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The Ohio State University

The Ohio State University. Key Issues Impacting Employer- Provided Pension Plans April 11, 2006 Gary Price. As The Old Saying Goes…. “Retirement is the time when you never do all the things you intended to do when you have the time.” Anonymous. Agenda.

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The Ohio State University

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  1. The Ohio State University Key Issues Impacting Employer- Provided Pension Plans April 11, 2006 Gary Price

  2. As The Old Saying Goes… “Retirement is the time when you never do all the things you intended to do when you have the time.” Anonymous

  3. Agenda • Defined-benefit plans…what are they • Defined-benefit plans…the current environment • The role of the PBGC • The airline industry • Accounting for defined benefit plans

  4. Defined Benefit (DB) Pension Plans DB pension plans promise a benefit that is generally based on an employee’s salary and years of service, with the employer being responsible to fund the benefit, invest and manage plan assets, and bear investment risk.

  5. The Basic Issue A number of factors have thrown the DB pension plan system into financial turmoil, including: -declining equity markets -low interest rates -financially weak industries The combination of the three has resulted in significant underfunding. Some parties have also suggested that funding rules (dictated by the IRS and ERISA) and accounting rules (dictated by the SEC and FASB) are also major contributors to the problems- creating the “perfect storm.”

  6. Defined Benefit Pension Plans – Some Facts • Over $2 trillion worth of benefits covering over 44 million participants • Peaked at roughly 112,000 plans in the mid-1980s…today roughly 30,000 plans exist • Many of the plans that exist today are in our oldest, most mature industries (automotive, airlines, steel, etc.) • Benefits are generally not portable as they are in 401-K plans Historically, these plans were the favored retirement plans of the Ozzie and Harriet generation

  7. Defined Benefit Plans - Funding • Today’s rules (created in 1974) that govern how much money an employer must put into a pension plan are complex, confusing and do not ensure that plans become well funded • Current measures of assets and liabilities are not accurate & meaningful • Underfuned plans have too long to make up shortfalls and employers can take “funding holidays” without regard to a plan’s funding level • Maximum deductible contributions are set too low • Underfunded plans are allowed to increase benefits

  8. Defined Benefit Plans – Funding • The dilemma is that in 1980 there were about 28 million participants – today there are over 35 million participants • These numbers mask the downward trend in the DB system, as the numbers reflect not only active workers but also retirees, surviving spouses and separated vested participants. • So active participants today make up less than 50% of the total Today nearly $500 billion of pension underfunding must be spread over a base of declining active workers!

  9. Defined Benefit Plans - Funding • In 1999, the Pension Benefit Guaranty Corporation estimated total underfunding at approximately $30 billion…at the end of 2004 that number was over $450 billion • While many employers are financially healthy and should be capable of meeting their obligations, the amount of underfunding in plans sponsored by financially weaker employers has never been higher.

  10. Reasonably Possible Exposure(Dollars in Billions)

  11. The Role of the Pension Benefit Guaranty Corp. • This is the federal agency that insures private pensions • Privately funded by sponsors…essentially a per head tax of $19 that has not increased in 15 years and are not risk-based • Some retirees lose benefits when the PBGC steps in due to limits established in law by Congress (for example, workers at United Airlines will receive 80% of their accrued benefits, the shortfall being more than $3 billion) and other provisions. Some have also put forward the notion that the PBGC system creates a “moral hazard.” In other words, the presence of PBGC insurance may create incentives for struggling companies to place other financialobligations first.

  12. PBGC Net Position Single-Employer Program FY 1980 – FY 2004 Billions $9.7 $7.7 -$3.6 -$11.2 -$23.3 12

  13. PBGC • The PBGC currently has approximately $40 billion in assets • The PBGC currently has over $62 billion in liabilities with nearly $100 billion of new exposure from financially weak sponsors (it is estimated that GM’s pension obligations are underfunded by $31 billion) • The PBGC currently has over 350 active bankruptcy cases…37 of those have underfunding claims of $100 million or more, including seven in excess of $500 million • In May 2005, United Airlines pension promises were assumed by the PBGC at a then estimated nearly $10 billion The PBGC is clearly at risk…and with it the pension security of 44 million Americans.

  14. The Airline Industry - A Perfect Storm • Mature industry, heavily unionized, significant pension promises • Major airlines have reported losses over $30 billion over the past four years • Congress during this time has provided approximately $9 billion in financial assistance • In total, airline sponsored plans are estimated to be underfuned by over $30 billion It should be noted that automotive related firms may represent the greatest risk…with over $60 billion in underfunding.

  15. Delta Air Lines • The Company is currently operating under Chapter 11 of the US Bankruptcy Code • At 12/31/00, Delta reported plan assets of $10.4 billion to cover liabilities of $9.2 billion • At 12/31/05, Delta reported plan assets of $6.5 billion to cover liabilities of $12.8 billion WHAT HAPPENED IN FIVE YEARS? • Significant decrease in long-term interest rates (250 bp) • Decline in returns in equity markets (100 bp) • Financially troubled company with weak cash flows from operations

  16. Delta Air Lines Most importantly, a major business risk has emerged for Delta. Under the pilot plan, Delta pilots who retire can elect to receive 50% of their benefit currently and the other 50% as an annuity. Many pilots have elected to do this over concerns that the Plan might be terminated in bankruptcy. As of 1/31/06, 1,700 of Delta’s 5,900 pilots are at or over age 50 and thus eligible to retire at the beginning of February 2006. Delta could have a temporary or even longer-term shortage of pilots.

  17. Delta Air Lines • The pension issue poses also poses a major liquidity issue for the Company. In 2005, Delta contributed $325 million to its DB plans. • Under current funding rules, Delta estimates that its funding requirements under its plans in 2006, 2007 and 2008 to be approximately $3.4 billion! It is questionable whether Delta could make these payments currently or even when it emerges from bankruptcy.

  18. Accounting for DB Plans - FASB Guidance • SFAS 87, Employers’ Accounting for Pensions • SFAS 88, Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits • SFAS 132, Employers’ Disclosures about Pensions and Other Postretirement Benefits • Special Report, A Guide to Implementation of Statement 87 on Employers’ Accounting for Pensions • Special Report, A Guide to Implementation of Statement 88 on Employers Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits

  19. SFAS 87 Objectives • To provide a measure that • Reflects the terms of plan • Better approximates cost recognition • Is more understandable and comparable • To provide users with better information through more disclosures • To improve reporting of financial position • Minimum liability for under funded plans

  20. Generally broke the direct linkage between funding and expense • Actuarial assumptions (principally economic) may differ for funding and accounting • SFAS 87 methods for amortization not allowed for tax purposes • SFAS 87 expense (income) may be • Less than minimum ERISA contribution • Greater than maximum tax deduction SFAS 87 Impact of Funding

  21. Establishes standards for employers who offer pension benefits • Applies to all pension plans, except those offering only life or health insurance benefits • Principal focus is on defined benefit plans • Funded and unfunded • Domestic and foreign • Qualified and nonqualified • Defined contribution and multiemployer plans SFAS 87 Scope

  22. Requires single (actuarial) cost method • Provides guidance on selection of assumptions • Requires amortization of (actuarial) gains and losses in excess of a prescribed minimum • Limits methods and time periods for amortization of prior service cost • Requires transition amount computation andamortization • Requires balance sheet reflection of additional minimum liability • Expands disclosure requirements SFAS 87 Overview

  23. Benefits approach (projected unit credit method) -- required for accounting purposes • Total benefit projected for each participant • Pro rata portion of benefit for each year of service (Actuarial) PV of benefit is service cost • Cost approach (e.g., entry age normal or aggregate method) -- may be used for funding purposes • Total benefit projected • Cost of benefit is discounted • Result is allocated to each year of prospective service SFAS 87 Attribution

  24. SFAS 87 Benefit Obligations • SFAS 87 requires computation and disclosure of: • Vested benefit obligation (VBO) • Accumulated benefit obligation (ABO) • Projected benefit obligation (PBO)

  25. Periodic cost equals: • The sum of: • Service cost • Interest cost • Amortization of: -- Transition obligation -- Prior service cost -- Gains and losses • Minus: • Expected return on plan assets • Amortization of transition asset Componentof Periodic Cost

  26. Determined Prior to Year End Based on Expected Return on Assets Year-End Disclosure Using Actual Return on Plan Assets Illustration of Expense vs. Disclosure Service cost $ 20 Service cost $ 20 Interest cost 100 Interest cost 100 Expected return on assets (140) Actual return on assets (300) Amortization of Unrecognized: Amortization of Unrecognized: Transition (asset) (300) Transition (asset) (300) Prior service cost 50 Prior service cost 50 (Gains)/losses 200 (Gains)/losses 200 Subtotal amortization ( 50) Subtotal amortization ( 50) Deferral of gains/losses on plan assets during prior year 160 Net amortization and deferral 110 Total expense (70) Total expense (70)

  27. Actuarial present value of benefits attributed to services rendered during the year • Comparable to normal cost used for funding purposes • Represents the increase in PBO/APBO attributable to employee service for the period • Unaffected by plan's funded status • Flexibility: Assumption changes that increase PBO/APBO directly increase service cost SFAS 87 Service Cost

  28. PBO/APBO $10,000,000 (beginning of year*) Discount rate assumption X 7% (beginning of year) Interest cost $ 700,000 * Adjusted for benefit payments during the year SFAS 87 Interest Cost

  29. Change in discount rate has relatively little impact on interest cost in most cases SFAS 87 Interest Cost (continued) Example: Non-discount Rate Change Discount Rate Change PBO/APBO Before $1,000 $ 1,000 After 940 940 Discount rate Before 7 1/2% 7 1/2% After 7 1/2% 8% Interest cost Before $ 75.0 $75.0 After 70.5 75.2

  30. SFAS87 Returnon Plan Assets Market-related value of assets $3,000,000 (generally beginning of year) Earnings rate assumption X 9% Expected return $ 270,000 (Used for expense measurement) Actual return (Disclosed) $ 300,000

  31. SFAS 87 Return on Plan Assets (continued) • Plan assets must be segregated and restricted • May include employer securities, if transferable • Asset values based on beginning of year amount adjusted for contributions and benefit payments during the year • Market-related value is fair value or a consistently applied approach that smoothes asset-related gains/losses over period not to exceed five years • Various methodologies used to compute market-related value

  32. Market-Related Values • MRV is basis on which expected return on plan assetsis calculated • MRV may be either: • fair value, or • calculated value that smoothes asset fluctuations over period up to 5 years • method must be systematic and rational and treat gains and losses similarly • MRV generally less than current fair value due to recent increases in stock values

  33. Market-Related Values (continued) • Widely used MRV approaches: • Fair Value of plan assets at each measurement date • Moving-average amortizing realized and unrealized gains/losses over a period up to 5 years • FASB gain/loss method, used in Illustration 4 of SFAS 87 • Other approaches • Faster recognition over 2- or 3-year smoothing • Different approach for different classes of assets • Fresh start for assets of an acquired company • Immediate recognition of some portion of gain/loss in MRV and smoothing of remainder

  34. Market-Related Values Under Alternative Approaches MRV Approach FASB Gain/Loss Moving-Average MRV as of Fair Value ApproachApproach beginning of year: 1991 $100.00 $100.00 $100.00 1992 119.00 118.20 113.40 1993 140.00 138.46 128.60 1994 164.00 161.17 146.20 1995 168.00 182.13 162.20 1996 222.00 210.74 186.60

  35. Market-Related Values SFAS 87 Accounting Rules • Change in MRV method is considered a change in accounting under APB 20 • Moving closer to fair value generally meets test of preferability • Need to compute cumulative catch-up adjustment since adoption of SFAS 87 • Consider whether this catch-up adjustment is material

  36. SFAS 87 Aspects of Delayed Recognition • Changes in the PBO/APBO and value of assets are: • Not recognized as they occur, but gradually over subsequent periods • Ultimately recognized (but portion of deferred gains orlosses may be held within the corridor) • May be offset by subsequent changes • Expense recognition achieved through amortization

  37. SFAS 87 Amortization of Prior Service Cost • Declining pattern of amortization • Method similar to sum-of-the-years'-digits method • May use straight-line amortization over average remaining service period (ARSP) of employees expected to receive benefits • Amortization period - expected service period of active employees expected to receive benefits • SFAS 87: Period to expected retirement

  38. SFAS 87 Amortization of Prior ServiceCost (continued) • Negative plan amendments • First offset against any positive prior service cost • Amortize remainder • History of regular amendments • Amortize over "period benefited" (e.g., union's contract period), which may be shorter than ARSP

  39. SFAS 87 Substantive Commitment • Anticipate future amendments if: • History of regular increase • Other evidence • "Present commitment" to make future amendments • Disclose existence and nature of commitment • In practice, rarely used in pension accounting except in some rate-regulated situations

  40. Accounted for on a combined basis • Effect of assumption changes • Experience different than assumed, both asset and obligations related • Excludes difference between MV and MRV • Corridor approach • Prescribed minimum -- 10% of greater of PBO/APBOor market-related value of plan assets • Straight-line amortization over ARSP for excessoutside corridor SFAS 87 Unrecognized (Actuarial) Gains and Losses

  41. SFAS 87 Unrecognized (Actuarial) Gains and Losses (continued) • Alternative approaches permitted if meet certain tests: • Amortization greater than minimum • Method applied consistently • Method applied similarly to gains and losses • Method disclosed

  42. Balance Sheet Considerations • Accrued (prepaid) pension liability (asset) • Based on employer's cumulative contributions/benefit payments compared to cumulative FAS 87/106 expense • Additional SFAS 87 liability for unfunded accumulated benefits • ABO minus fair value of assets • Offset by intangible asset up to amount of any unrecognized prior service costs • Excess charged to stockholders' equity

  43. SFAS 87 Accounting for More Than One Plan • Measure each plan separately • Separate disclosure of overfunded and under funded plans

  44. Up to three months before year end date • May change asset values or discount rate considerably • Consider treatment of plan changes or and fiscal year end SFAS 87 Measurement Date

  45. Discount Rate: Impacts obligation, but less impact on expense -- rules require that rate selected be based on high quality bond yields at each measurement date • Risk: Using too high a rate may be questioned by auditors and also increases risk of having actuarial losses if interest rates fall • Salary Increases: Impacts pension and retiree life obligations-- rules require underlying inflation component be consistent with other assumptions (discount rate, trend rate) • Risk: Using too low a rate may result in actual salary increase higher than assumed causing annual losses to occur. • Eventually may need to change assumption (timing of which is flexible) resulting in large actuarial loss Selecting Actuarial Assumptions

  46. Earnings on Plan Assets: Direct impact on annual expense (applied to MRV) • Risk: Highly visible; also, investment experience lower than expected results in potential losses; impacts future expected return component of expense (e.g., if lower assumption in future) and potential gain/loss amortization • Health Care Cost Trend: Direct impact on obligations and expense; impact depends on whether retiree health plan is capped or not • Risk: Similar to salary scale, but may be of little impact if cost cap Selecting Actuarial Assumptions (continued)

  47. Average Per Capita Costs: Direct impact on retiree health expense; costs driven by plan design and recent claims experience • Risk: Too low a rate might generate losses in future • Demographic assumptions (turnover, retirement age, mortality): Greater impact on retiree health than on pensions • Other Retiree Health Assumptions (e.g., percent married and electing coverage): Impacts retiree health obligations and expense • Risk: Too low might generate losses Selecting Actuarial Assumptions (continued)

  48. SFAS 132 Defined Benefit Plan Disclosures • Description of the plan • Components of pension expense • Reconciliation of the funded status of the plan to the employer's balance sheet • Weighted-average assumed discount, earnings and salary progression rates • Alternative amortization methods • Related party transactions

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