Knowledge & Insights

2015 Survey Economic assumptions in accounting for pension and other post‑retirement benefits

Highlights of our annual survey results Morneau Shepell is pleased to provide a survey of the assumptions being used by approximately 100 Canadian public companies to account for the costs of their defined benefit plans. Information is collected from audited financial statements as at December 31, 2014. This is the fifteenth year that the survey has been produced. Accounting for publicly accountable enterprises has moved to International Financial Reporting Standards (“IFRS”) for fiscal years beginning on or after January 1, 2011. In June 2011, the International Accounting Standards Board (“IASB”) published the revised standard Employee benefits (“IAS 19 (revised)”). This revised standard is effective for years beginning on or after January 1, 2013. This survey therefore reflects assumptions and figures in line with IAS 19 (revised).

Discount rate for pension plans Following last year’s increase (the first in five years), the discount rates used for pension plans have now decreased again. The median discount rate decreased by 80 basis points (“bps”) in 2014. The median discount rate was 3.95% as at December 31, 2014 compared to 4.75% a year earlier. Roughly 95% of companies surveyed decreased their discount rate in 2014. The following charts summarize the discount rates used in the valuation of defined benefit pension plans as at December 31, 2014 (rounded to the nearest 0.25%), as well as the historical evolution of the median discount rate over the last 10 years, based on our past surveys.

Discount rate / Pension plans 5.00% 0% and higher 4.75% 4.50% 4.25% 4.00% 3.75% 3.50%

27%

2%

41%

1% 22% 4% 3% 56%

2% 24% 2% 8% 3%

5% 3.25% and lower 0% December 31, 2014

2015 Survey - Economic assumptions in accounting  for pension and other post‑retirement benefits | July 2015

December 31, 2013

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Historical evolution of the median discount rate

Discount rate / Duration

7%

4.25%

6%

4.00%

5%

3.75%

4%

3.50%

3%

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 December 31

The spread in discount rates used has narrowed since last year. About 80% of companies used a discount rate between 3.75% and 4.00% (a spread of one quarter percent), while 68% of companies used a discount rate between 4.75% and 5.00% (a spread of one quarter percent) at the end of the preceding year. As stated in the standard, the discount rate must reflect the estimated timing of benefit payments. In practice, companies often achieve this by applying a single weighted average discount rate that reflects the estimated timing and amount of benefit payments. Consequently, the discount rate used by any one company will vary depending on the duration of the pension plan. Not all companies in the survey disclosed the duration in their financial reports. The following chart shows the discount rate and the associated duration of pension liabilities based on the information available.

2015 Survey - Economic assumptions in accounting  for pension and other post‑retirement benefits | July 2015

3.25% 10

12

14

16

Discount rate

18

20

22

24

Trend line

Financial theory states that corporate bond yields increase as bond terms increase (although not linearly). This theory seems to be supported by the survey data, given the trend line shown in the chart above. However, the chart also reveals a few outliers. This can perhaps be explained by some companies disclosing a weighted discount rate that includes post-employment benefits while disclosing a duration that does not. Over time, the yields on high-quality long-term corporate bonds may vary considerably. The discount rate should be expected to vary in a similar fashion. The next graph compares the spot rate curves as at December 31 for the years 2013, 2014, and more recently for June 30, 2015. Spot rate curves, provided by Morneau Shepell, conform to the principles of CIA Educational Note, published in September 2011.

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Discount rate for non-pension benefits

High-quality corporate bonds 6% 5% 4% 3% 2% 1% 0% 0

5

June 30, 2015

10

15

20

25

30

December 31, 2013

December 31, 2014

If the spot rate curve were to remain at June 2015 levels until the end of the year, the expected discount rates at December 31, 2015 would be similar to those used at December 31, 2014. The following chart compares the median discount rates (rounded to the nearest 0.25%) in our survey to the average discount rates from a U.S. study1.

The median rate used as at December 31, 2014, for non-pension benefits is 3.90%, a rate slightly different than the median rate used for pensions. The following chart shows the difference between the discount rate used in the valuation of non‑pension benefits and that used for pension plans, rounded to the nearest 25 bps (a positive value indicates a higher rate for non-pension benefits than for pensions and vice versa). Difference in discount rates (non-pension benefits vs. pensions)

Median discount rate by country 2014

The duration of non-pension post-employment benefits is often significantly different from that for pensions. For example, the duration of the defined benefit obligation (DBO) for a retiree medical plan is often longer than that for pension plans. As a result, the choice of discount rate for the valuation of post‑employment benefits can be different than it is for pensions, in theory (see the Appendix on selecting the discount rate for more on this). While some companies use rates that differ by type of plan, many elect to use a single blended rate, or they simply use the rate for the most material plan.

4.00%

N/A

4.75% 4.75%

2013

4.25% 4.00%

2012

4.50% 4.75%

2011

5.25% 5.50%

2010 Canada

0.75% and higher

2%

0.50% 0.25%

10% 4%

0.00%

71%

-0.25%

3%

-0.50%

4%

-0.75% and lower

6%

U.S.

In 2014, most companies surveyed used similar discount rates for pensions and non-pension benefits. Only 29% of companies used a significantly different discount rate for non-pension benefits (compared to 36% in our previous survey).

1 Source: 2015 Study of Economic Assumptions, prepared by Deloitte & Touche Human Capital Advisory Services (U.S.). (At the time this survey was prepared, the 2015 U.S. study had not yet been published by Deloitte and the average discount rate at December 31, 2014 for U.S. companies was unavailable. This survey will be updated once the U.S. study is published.)

2015 Survey - Economic assumptions in accounting  for pension and other post‑retirement benefits | July 2015

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Rate of compensation increase

Spread: discount rate / compensation

Plans that provide pay-related benefits are required to make an assumption about the rate of compensation increases. IAS 19 (revised) indicates that it should reflect “inflation, seniority, promotion and other relevant factors, such as supply and demand in the employment market”. The median compensation increase assumption as at December 31, 2014, was 3.25%, identical to last year’s median. We found 76% of companies using rates between 3.0% and 4.0%. In some cases, however, this assumption is much lower than the median, leading one to question whether some companies are properly reflecting the impact of individual job progression in their disclosed assumption.

16% 7% 18% 3%

1.25%

20% 28%

1.00%

9% 11%

0.75%

4% 22%

0.50%

7% 9% 4% 15% 2% December 31, 2013

9% 3% 5% 24% 21% 12% 20%

31%

3.00%

2.25% and lower

1%

December 31, 2014

3.25%

2.50%

10%

1.50%

6%

3.50%

2.75%

1.75%

1%

0.00% and lower

6% 6%

4.00% 3.75%

2.00%

10%

0.25%

Rate of compensation increase 4.25% and higher

3%

2.25% and higher

20% 3%

Our survey shows that less than 30% of companies changed the rate of compensation increase assumption by approximately 25 bps or more (up or down) at December 31, 2014. There is some debate over how frequently this assumption should be changed. IAS 19 (revised) states that financial assumptions should be based on market expectations at the end of the reporting period. Change in compensation increase assumption (2014 vs. 2013)

6% 6% 4%

0.50% and higher

9% 9% December 31, 2014

0.25%

December 31, 2013

4% 2%

0.00%

73%

-0.25%

The following graph shows the spread between the discount rate and the rate of compensation increase. The spread can have a significant impact on the DBO for defined benefit pension plans. The median spread is 0.75% as at December 31, 2014, which is 65 bps lower than last year. A decrease in the spread results in a higher DBO. 2015 Survey - Economic assumptions in accounting  for pension and other post‑retirement benefits | July 2015

11%

-0.50%

8%

-0.75% 0% -1.00% and lower

2%

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Pension plan financial situation and financial assumptions

Medical cost trend

The companies in our survey show a 91% overall ratio of pension assets to DBO for accounting purposes. This result may be slightly understated since it includes some non-registered plans for which no funding is legally enforced under the Canadian regulatory environment. The ratio is highly influenced by the actual return on plan assets, the discount rate assumption and special contributions made to cover pension plan deficits. The distribution of companies based on their overall ratio at December 31, 2014 is shown in the following chart. Pension plan ratio of asset value to accounting DBO (distribution of companies) 13%

100.00% and higher

The following charts show the December 31, 2014 medical cost trend assumption compared to December 31, 2013. About 84% of companies used an ultimate trend rate between 4.5% and 5.5%. The median rate as at December 31, 2014 is 4.5%, which is 10 bps lower than last year. Ultimate medical cost trend

31%

80.00% to 89.99% 70.00% to 79.99%

34% 40%

5.00% and higher

16%

60.00% to 69.99%

52% 48%

4.50% to 4.99%

7% 4%

4.00% to 4.49%

As mentioned, the ratio is highly influenced by the return on assets and discount rate, for which we have summarized historical data in the next chart. Discount rate and actual return on assets 20% 6,75%

15%

6,25%

10%

5,75%

5% 0%

5,25%

3.99% and lower

11% 8% 3% 4%

December 31, 2014

December 31, 2013

The median assumption for the short-term medical cost trend rate was 6.5% at December 31, 2014, which is 50 bps lower than last year’s median rate. A total of 86% of companies used an assumption of less than 7.5% (compared to 71% in 2013), confirming the reduction of medical cost growth across the market.

-5%

4,75%

-10%

4,25% 3,75%

Often, medical costs are assumed to increase at a higher rate in the short term, declining in steps to an ultimate rate over a period of several years.

29%

90.00% to 99.99%

59.99% and lower

When retiree medical coverage is offered, a key assumption in the valuation of the DBO is the rate of future medical cost increases. IAS 19 (revised) provides guidance on factors that companies should consider in selecting this assumption.

-15% 2006 2007 2008 2009 2010 2011 2012 2013 2014 Median Discount Rate

-20%

Median Real Return on Asset

2015 Survey - Economic assumptions in accounting  for pension and other post‑retirement benefits | July 2015

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Pension plan asset allocation

Short-term medical cost trend 9.00% and higher

1% 1% 6%

8.00% to 8.99%

11% 32%

7.00% to 7.99%

39%

The average asset allocation as at December 31, 2014, was 48% in equities, 45% in fixed income and 7% in other assets (compared to 51% in equities, 43% in fixed income and 6% in other assets as at December 31, 2013). The distribution of the proportion of funds invested in equities is shown below:

26% 22%

6.00% to 6.99%

20%

5.00% to 5.99%

11% 15% 15%

4.00% to 4.99%

Under IAS 19 (revised), the allocation of pension fund assets between equities, fixed income and other assets must be disclosed. Additional categories may be added to facilitate the readers’ understanding of the investment risks faced by the fund.

3.99% 0% and lower 1%

Company distribution by pension plan equity weighting

December 31, 2014

December 31, 2013

65.00% and higher

The medical cost increase rate reaches its ultimate level in 2024 (median) (compared to 2021 in 2013). Despite the decline in the medical cost trend in recent years, the increase in the median year means that the companies surveyed do not expect the trend to reach its ultimate rate anytime soon. We will continue to closely monitor to this assumption in future surveys. Ultimate medical cost trend (year in which ultimate rate is attained) 2031 and later

5% 19%

2029-2030 8%

2027-2028

16%

2025-2026 2023-2024 2021-2022

5% 6% 11%

2019-2020 2017-2018 2015-2016 2014

18% 5%

5%

60.00% to 64.99%

17%

55.00% to 59.99%

16% 15%

50.00% to 54.99% 45.00% to 49.99%

8%

40.00% to 44.99%

8%

35.00% to 39.99% 30.00% to 34.99% 29.99% and lower

13% 6% 12%

Under the revised IAS 19 (revised), the defined benefit cost is no longer impacted by the expected long-term return on asset assumption. Some companies may consider increasing the proportion of assets invested in fixed income to reduce their pension plan risk without increasing the amount recognized in profit or loss. The average asset allocation at December 31, 2014 compared to the previous year indicates a slight shift from equities to fixed income. However, it is difficult to say if the shift was due to a reallocation in the plan assets.

7%

2015 Survey - Economic assumptions in accounting  for pension and other post‑retirement benefits | July 2015

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Defined benefit cost – IAS 19 (revised)

Additional disclosures – IAS 19 (revised)

With respect to pension plans, the following graph shows the aggregate amount recognized in profit or loss (sum of the service cost and the net interest on the net defined benefit liability) and the aggregate amount recognized in other comprehensive income (remeasurements of the net defined benefit liability).

Disclosure requirements were expanded in IAS 19 (revised), mostly to reflect the level of risk inherent in an entity’s defined benefit plans. However, some parts of the standard may be subject to interpretation and require professional judgment. Consequently, the level of detail in the disclosures may vary from one company to another. For example, 90% of the companies surveyed disclosed a sensitivity analysis of the defined benefit obligation (as required by IAS 19 (revised)), while 10% either disclosed it on the amount recognized in profit or loss or did not disclose any. The following chart shows which actuarial assumptions were used for those companies that disclosed a sensitivity analysis.

For 2014, these amounts are $2.9 billion and $7.5 billion respectively. The decrease in the amount recognized in profit or loss compared to the previous year ($3.5 billion in 2013) is due to the increase in the discount rates at the end of 2013 and the significant return on plan assets in 2013. The remeasurements of $7.5 billion consist of actuarial losses on the defined benefit obligation resulting from lower discount rates as at December 31, 2014, despite higher returns on plan assets in 2014 (compared to the interest generated by using the discount rate). Historical amounts recognized in profit or loss and remeasurements recognized in other comprehensive income ($ billion)

Actuarial assumptions used in the sensitivity analysis 100%

Discount rate Rate of compensation increase

63%

Mortality

60%

Inflation rate 2.9

2014 2013

7.5

Other

24% 3%

3.5 -12.9 2.0

2012

4.9 1.9

2011

9.0

1.8

2010

5.9 Profit or loss

Other comprehensive income

Prior to 2013, IAS 19 stated that remeasurements recognized in other comprehensive income (OCI) had to be recognized immediately in retained earnings (in the statement of equity). In IAS 19 (revised), remeasurements may be transferred to any other component in equity. Alternatively, they may be left in accumulated other comprehensive income (AOCI). About 65% of the companies in our survey decided to transfer the remeasurements immediately to retained earnings, while the others (35%) recognized the amounts in AOCI. 2015 Survey - Economic assumptions in accounting  for pension and other post‑retirement benefits | July 2015

IAS 19 (revised) also requires that the fair value of plan assets be disaggregated into classes that distinguish the nature and risks of those assets (ex.: industry type, company size, geography, etc.). About 60% of the companies surveyed provided any level of additional information with respect to the breakdown of the fair value of plan assets.

For more information This survey is intended to provide information regarding the assumptions disclosed by a wide range of companies and, as such, can provide an indication of trends. The assumptions used for your own employee benefit plans will depend on a number of factors. For more information, please speak to your Morneau Shepell consultant.

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Appendix – Selecting the discount rate In general, the DBO for defined benefit plans is highly sensitive to the discount rate assumption. For example, a 25 bps decrease in the discount rate can increase the DBO by as much as 5%. IAS 19 (revised) provides general guidance for the selection of the discount rate assumption. The discount rate should be determined by reference to market yield on high-quality corporate bonds. In countries where there is no deep market in such bonds, the market yield on government bonds should be used. The discount rate should reflect the estimated timing of benefit payment, but it is common practice to apply a single weighted average rate. However, the precise methodology for computing this rate is not prescribed. The Canadian Institute of Actuaries (CIA) published an Educational Note in September 2011 which offers advice to pension actuaries who are engaged by an entity to provide guidance on the discount rate to use for accounting purposes. The Educational

2015 Survey - Economic assumptions in accounting  for pension and other post‑retirement benefits | July 2015

Note describes a methodology to extrapolate the long end of the high-quality corporate yield curve that the Task Force believes would be appropriate in the current economic environment. This new methodology uses high-quality corporate and provincial (adjusted) bonds. It is possible that some entities may not have applied the proposed methodology set forth by the CIA in establishing the discount rate as at December 31, 2014, and may have instead used an alternative model that still conforms to the principles of the Educational Note, or in some rare instances they may have continued with the previous method. This could result in different discount rates for similar pension plans, given current conditions in financial markets. Information on high quality Canadian corporate and provincial bonds (rated AA or higher) is generally available from independent sources, and can serve as a starting point in the determination of the discount rate.

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Morneau Shepell is the largest company in Canada offering human resources consulting and outsourcing services. The Company is the leading provider of Employee and Family Assistance Programs, as well as the largest administrator of pension and benefits plans. Through health and productivity, administrative, and retirement solutions, Morneau Shepell helps clients reduce costs, increase employee productivity, and improve their competitive position. Established in 1966, Morneau Shepell serves approximately 20,000 clients, ranging from small businesses to some of the largest corporations and associations in North America. With about 3,700 employees in offices across North America, Morneau Shepell provides services to organizations across Canada, in the United States, and around the globe. Morneau Shepell is a publicly traded company on the Toronto Stock Exchange (TSX: MSI).

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