KPMG Pensions Accounting Survey in the Netherlands

2011 Year-End preview and 2010 Year-End retrospective kpmg.nl

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Introduction
Under accounting standards such as IFRS, companies are required to report pension liabilities and pension cost in respect of their defined benefit plans in accordance with a very prescriptive set of rules. International Accounting Standard no. 19 (IAS 19), paragraphs 72-91, sets out the requirements with regard to the actuarial assumptions that should be used for calculating the pension liabilities and pension cost. The choice of pension assumptions facing company directors is not straightforward and there is a wide spread of potential alternatives.
The KPMG Pensions Accounting Survey looks at the trends and assumptions used in pension accounting in the Netherlands, of companies reporting under IFRS at 31 December 2010. The assumptions are based on publicly available information of companies quoted on the Euronext Amsterdam stock exchange. This survey covers companies advised by all the major actuarial consultancies and therefore provides some insight into market practice in the Netherlands. An important development regarding IAS 19 is the publication of the amended IAS 19 guidelines in June 2011. The amendments will have effect on annual reports starting 1 January 2013. The most important changes in accounting policy and the expected impact on the pension liabilities and pension cost are discussed in this survey.

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Headlines
Key headlines of this survey are: Changes in accounting guidelines can have significant impact on the balance sheet position and the pension cost. These changes will become apparent in 2013. There are many different methodologies to determine the discount rate. Most companies are assisted by actuarial advisors to determine their discount rate. Generally, a yield curve is fitted based on an (adjusted) Bloomberg or (adjusted) iBoxx AA corporate bonds universe. This leads to a range of discount rates used between 3.6% and 5.7%, where most companies use a discount rate between 4.7% and 5.2% as at 31 December 2010. The implied inflation rates seem to converge to 2% which is the long term expected inflation rate used by the European Central bank. The assumption for pension increases falls behind by the actual inflation as the current financial situation of many plans will not allow for full compensation of inflation. Assumed life expectancies continue to rise. Companies are increasingly using generational mortality tables. New generational mortality tables have recently been issued by the Dutch Actuarial Association, however recent research by the Dutch Central Bureau of Statistics (CBS) shows stronger improvement in the longevity trend than assumed in the AG 20102060 mortality tables. This can have a further impact on the liabilities of 0% to 5%, depending on the currently used mortality tables and trends.

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Pension accounting changes

In June 2011, the International Accounting Standards Board (IASB) published the amended IAS 19 guideline, with mandatory adoption for years starting on or after 1 January 2013. The main changes are the following;
The corridor methodology will no longer be allowed to improve clarity of the balance sheet position. This means that actuarial gains/losses have to be recognized in the period that they occur. This is consistent with a market value approach for the liabilities. This will improve insight in the actual liabilities of the company, but will also result in volatile liabilities and movements as a result of changes in assumptions and differences between assumptions and reality. The expected return on assets item in the pension cost will be changed. Currently it is recorded in companies profits based on the asset mix and a building block approach. The current form of an expected return on assets credit will be replaced by an interest item based on AA corporate bond yields equal to the discount rate used to determine the value of the obligations. Whilst the move will improve transparency, companies will lose the ability to smooth earnings through setting their expected return assumptions, especially in relation to the abolishment of the corridor methodology, causing the pension cost to become more volatile. This in turn may force some rethinking on the investment strategy. The disclosure requirements are improved to better reflect the characteristics of the defined benefit plans and give insight into the risks arising from these plans. Using the discount rate instead of the expected return on assets assumption will impact many companies. The pension cost, recorded in P&L, will increase by 0% to 20% as a result of this change in accounting policy. This effect will be offset by the direct recognition of gains/losses on assets. However, this will be reflected in other comprehensive income (OCI) instead of P&L. In addition to the technical changes, disclosure requirements are also improved. This will lead to a situation where companies can actually be compared. Currently every company has their own disclosure format. Therefore, beside the required numbers, the information made available varies widely.

The impact of these changes can be predicted using the figures from 31 December 2010. Many companies are currently using the corridor methodology and immediate recognition of all actuarial gains/losses will lead to a total increase of 14 billion in pension liabilities of the researched companies. Individual impact on the balance sheet position ranges from a 1.7 billion decrease to a 5.9 billion increase of the pension liabilities.

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Discount rate
According to IAS 19 (paragraph 78), the rate used to discount estimated cash flows should be determined by reference to market yields at the balance sheet date on high quality corporate bonds. It is market practice to use corporate bonds with an AA rating (or equivalent) for this purpose.
Development of AA corporate bond yields We see that the discount rates have gradually dropped until August 2010, at which time the market value of the liabilities was at its peak. From that moment onward we have seen an increase in rates until March 2011 and a slight decrease in the last few months. We see that both iBoxx and Bloomberg curves have slightly risen since 31 December 2010 with respectively, 13 and 17 basis points. The current turmoil in the financial markets can have an impact on the discount rate movements in the coming months. In the past years, companies have started to pay more attention to assumption setting and actuarial advisors are increasingly responding to this by using more sophisticated methods for determining the discount rate. One of the differences that we see is that the bond yield universe differs from company to company. This can lead to differences in the basis which is illustrated in the chart below, which compares 15-year spot rates derived from Bloomberg (EUR Composite AA BFV Curve, ticker F667) and iBoxx (EUR Corporates AA) data, two widely used indices for this purpose. These rates show the same fluctuations, but are not at the same level, this also holds for other maturities. In addition to using different bond universes, various methodologies are used to determine a yield curve. Based on the data points a yield curve has to be fit through these points to contstruct a yield curve which can be used to determine the discount rate. This can be done using several methods, some of which are: Using an existing curve, such as the Bloomberg (EUR) Composite AA BFV curve, and interpolate between known datapoints where required. A zero-coupon curve can easily be derived from such a (par) yield curve. Constructing a number of datapoints where the yields are calculated as (weighted) averages wihtin a maturity range or basket. The yield curve is obtained by interpolation between the datapoints and a zero coupon curve can be obtained (under the assumption that the yield curve reflects par yields). Alternatively, a yield curve can be fitted through the bond universe, so that the total of differences between the curve and the actual bond prices is minimised. This method assumes that the yield curve can be described by some (mathematical) function of which the parameters need to be estimated. Literature on yield curves provides several methods that can be used for this purpose.

Bloomberg and iBoxx (maturity 15 years)

7% Rate 6% 5% 4% 3%
Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10

Bloomberg iBoxx

Jan-11

Mar-11

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May-11

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For longer maturities, market information is normally limited. If discount rates are required for longer maturities the yield curve can be extrapolated, which is in most cases done by: Keeping the spot rate constant after a certain maturity, or Keeping the credit spread (on a risk free curve) constant after a certain maturity. In other commonly used methods in finance, the longer end of the curve is based on a (constant) ultimate forward rate.

Making choices in developing a yield curve can lead to significant differences in the resulting yield curve, as can be seen from the chart below. This chart reflects the methodologies used by different actuarial advisors;

Discount rates used at the 2010 Year-End Most companies in the Netherlands set their discount rate assumptions based on one of the previously mentioned methods compiled by their actuarial advisors. The median discount rates adopted by companies at 31 December 2010 is 5.1% and most companies have used a discount rate between 4.7% and 5.2%, which is generally consistent with spot rates for maturities between 15 and 20 years given by most of the yield curves shown.

Spot curves actuarial rms

7%

Discount rate
18% 16%
17%

6%

5% 14% 4% Percentage of companies Spot rate

14%

12%
12%

3%

10% 8% 6% 4% 2%
3% 5% 5% 3% 2% 9% 8% 8% 8% 8%

2%

1%

0% 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 Maturity

0% <4,5% 4,5% 4,6% 4,7% 4,8% 4,9% 5,0% 5,1% 5,2% 5.3% 5,4% 5,5% >5,5%

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Inflation
Development of the inflation rate The graph below shows the Euro swap implied inflation curve, which essentially reflects how inflation is priced by the market. The graph shows that, compared to 31 December 2009, 31 December 2010 long-term inflation rate is initially at a higher rate as a result of the current inflation rates. Another observation is that the implied inflation has decreased by around 0.5% point, from 2.5% to 2.0%. The short- and mid-term swap inflation curve has significantly flattened and implied inflation varies between 1.7% and 2.3%. The curve also shows that the market implied inflation rate is broadly in line with the ECB long-term view. Inflation rates used at the 2010 Year-End The majority of companies are assuming a long-term inflation rate of 2.0%. This is consistent with the ECBs objective to keep inflation below, but close to, 2%. Dutch pension plans generally try to increase pensions in line with price inflation, however, as pension increases are almost invariably conditional upon investment returns, increases tend to be lower in current times. Many companies reflect this is in their assumptions for the long-term rate of pension increases. As a result the rate of expected pension increases is generally below the inflation rate of 2.0%.

Ination EUSWI
3% 2,5% 2% 1,5% 1% 0,5% 0% 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 Maturity 31/12/2008 31/12/2009 31/12/2010

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Expected return on assets

Expected return on plan assets varies significantly between companies for a variety of reasons. The rate of expected return of the companies observed ranges between approximately 3.5% and 6.5%.
The differences are of course largely caused by variety in plan asset allocation, but differences in market views on investment returns are an important factor as well. The median expected return on assets assumed is 5.1%. With the abolishment of the possibility of crediting the expected return to the P&L (see Pension accounting change section), companies will be less able to manage the P&L pension charge. However, it could be argued that a rate of return on plan assets cannot be reasonably estimated and should therefore not be used for accounting purposes.

Expected return on assets

30% Percentage of companies 25% 20% 15% 10% 5% 0% <4,0% 4,0%-4,5% 4,5%-5,0% 5,0%-5,5% 5,5%-6,0%
9% 3% 5% 12% 14% 25% 22%

6,0%-6,5%

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>6,5%

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Life Expectancy
Historically, most pension funds use mortality tables issued by the Dutch Actuarial Association (Actuarieel Genootschap, hereafter: AG). In August 2010 the AG issued new mortality tables allowing for a significant longevity improvement which has been observed since 2001.
In the meantime the Dutch Central Bureau of Statistics (CBS) published mortality rates and research notes (Bevolkingsprognose 20102060: sterkere vergrijzing, langere levensduur, March 2011) which show an even stronger trend. This trend can be seen in the graph below, for reference we have included historical information on expected future lifetime. Most companies have used the AG 2010-2060 mortality table in the IAS 19 figures, some with longevity trends. Whether this sufficiently incorporates further improvements of longevity is open to debate. For the coming years we foresee that many companies will adopt the observable trends which will generally result in further increases in liabilities ranging from 0% to 5%, depending on the mortality tables currently used.

Expected future lifetime from age 65 (CBS)

Men (65) 2008-2050 Women (65) 2008-2050 24 22 20 18 16 14 12
1950 1956 1962 1968 1974 1980 1986 1992 1998 2004 2010 2016 2022 2028 2034 2040 2046 2052 2058

Men (65) 2010-2060 Women (65) 2010-2060

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About KPMG Netherlands

KPMG Netherlands offers services in the fields of audit, tax and advisory. We offer our services to a broad group of clients: major domestic and international companies, medium-sized enterprises, non-profit organisations and government institutions. The complicated problems faced by our clients require a multidisciplinary approach. Our professionals stand out in their own specialist fields while, at the same time, working together to offer added value that enables our clients to excel in their own environment. In doing so, we draw from a rich source of knowledge and experience, gained worldwide in the widest range of different organisations and markets. We provide real answers so that our clients can make better decisions. Risk & Actuarial Services (RAS) Risk & Actuarial Services offers creative business strategies to clients in the rapidly changing insurance and pensions industry. We also bring insight and quantitative analytic skills to other clients assisting them with the challenges they are facing. We support numerous pension funds and companies with advice on pension plan design, pension valuations and risk analysis. Our team of (qualified) actuaries works together with other KPMG professionals to form multidisciplinary teams and guarantee the best service for our clients.

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Contact us Edward Snieder T: +31 (0)20 656 7941 E: snieder.edward@kpmg.nl Alexander van Stee T: +31 (0)20 656 4673 E: vanstee.alexander@kpmg.nl Marc Simon Visser T: +31 (0)20 656 7055 E: visser.marcsimon@kpmg.nl www.kpmg.nl

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. 2011 KPMG Advisory N.V., a Dutch public limited liability company under Dutch law, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG-network of independent member firms affiliated with KPMG International Cooperative (KPMG International), a Swiss entity. All rights reserved. Printed in the Netherlands. The KPMG name, logo and cutting through complexity are registered trademarks of KPMG International Cooperative. 120_0711