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Pension accounting primer
1. Understanding Actuarial Results
A Pension Accounting Primer
Johnson, West & Co., PLC
Van Iwaarden Associates
June 16, 2010
Mark Schulte, FSA, EA, MAAA
612.596.5971
marks@vaniwaarden.com
2. Outline
1. Goals of the presentation
2. Orientation
– DB pension plans
– Strings attached
3. Actuarial speed dating
4. Actuarial Results
5. Summary/Q&A
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3. Presentation Goals
Basic understanding of:
– How pension liabilities are calculated
– What pension liabilities mean and how they are similar/different
– How to convert liabilities in to “usable” results
– What to do with the results.
Become conversant/comfortable with:
– What actuaries are preparing for you
– What accountants want from you
– Explaining it all to your peers
Know when to get involved and when to let
actuaries and auditors “hash it out”.
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4. Non-Aspirations
Make you all actuaries
– Details are important for actuaries; clients usually just need to
understand the concepts
– But maybe you can be an armchair actuary
Make actuarial science exciting
– Simply not possible in many situations
– It should be understandable
Make me an accountant
– I have never been an accountant, and likely never will be
– All statements in this presentation will be from an actuarial perspective
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5. Orientation
We’re all here because you sponsor a DB pension
plan or are involved with these plans.
Defined Benefit (DB) vs. Defined Contribution (DC)
– DB: Employer has promised a benefit and must make
variable contributions.
– DC: Employer has promised a contribution and employee
gets variable benefits.
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6. Orientation
Purposes of pension plan
– Attract and retain employees; reward service to company
– Orderly succession of employees
– Tax deductions
– Paternalism (?)
Since tax deductions are involved and promises are being
made, DB pension plans come with “strings attached”
The “strings” are usually the aggravating part of a DB plan,
but all qualified retirement plans have them in some form.
– Fiduciary responsibilities for fund selection
– ADP/ACP testing
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7. Orientation
“Strings Attached” IRS
• Benefit Equality
• Plan design (benefit accruals)
• Nondiscrimination in coverage and benefits
• Annual Contributions
• Minimum required
• Maximum deductible
• Reporting (Form 5500, participants)
Pension Plan
PBGC
• Pension insurance premiums
• Flat rate
• Variable rate (VRP)
• Reporting (to PBGC, to participants)
Accounting/FASB
• Company liability for benefit promises
• Many nuances to accrual accounting
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8. Actuarial Speed Dating
Basic Premise of All Actuarial Pension Calculations
A promise has been made to make a stream of payments
(or lump sum) at some point in the future.
Given assumptions about projected benefit amount and
likelihood of receiving payments, what is the value of the
benefit in today’s dollars?
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9. Actuarial Speed Dating
Data Census data for all participants Economic:
• Discount rate(s)
• Expected return on assets
• Pay increases
Assumptions • Inflation
• Regulatory (wage base, comp
limits)
Methods Asset methods
Demographic:
• Turnover, disability, retirement,
Liability methods
death
• Marriage, spouse age
Plan Provisions How benefits
• Form of payment
• Participation (OPEB)
are defined
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10. The Actuarial Model
Data Assumptions Methods Plan Provisions
Actuarial Model
Present Value of Benefits
Liabilities
Accrued
Projected
Future Costs
Accounting Funding Other
• PBGC
• Benefit Restrictions
• Nondiscrimination compliance
• Benefit distributions
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11. Actuarial Speed Dating
Determining the value of pension payments
Period of Annuity Payments
35 45 65 95
Start Current Retirement Death
Working Age Age
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12. Actuarial Speed Dating
Term structure of interest rates
6%
Return
3%
5 years Time 30 years
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13. Actuarial Speed Dating
Segment interest rates
6%
4%
Return
2%
Segment 1 Segment 2 Segment 3
Time
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14. Actuarial Speed Dating
Calculating the present value of benefits
6%
4%
35 45 65 95
Hire Current Retirement Death
Age Age Age
Example: $100 x (1+.04)^(-20) = $46
$100 x (1+.06)^(-50) = $5
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15. Actuarial Speed Dating
We can calculate a present value – Now what?
Liability calculations:
Liability Measure Acronym Pay Service
Present Value of Benefits PVB Projected Projected
Projected Benefit Obligation PBO Projected Current
Accrued Benefit Obligation ABO Current Current
Vested Benefit Obligation VBO Current Vested
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16. Actuarial Results
We now know the basic process for calculating liabilities
Similarities for most actuarial calculations:
– Data
– Assumptions: Demographic
– Assumptions: Some economic
– Plan provisions
Differences between actuarial calculations
– Assumptions: Certain economic
• Discount rates/segment rates/yield curves
• Inflation/regulatory increases/salary scale
– Methods
• Liability methods (i.e., pattern for recognizing liabilities)
• Asset methods (smoothing)
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17. Actuarial Results
Funding
– IRS requirements (most methods mandated)
– Funding policy (often overlooked due to PPA requirements)
Accounting
– GAAP accounting for plan sponsor/employer (ASC 715)
• FAS 87 expense
• FAS 158 disclosures
• FAS 88 curtailment/settlements
– FAS 35 accounting for Plan
Other
– PBGC variable rate premiums
– Plan benefit calculations
– Nondiscrimination testing
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18. Actuarial Results
PPA GAAP FAS 35 PBGC
Inputs Funding Accounting Accounting Premiums
Data Participants at beginning of plan year Participants on last
day of prior plan year
Assumptions
- Demographic Same
- Economic Segment rates Single rate Expected return PBGC segment
(24 month avg.) Pay increases on plan assets rates (snapshot)
Regulatory Option to use
EROA
funding rates
Methods
- Liability ABO PBO, ABO ABO, VBO VBO
- Asset MVA, AVA MVA, MRVA MVA MVA
Plan Provisions Same
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19. Actuarial Results
FAS #35 Accounting
– Plan Accounting
– Focus on long-term COST to Plan of providing benefits
• How much money does plan need today to pay benefits, based on
assumed return on assets?
• Benefit cost perspective means we use Expected Return on Assets as
liability discount rate
– Disclose:
• Benefit liabilities (vested and non-vested) and reconciliation
• Funded status
GAAP Accounting
– Corporate accounting
– Focus on LIABILITY to the plan sponsor
• If company was sold, what would be “cost” of pension liability today?
• Liability cost is similar to a plan termination calculation (i.e., cost to
purchase bonds or annuity contracts to satisfy liabilities)
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20. Actuarial Results
GAAP Accounting Highlights
Balance sheet liability
– Also known as Funded Status or Unfunded PBO
– Previously known as (accrued)/prepaid pension cost
– Move to mark-to-market, but use PBO liability
Change in balance sheet liability
– Also known as change in Funded Status
– Two components
• Amount recognized in earnings (FAS expense); plus
• Amount recognized in Other Comprehensive Income
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21. Actuarial Results
GAAP Accounting Highlights
FAS Expense
– Amount recognized in earnings each year (accrual accounting)
– Liability “earned” during year, plus adjustments for:
• Interest on balance sheet liability
• Offset for expected return on assets
• Amortization of unrecognized prior service costs, gains/losses.
Additions to Other Comprehensive Income
– Items not yet recognized in earnings
– Includes:
• New unrecognized amounts (prior service costs, gains/losses); minus
• Amortization of unrecognized amounts
Auditors will check that balance sheet liabilities reconcile!
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22. Actuarial Results
GAAP Accounting Highlights
Sample reconciliation of funded status
A. Projected Benefit Obligation (PBO) $ (1,000)
B. Fair value of assets 800
C. Funded status (A. + B.) $ (200)
D. Unrecognized transition obligation $ 0
E. Unrecognized prior service credits/(costs) (50)
F. Unrecognized gains/(losses) (110)
G. Accumulated OCI (D. + E. + F.) $ (160)
H. (Accrued)/Prepaid Pension Cost (C. – G.) $ (40)
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23. Actuarial Results
“Specialty” Accounting Calculations (FAS #88)
Settlement
– Event that eliminates plan sponsor risk and responsibility for PBO
• Example: Large lump sum payments (one or many)
• PBO reduction > SC + IC
– Shortens lifespan of plan
– Immediate recognition of UGL, in proportion to reduction in PBO
• Example: Settle 20% of PBO, then recognize 20% of UGL
Curtailment
– Event that significantly reduces rate of benefit accrual (e.g., plan freeze)
– Shortens amount of “future service” over which we amortize prior
service costs
– Immediate recognition of UPSC, in proportion to reduction in future
service
Curtailments and settlements often occur in tandem!
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24. Summary
DB plans (like any qualified retirement plan) have
complexities.
– But they don’t need to be overwhelming
– Frozen plans have special responsibilities
Most actuarial calculations are based on similar
principles, but there are a few adjustments based on the
intended use of the result.
If results are unclear, be sure to ask your actuary or
auditor!
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