Actuarial 101 and 201 Accounting Concepts for Retirement and Welfare Plans

1. Actuarial 101 and 201Accounting Concepts for Retirement and Welfare Plans Pension Accounting Basics Instructors: Joe Rankin David Grubb Vince Mannino

2. Goals • Overview accounting issuesfor pensions and other postretirement benefit plans. • Distinguish between defined contribution and defined benefit plans and welfare benefit plans. • Define very high level accounting concepts; discuss why the concepts are important; elaborate on the most difficult itemsto understand. Non-Goals • Make Actuarial Science fun and exciting! • Differentiate between the funding, termination, tax and accounting issues. • Understand the difference between the plan perspective and the company perspective.

3. Historical Perspective FASB • It was difficult to compare the pension accounting of one company to that of another. • Broad use of varying assumptions and methods. • The first pension accounting statement, Statement No. 35, Accounting and Reporting by Defined Benefit Pension Plans provided for reporting annual financial statements of defined benefit plans at the plan level (as opposed to the employer level).

4. Historical Perspective FASB – FAS 87 • The second pension statement, FAS 87, Employers' Accounting for Pensions, issued in the mid-1980s, is more conceptually “reliable” in that it matches the future benefits due the employee to the period in which the obligation is incurred.

5. Historical Perspective FASB – FAS 88 • Also issued in the mid 1980s was FAS 88, Employers' Accounting for Settlements and Curtailments of Defined Benefit Plans and for Termination Benefits which prescribes an employer's accounting for defined benefit pension plans that are curtailed (i.e., ended) and/or settled. • FAS 106 deals with retiree medical and health plans; previously employers accounted for the costs associated with postretirement benefits on a pay-as-you-go basis.

6. Historical Perspective FASB – FAS 132 • FAS 132 standardized the disclosures required for pension and other postretirement benefits, required some additional information from employers, and eliminated disclosures that were no longer considered useful.

7. Historical Perspective FASB – FAS 158 • Financial Accounting Standards No. 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans; this standard generally requires plan assets and liabilities to be measured as of the same date as the other assets and liabilities appearing on the balance sheet.

8. Retirement Plans Defined Contribution Plans • For purposes of pension accounting, a defined contribution plan is one in which the sponsor (i.e., the employer) provides pension benefits to employees in return for services rendered. • The plan provides an individual account for each participant. • Defined contribution retirement plans include: • 401(k) plans • Simplified Employee Pension plans - SEPs • Savings Incentive Match Plan for Employees - SIMPLEs • KEOGH (HR10) plans • Individual participant bears the investment risk in most account balance plans.

9. Retirement Plans Defined Benefit Plans • Under a defined benefit plan, the responsibility of providing for the employee in retirement remains with the employer. • Employer bears the investment risk in most defined benefit plans.

10. Retirement Plans Defined Benefit Plans Benefit Formulas The employer agrees to provide the employee upon retirement a benefit amount based on a “definitely determinable” benefit formula. Typically, the formula is one of three general types: (1) Flat-Benefit Formula • The flat-benefit formula pays a flat dollar amount for each year of service recognized under the plan. For example, an employee's monthly pension might equal $20 multiplied by the number of years of service. An employee under this plan who worked for 25 years would receive a monthly benefit of $500 ($20 × 25 years).

11. Retirement Plans Defined Benefit Plans Benefit Formulas (2) Career-Average Formulas • There are variations of career-average formulas. Generally, the employee earns a percentage of the pay recognized for plan purposes in each year he or she is a plan participant. For example, assume that the benefit is based on 2% of an employee's career average monthly salary of $5,000 and that the employee has 25 years of service. The monthly benefit would be $2,500 (.02 × $5,000 × 25 years).

12. Retirement Plans Defined Benefit Plans Benefit Formulas (3) Final-Pay Formulas • Under final-pay formulas, benefits are based on a predetermined percentage of the average earnings of the employee for a stated period preceding retirement multiplied by the employee's years of service. • For example, assume that the plan uses 2% formula and that an employee's average monthly salary over the specified three-year period was $10,000 and that he or she worked for 25 years. The employee would receive monthly benefits of $5,000 in retirement (.02 × $10,000 × 25 years).

13. Retirement Plans Defined Benefit Plans Cash Balance Plans • Although classified as a defined benefit plan, a cash-balance pension plan is really a hybrid sharing many of the characteristics of a defined contribution plan; under a cash-balance plan, the employer contributes a percentage of an employee's salary (e.g., 2%- 5%) to the pension trust based on a formula. In addition, the employer guarantees the employee a certain rate of return on the funds invested.

14. Retirement Plans Defined Benefit Plans Cash Balance Plans • The FASB is concerned with the classification of the cash-balance plan since it contains features of both the defined benefit and defined contribution plans. In FAS 87, the FASB commented as follows: A pension plan having characteristics of both a defined benefit plan and a defined contribution plan requires careful analysis. If the substance of the plan is to provide a defined benefit as may be the case with some "target benefit" plans the accounting requirements shall be determined in accordance with the provisions of this statement [FAS 87] applicable to a defined benefit plan and the disclosure requirement shall be determined in accordance with the provisions of paragraphs 5 and 8 of statement 132(R).

15. Retirement Plans Defined Benefit Plans Single-Employer, Multi-Employer, and Multiple-Employer Plans • FAS 87 primarily addresses single-employer plans. Single-employer plans are generally maintained by one employer, although the term also describes plans maintained by related parties such as a parent company and its subsidiaries. • Employers may maintain more than one pension plan for employees or particular categories of employees.

16. Retirement Plans Defined Benefit Plans Multi-Employer Plans • Under a multi-employer plan, two or more unrelated employers contribute assets to one pension plan generally administered by a board of trustees. • A multi-employer plan usually results from a collective-bargaining agreement. As such, the board of trustees is often composed of representatives of management and unions. • Multi-employer plans are frequently referred to as joint trusts or union plans.

17. Retirement Plans PANEL DISCUSSION – Multiemployer Plans The FASB has issues an exposure draft on an “Employer’s Participation in a Multiemployer plan”. • How do multiemployer plans work – both at the plan level and the employer accounting level? • What is the FASB exposure draft intending to accomplish? • What is the likely impact on employer’s that participate in Multiemployer plans?

18. Actuarial 101 and 201Accounting Concepts for Retirement and Welfare Plans FAS 87 Employers' Accounting for Pensions

19. FAS 87 Although FAS 87 superseded all previous standards for employers' accounting for pensions, it did retain three fundamental features of preceding official pronouncements on pension accounting: • delayed recognition of certain events, • net cost, and • offsetting liabilities and assets.

20. FAS 87 Features Retained from Previous Pronouncements 1. Delayed Recognition • Rather than being expensed as they occur, certain changes in the pension obligation and plan assets are recognized gradually and systematically in net periodic pension cost over subsequent periods. • For example, assume an employer amends a current pension plan to increase the benefits paid to employees in retirement by five percent per year. Rather than charge this increase in benefit obligation to pension expense for the period, the employer gradually amortizes the expense over the average remaining service years of employees covered by the amended plan.

21. FAS 87 Features Retained from Previous Pronouncements 2. Net Cost • "Net periodic pension cost" refers to the amount recognized in an employer's financial statements as the cost of a pension plan for a period. • Net periodic pension cost has several components. Some of these components, such as service and interest costs, add to a company's net periodic pension expense. Others, such as the expected return on plan assets, reduce these expenses.

22. FAS 87 Features Retained from Previous Pronouncements 3. Offsetting Liabilities and Assets • Neither the assets contributed by the employer to the pension plan nor the full pension liability appears on the balance sheet. Rather, it is the difference between total employer contributions to the plan (plan assets) and the pension obligation (liability) that is included in the balance sheet. • If cumulative contributions exceed the pension obligation, the excess appears in an asset account, prepaid pension cost. If cumulative costs exceed cumulative contributions, the difference appears in a liability account, accrued pension cost.

23. FAS 87 1. Basic Liability Terminology • Vested Benefit Obligation (VBO) • Accumulated Benefit Obligation (ABO) • Projected Benefit Obligation (PBO)

26. FAS 87 2. Determining the Discount Rate • The higher the discount rate used, the lower the pension obligation. The lower the discount rate used, the larger the pension obligation.

27. Liabilities Increase as Discount Rate Decreases

28. FAS 87 2. Determining the Discount Rate • The objective of selecting assumed discount rates is to measure the single amount that, if invested at the measurement date in a portfolio of high-quality debt instruments, would provide the necessary future cash flows to pay the accumulated benefits when due. • Discount rates are determined using current market conditions.

29. FAS 87 2. Determining the Discount Rate • http://www.soa.org/professional-interests/pension/resources/pen-resources-pension.aspx

30. FAS 87 PANEL DISCUSSION – Discount Assumption • What role does the discount rate play in determining liabilities? • Why is the discount rate an important consideration in today’s economic environment? • What other factors and assumptions require careful review? Why? • What is the role of auditor in reviewing the assumptions set by the actuary?

31. FAS 87 3. Plan Assets • Generally, fair value is required to be used for FAS 87 underERISA. This method applies to investments held in the plan under FAS 87 as well.

32. FAS 87 4. Measurement Date • Pension obligations need to be measured as of the date of the financial statements. Prior to FAS 158, the employer may select a date that is not more than three months prior to that date if used consistently from year to year.

33. FAS 87 Pension Benefit Obligation (PBO) Projected Benefit Obligation (BOY)   + Service cost   + Interest cost – Benefits paid to retirees   = Projected Benefit Obligation (EOY)

34. FAS 87 Net Periodic Pension Cost • The amount recognized in an employer’s financial statements as the cost of a pension plan for a period. • Components of net periodic pension cost are service cost, interest cost, actual return on plan assets, gain or loss, amortization of prior service cost or credit, and amortization of the transition asset or obligation existing at the date of initial application of … Statement 87. • The basic formula is: Service cost + Interest cost – Expected return on plans assets

35. FAS 87 Net Periodic Pension Cost a. Service Cost – Service cost is defined by FAS 87 as "the actuarial present value of benefits attributed by the pension benefit formula to services rendered by employees during that period.” b. Interest Cost – Interest cost recognizes the effect of the passage of another year on the pension obligation; it is a measure of the PBO multiplied by the assumed discount rates. c. Expected Return on Plan Assets – An expected rather than the actual return on plan assets.

36. FAS 87 Net Periodic Pension Cost Additional Elements of Net Periodic Pension Cost • Prior Service Costs – FAS 87 allows for the gradual, amortized recognition of the amended benefits. • Unrecognized Actuarial Losses and Gains – gains and losses – resulting from experience different than assumed.

37. FAS 87 Additional Issues 1. Business Combinations 2. Non-U.S. Pension Plans – (IAS 19 is the standards that governs most such arrangements.) 3. Pension Accounting for Smaller Employees 4. Insurance Companies Fail to Provide Annuity Benefits

38. FAS 87 PANEL DISCUSSION – Pension Protection Act The Pension Protection Act of 2006 has had far reaching impact on employer funding of defined benefit pension plans. • How does the more aggressive funding requirement impact accounting? • How has subsequent legislation such as Pension Relief Act of 2010 impacted plan funding?

39. Actuarial 101 and 201Accounting Concepts for Retirement and Welfare Plans FAS 88 Settlements and Curtailment of Benefits

40. FAS 88 Settlements and Curtailment of Benefits • For purposes of this FAS 88, a curtailment is an event that significantly reduces the expected years of future service of present employees or eliminates for a significant number of employees the accrual of defined benefits for some or all of their future services. Curtailments include: • Termination of employees' services earlier than expected, which may or may not involve closing a facility or discontinuing a segment of a business. • Termination or suspension of a plan so that employees do not earn additional defined benefits for future services. In the latter situation, future service may be counted toward vesting of benefits accumulated based on past service. [FASB Statement No. 88]

41. FAS 88 Settlements and Curtailment of Benefits • FAS 88 specifies when these previously unrecognized amounts are to be recognized in earnings and as adjustments to assets and liabilities. • Examples of a settlement or curtailment include: • Pension plan is terminated AND obligations are settled by the purchase of annuities. • Defined benefit plan is “frozen” where benefits no longer accrue to any participant – “hard freeze”. • Defined benefit plan is “frozen” where benefits no longer accrue to any new participant but some participants still accrue benefits – “soft freeze”. • A defined benefit plan exists where a substantial number of employees are terminated.

42. FAS 88 Settlements and Curtailment of Benefits Settlements • A settlement is defined as a transaction that (a) is an irrevocable action, (b) relieves the employer (or the plan) of primary responsibility for a pension benefit obligation, AND (c) eliminates significant risks related to the obligation and the assets used to effect the settlement. [FASB Statement No. 88]

43. FAS 88 Termination and Curtailment of Benefits Curtailments • FAS 88 defines a curtailment as "an event that significantly reduces the expected years of future service of current employees or eliminates for a significant number of employees the accrual of defined benefits for some or all of their future services.“ [FASB Statement No. 88] • This event may be the result of termination of the employee's services or of the defined benefit plan. Not all curtailments are settlements.

44. FAS 88 Termination and Curtailment of Benefits Asset Reversion • In plans where plan assets exceed pension obligations, the excess assets MAY revert back to the employer.

45. FAS 88 PANEL DISCUSSION – Curtailments • In what particular situations must settlement accounting used? • Generally, what is the impact of settlement accounting ? • Do different types of benefit “freezes” treated differently for settlement account?

46. Actuarial 101 and 201Accounting Concepts for Retirement and Welfare Plans FAS 106 Accounting for Post-Employment Benefits Other Than Pensions Instructor: Joe Rankin

47. FAS 106 – Financial Accounting Standards FASB statement No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions. Benefits Reported Under FAS 106 • Postretirement benefits include but are not limited to: • post-retirement health care • life insurance provided outside a pension plan • Other welfare benefits such as day care and tuition assistance. This kind of obligation may or may not be funded.

48. FAS 106 – Financial Accounting Standards FASB statement No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions. Benefits Reported Under FAS 106 • FAS 106 applies to any arrangement – written or unwritten – that is in substance a post-retirement benefit plan. Benefits Not Reported Under FAS 106 • FAS 106 does not apply to employer pension plans or life insurance benefits or other ancillary benefits provided through a pension plan.

49. FAS 106 – Financial Accounting Standards FASB statement No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions. … objectives in issuing this Statement are to improve employers' financial reporting for postretirement benefits in the following manner: • To enhance the relevance and representational faithfulness of the employer's reported results of operations by recognizing net periodic postretirement benefit cost as employees render the services necessary to earn their postretirement benefits. • To enhance the relevance and representational faithfulness of the employer's statement of financial position by including a measure of the obligation to provide post retirement benefits based on a mutual understanding between the employer and its employees of the terms of the underlying plan.

50. FAS 106 – Financial Accounting Standards FASB statement No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions. • To enhance the ability of users of the employer's financial statements to understand the extent and effects of the employer's undertaking to provide postretirement benefits to its employees by disclosing relevant information about the obligation and cost of the post retirement benefit plan and how those amounts are measured. • To improve the understandability and comparability of amounts reported by requiring employers with similar plans to use the same method to measure their accumulated postretirement benefit obligations and the related costs of the postretirement benefits. [FASB Statement No. 106]