International Accounting Standards
The Assumptions Roller Coaster
Looking back on 2021
Looking in the rear-view mirror, the milestones in 2021 were the adoption of LPP/BVG 2020 tables, a slight increase in discount rates, and excellent investment performance.

For additional information on accounting assumptions used at year-end 2021, please click the button to access the full publication of our 2021 Survey.
In terms of international accounting standards, these developments have resulted in an improved financial situation:

The switch to the new LPP/BVG 2020 tables has had the effect of reducing accounting liabilities by roughly 4% to 5% depending on membership structure. The main reasons for this reduction are a more moderate than expected rise in life expectancy, higher probabilities of termination, and lower probabilities of disability and of having to pay a spouse’s or partner’s pension after death.

In 2021, discount rates rose slightly (by between 15 and 25 basis points) resulting in a decrease in accounting liabilities of around 2% to 4%.

Pension funds achieved exceptional investment performance, mostly ranging from 6% to 10%.
As a result, funded status calculated according to international accounting standards (assets divided by accounting liabilities) very often approached 100%. That value was even exceeded sometimes, which has reopened the question of limiting the asset on the balance sheet under IFRS.

Another lesson learned from the 2021 financial year was that pension funds often decided, quite rightly so given their improved financial situation, to grant a generous interest credit on members’ retirement savings accounts. The significance of these decisions sometimes required last-minute adjustments in the calculation of accounting liabilities at the year-end closing.

This brief look back on 2021 opens the discussion of certain issues which will be important in 2022 when setting assumptions for international accounting standards. The discussion about demographic assumptions can generally be set aside, and the focus will mainly be placed on the financial assumptions.
Outlook for 2022

If we put the spotlight on 2022, it is inevitable that the subject of the interest crediting rate assumption cannot be avoided. But why is this?

The vast majority of pension funds have faced up to their responsibilities in recent years. They have lowered their technical interest rate, reduced their conversion rates, and sometimes even switched to generational mortality tables. These decisions had the combined effect of reducing the required return. At the same time, investment performance has been excellent in the past few years. These factors have led to a significant improvement in the financial situation of pension funds. Some pension funds have even made provisions for future interest credits and/or have free funds.

Therefore, it seems quite natural in this context to envision higher interest crediting rates than in the past, especially in view of inflation returning. The recent decisions taken by pension fund boards confirm this feeling. Regardless of how the assumption was determined in the past, the fact remains that it was traditionally not very far from the minimum LPP/BVG interest rate. That was justified by the low interest-rate environment and the high required return induced by the high technical parameters (technical interest rate, conversion rates, etc.). Today, the situation is quite different: required returns have fallen, financial situations have improved, and interest rates have increased, so it does not seem entirely inconceivable to assume that in the medium to long term the interest crediting rate will be closer to the expected return from the investment strategy than it was in the past.

It is also not unrealistic to assume that the nominal return expected by the investment strategy will be, depending on the equity allocation, in the range of 1.75% to 3.75%. As a result, assuming a future nominal interest crediting rate close to 1% may no longer represent the best estimate of the future, all the more so when pension funds have made provisions for future interest credits or have free funds.

An upward adjustment of the interest crediting assumption will inevitably result in an increase in accounting liabilities. Even if justified and necessary, this is not likely to please chief financial officers who have to review this assumption. In this context, other assumptions should also be reviewed.

As suggested above, a return of inflation means that it may be necessary to review the salary increase assumption. It is likely that the rise in inflation will be accompanied by a rise in discount rates, which would reduce accounting liabilities. Between 1 January and 31 March, rates increased by roughly 100 basis points (reaching their highest level since 2014), leading to a reduction in accounting liabilities of around 12% to 18% depending on the duration. Over the same three-month period, it was not unusual to see that pension fund investments also posted negative performance of -4% to -6% at the end of March. Therefore, it is possible that the year-to-date financial situation has improved after three months from the point of view of accounting standards.  

The trend in interest rates and investment performance cannot be dissociated from the tragic events unfolding in Ukraine. The evolution of interest rates should be carefully monitored: if changes are attributable to increased credit risk, this might lead to a higher risk of corporate default (loss of AA rating) and thus to a modification in the basket of bonds used to determine discount rates.

We should also take a closer look at the lump-sum capital at retirement assumption (generally 15% to 30%). It is likely that the reduction in conversion rates observed in recent years, the prospects of higher returns and the reduction in tax rates on lump-sum benefits in certain cantons are likely to influence the behaviour of pension fund members at retirement. In the future, they could opt more frequently for lump-sum benefits. An increase in this assumption would lead to a decrease in accounting liabilities in most cases.

In conclusion, both the financial situation of pension funds and their technical parameters have improved significantly in recent years. The long-term outlook for nominal investment returns have also improved. Given this new environment certain assumptions made in the past (notably the interest crediting assumption) must be reviewed.  At a time when the requirements of auditing companies are becoming more and more stringent, it is necessary to ensure that the assumptions used always represent the best estimate for the future.

The consultants at Aon are available to support you in this process.
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