scheme members agree (or are forced) to accept a reduction in benefits, or, possibly, the state provides a bail out.
If US multi-employer plans fail then they are taken over by the state sponsored Pension Benefit Guarantee Corporation, but this results in a significant reduction in the benefits payable for scheme members. In addition, the PBGC is itself severely underfunded and is in danger of becoming insolvent without government support. In 2019 legislation was enacted to provide a state bail-out (of sorts). In effect, the bail-out involves the government lending to pension schemes to enable them to remain solvent in the short-term and, it seems, to increase their investment in risky assets so that in the longer-term they might earn their way out of trouble.
In our view the so-called bail-out is misguided. It will just add further risk an already high-risk system and do little to solve the structural problems. Multi-employer plans need better funding by the sponsoring employers and de-risking through asset-liability matching; not the opposite. Changing the accounting to ensure these obligations are recognised in company balance sheets would be a good first step towards achieving this.
There is much commentary available on this subject. For a couple of examples click here and here. We particularly agree with a comment in the latter article that one of the reforms needed to deal with the US multi-employer pension crisis is … “Requiring companies to recognize unfunded liabilities on their balance sheet”
Standard setter attempts to improve the accounting
The root of the problem for investors is the lack of DB accounting for multi-employer pension schemes. It appears to be relatively easy for companies to avoid DB accounting under IFRS by utilising IAS 19.36. We suspect that, in practice, the phrase “does not have access to” might be being interpreted as “has not asked for” which means that DB accounting becomes, in effect, optional. Investors would be better served if this were to stop.
Better enforcement by regulators and auditors of the existing IFRS rules would help. However, ultimately, only better disclosure, or ideally an end to the DB accounting ‘opt-out’, will ensure that investors see the true implications of multi-employer pensions. Both the IASB and FASB have previously attempted improvements.
- IASB: In 2004 the IFRS interpretations committee issued a proposed amendment to IAS 19 (D6) that would have resulted in far fewer exceptions to the application of DB accounting for multi-employer schemes.
- FASB: In 2010 FASB proposed to require disclosures of an entity’s share of the deficit of multi-employer schemes or disclosures that would at least enable investors to have a better idea of that share. (FASB did not go so far as to propose the application of DB accounting.)
There was a lot of opposition to these proposals from companies and the pensions industry. Neither were implemented.
We think that the accounting for multi-employer pensions needs to be improved; liabilities should appear on the balance sheet and should be measured just like all other defined benefit pension obligations.
Insights for investors
- Pension liabilities recognised in the balance sheet may not include those related to multi-employer pension schemes. You should be able to identify this and its likely materiality from the footnotes and risk disclosures.
- Remember that any unrecognised but disclosed deficit for multi-employer plans may be measured using an actuarial valuation basis. This is unlikely to be relevant for use in equity valuation.
- Further information about underlying scheme assets and gross liabilities is needed to estimate the net liability and expense on a more realistic IAS 19 basis. For US plans use the Form 5500 data.
- Remember that an actuarial deficit of zero will almost certainly not be zero once the scheme liabilities are restated to an IAS 19 basis.
- Multi-employer plans also create cash flow and investment risks. Read the risk disclosures and consider how contributions may change in the future. Look through to the underlying asset allocation to assess implicit investment risks.
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