Using Various Discount Rate Approaches to Develop Defined Benefit Plan Cost (under IFRS)

Issue Date: January 2016

In Brief

In determining the service cost and the net interest on the defined benefit liability (asset) components of a defined benefit plan under IFRS, one key assumption is the discount rate. Many entities and their actuaries have been considering various alternative approaches to determining the discount rate for purposes of calculating interest cost and service cost.

Entities considering changing to an alternative approach will need to evaluate a number of areas, including the appropriateness of the proposed alternative approach, whether the change should be applied consistently for both service cost and interest cost or how the change would be reflected for accounting purposes. This Newsletter addresses some of these considerations.

Traditional/Current Approach—A Single Weighted Average Discount Rate

Under current, commonly accepted and applied practice for pension and other postemployment benefits plans under IFRS, most entities use the traditional approach, whereby they use a single weighted-average discount rate. Under this approach, to measure the defined benefit obligation (DBO), a single weighted-average discount rate is developed at year-end measurement date which reflects the estimated timing and amount of all benefit payments. The discount rate is determined based on the projected future benefit payments related to past service of all members of the plan.

This single weighted-average rate is likewise used to recognize the service cost and the net interest on the net defined benefit liability (asset) in profit or loss.

Granular (or Disaggregated) Approaches

Many entities and their actuaries have been considering alternative approaches to determining the discount rate for purposes of calculating the service cost and the net interest on the net defined benefit liability (asset). In all situations, these alternative approaches should not have an impact on the discount rate used to determine the DBO and should not impact the measurement of the DBO itself. Accordingly, the DBO at the beginning of a period and at the end of a period is not affected by the methods used to develop the service cost and the net interest on the defined benefit liability (asset).

The following alternative approaches, using granular (or disaggregated) discount rates, are acceptable for the purpose of measuring the service cost and the net interest on the net defined benefit liability (asset):

• Approach 1—Separate single weighted-average discount rate for service cost—The discount rate to measure the service cost is determined based on the projected future benefit payments (or cash flows) related to the service provided by the active members in the year that follows the measurement date (the service cost cash flows). The service cost is determined in the same way as the DBO is determined, but using a different set of cash flows. Typically, the duration of the service cost is longer than the duration of the DBO since the service cost is applicable only to active members, not to retirees. The discount rate used to measure the service cost would typically be higher than the discount rate used to measure the DBO; as a result, the service cost would generally be lower than the one calculated under the traditional approach.
• Approach 2— Yield Curve Approach—Under this approach, a separate discount rate (the spot is used for each projected cash flows (either a cash flow for the DBO or one for the service cost); the discount rates used are the spot rates associated with the cash flows. It may be referred to as the spot rate approach or the full yield curve approach. Under this yield curve approach, both the service cost and the interest cost would be different from the traditional approach.

The two approaches above could be viewed as more refined calculations of service cost that more closely reflects the timing of the benefits that will be earned in the year following the measurement date. We also note that, everything else being equal, the reduction in the service cost with interest under these two approaches (thus a lower expense in the profit or loss) will be offset by higher actuarial losses that are recognized in Other Comprehensive Income under IFRS.

Another approach sometimes referred to as the Vector Approach calculates the interest cost on the DBO and service cost by applying the first year spot rate (or forward rate) to the DBO at the beginning of the period. This approach is not acceptable because it is inconsistent with IAS 19 that requires the discount rate to be consistent with the estimated term of the DBO (paragraphs .083 and .123 to .126).

It is also important to note that the terminologies used by various consultants vary; it is important to understand the mechanics behind the calculations to assess whether the proposed methodology is acceptable.

Should your audit entity consider using a different approach other than Approach 1 or Approach 2 above, please consult with AEA.

Accounting Implications and Questions

Entities considering such changes must evaluate a number of areas, including the following:

• Is such a change considered a change in accounting principle or a change in accounting estimate? In our view, this is a change in accounting estimate that is applied prospectively.
• What disclosures would be necessary if such a change is made? Entities are expected to disclose the approach used to measure the service cost and the net interest on the defined benefit liability (asset) as well as the various discount rates used in the calculations (as per the illustration below, the use of the traditional approach results in one discount rate for all calculations, but the use of Approach 1 results in two different discount rates and the use of Approach 2 results in four different discount rates, although we note that the discount rate used in calculating the interest on the service cost would normally not be expected to be a material assumption). In light of IAS 8, we would also expect an entity to disclose the nature and amount of a change in an accounting estimate that has an effect in the current period or is expected to have an effect in future periods.
• What additional information and support management and their actuaries intend to provide to the auditors in order to facilitate the review of the calculations? For the year of the change, we should obtain sufficient information to understand the mechanics behind the calculations to assess whether the proposed methodology is acceptable. We would generally expect to receive a description of the proposed methodology, as well as documentation providing information on the cash flows used for the defined benefit obligation and the cash flows used for the calculation of the service cost, as well as the spot rates used in the calculations to discount each cash flows. In subsequent years, depending on the methodology adopted, obtaining the duration of the DBO and the duration of the service cost may be sufficient to assess the reasonability of the information presented to us.
• Is there a need to communicate the change with those in charge with governance such as the audit committee? Yes, under CAS 260, when significant as part of the audit of the overall financial statements, we should discuss qualitative aspects of an entity’s accounting practices which in this instance, involve the selection of an approach among other acceptable alternatives.

Illustrative Examples

To illustrate the impact of the different approaches discussed in this Newsletter, we have prepared a simplified example where both the DBO and the service cost have cash flows only at the end of year 5 and year 20 from the measurement date. The examples were prepared with the following information.

Beginning of year—30 September 2014				End of year—30 September 2015
Time	Spot Rate	DBO CF	SC CF	Time	Spot Rate	DBO CF
5	2.55219%	25,000	500	4	2.01645%	25,500
20	4.24581%	30,000	3,500	19	4.30732%	33,500

Illustration of various discount rate approaches

	Traditional approach	Approach 1—Separate single weighted average rate for service cost	Approach 2—Yield Curve Approach
DBO at beginning of year	35,100.36	35,100.36	35,100.36
Service cost (without interest)	2,086.30	1,964.49	1,964.49
Service cost with interest	2,164.89	2,045.74	2,040.43
Interest cost on DBO	1,322.17	1,322.17	1,117.02
SC + IC	3,487.05	3,367.90	3,157.45
Effective rate for DBO	3.77%	3.77%	3.77%
Effective rate for SC	3.77%	4.14%	4.14%
Effective rate for IC on DBO	3.77%	3.77%	3.18%
Effective rate for interest on SC	3.77%	4.14%	3.87%
DBO Reconciliation
DBO at beginning of year	35,100.36	35,100.36	35,100.36
Service cost with interest	2,164.89	2,045.74	2,040.43
Interest cost on DBO	1,322.17	1,322.17	1,117.02
Benefit payments	-	-	-
Actuarial losses (gains)	(10.93)	108.22	318.67
DBO at end of year	38,576.48	38,576.48	38,576.48

Observations in respect of the various approaches:

• At any time, the DBO is the same irrespective of the approach used.
• Compared to the Traditional Approach, both Approach 1 and Approach 2 would result in same service cost (without interest); this amount would normally be lower than the same figure under the Traditional Approach under a normal yield curve (upward sloping) for a typical plan.
• The service cost with interest would normally be lower under Approach 1 than the Traditional Approach, and lower under Approach 2 then Approach 1. Under IFRS, there will be higher actuarial losses recognized in OCI so the result is a “zero-sum game.”
• Only under Approach 2, the interest cost on the DBO is different and would generally be lower.
• Given that the DBO are the same at both the beginning and the end of year under all approaches, any differences in the service cost and interest cost will be reflected in actuarial gains and losses that are recognized in OCI.

If you need further details regarding the content of this newsletter, please contact AEA.