HRS Insight Human Resource Services

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1 HRS Insight Human Resource Services June 27, 2011 HRS Insight 11/11 Accounting for Pension Buy-In Arrangements Authored by: Ken Stoler, Partner The first pension "buy-inpurchased by a U.S. pension plan. This buy-in contract was recently arrangement is similar to a traditional nonparticipating annuity (a "buy-out"), where a plan transfers future responsibility for promised employee retirement benefits to an insurance company. Under the buy-in arrangement, however, the benefit obligation is not transferred to the insurer. Instead, the plan remains responsible for paying the benefits, but purchases a contract from the insurer which generates returns designed to equal all future benefits payments to covered participants. When accounting for a traditional buy-out annuity, the purchase of the annuity generally triggers settlement accounting, with often a significant income statement effect. The buy-in contract, however, typically generates no settlement but retains certain other advantages of an annuity purchase. This HRS Insight explores the advantages and disadvantages, and the accounting implications, of buy-in arrangements. Background Purchases of buy-in contracts have been gaining popularity overseas, but until recently had not been sold in the U.S. In May 2011, the first U.S.-based buy-in arrangement was completed. This contract offers the employer the ability to "lock in" the cash cost of some of its pension benefit obligation and virtually eliminate future volatility, while continuing to maintain the plan and offer benefits to employees. The buy-in contract is held by the pension plan, and essentially reimburses the plan for all future benefit payments covered by the contract. That is, as benefit payments are made

2 by the plan, the insurer will make equal payments to the plan under the buy-in contract. As a result, the net ongoing cash flow to the plan for the covered participants is nil, and the cost of providing benefits is entirely funded by the buy-in contract. The contract is generally a single-premium arrangement, where an upfront payment is made by the pension plan to the insurer in exchange for the contract. The buy-in is often priced similar to a buy-out annuity, since the economics are nearly the same (insurer taking on responsibility to make annual payments sufficient to cover promised retirement benefits). Generally, the buy-in contract also allows the holder to covert the arrangement to a buy-out annuity upon request and for no additional cost. After acquiring the buy-in contract, the employer has eliminated the risks associated with changes in the benefit obligation due to changing mortality rates, fluctuating interest rates, etc. However, the employer has not eliminated all risk, because the ability of the insurer to make good on the contract (i.e., the insurer's credit risk) remains. To the extent the insurer is unable to make payment in full on the buy-in contract; the employer would still be responsible for all promised benefit payments. Observation: The buy-in contract may cover some or all of the plan's existing benefit obligation, depending on the specific situation. For example, an employer may wish to purchase a contract covering only the benefits currently in payment status to retirees but not cover active employee's future benefits. For frozen plans, some employers may consider a contract that covers the entire benefit obligation. Each employer should assess its specific circumstances, and the associated benefits or drawbacks, in evaluating whether to purchase a buy-in contract. Accounting for a Buy-In Arrangement When a traditional non-participating buy-out annuity is purchased, an employer generally applies settlement accounting. The pension obligation is removed from the books, as are the assets used to purchase the annuity. If the price of the annuity contract exceeds the carrying value of the obligation, as is often the case, the excess is a loss. Any gains or losses deferred in accumulated other comprehensive income are also recognized in the income statement as part of the settlement gain or loss. Special rules apply if only part of the benefit obligation is settled. Observation: Since most plans today have deferred losses reflected in accumulated other comprehensive income, settlement via annuity purchase generally results in a significant income statement loss. In order to qualify for a settlement, the accounting literature 1 requires that three criteria all be met: 1) The action is irrevocable, 2) The employer is relieved of primary responsibility for the obligation, and 1 The US GAAP pension accounting literature addressing settlement accounting is in ASC International financial reporting standards (IFRS) related to settlement accounting are generally consistent with US GAAP.

3 3) The transaction eliminates significant risks related to the obligation and assets used to effect the settlement In the case of a buy-in contract, these three criteria are typically not met. First, the buy-in contract is often not irrevocable, as it may include a provision under which the arrangement can be terminated. A pre-defined cash surrender value or termination formula may be negotiated up front, and while a significant terminationn penalty may exist, it nonetheless affords the employer the ability to unwind the transactionn if desired. Based on this, the arrangement would not qualify for settlement accounting. In addition, settlementt accounting is not appropriate because the employer is not relieved of primary responsibility for the obligation. Under the terms of the contract the insurer is not assuming the retirement benefit obligation, and the employer remains responsible for the plan and making benefit payments to the plan participants. The employer continues to be considered the plan sponsor under ERISA. Unlike an annuity contract, where participants are notified that responsibility for payment of their benefits has been transferred to the insurer and the employer is no longer involved, participants are not notified of the buy-icannot look to the insurer for payments arrangement and directly. Furthermore, the employer/plan trustees could decide to use the money received under the buy-in contract for other purposes under the plan (i.e. to purchase other investments). The buy-in contract effectively is an investment by which the plan can receive payments from the insurer corresponding to the benefits due to the covered participants, but ultimately the primary responsibility has not been transferred. Thus, in the event the insurer was unable to make payment under the buy-in (for example, due to bankruptcy) ), the employer would still be obligated for the promised retirement benefits. Ongoing Pension Accounting for the Buy-In Asset Since settlement accounting is not applied and the contract is not considered an annuity, the buy-in contract represents an investment asset of the plan. Typically, the pension trust (and not the employer) would acquire the buy-in contract, and thus it would be accounted for as a plan asset. Plan assets are recorded at fair value as of each measurement date, and are therefore generally remeasured annually (unless an interim remeasurement is required if a significant event occurs). In presentation on the balance sheet the fair value of plan assets is netted against the related pension obligation. In determining the appropriate value at which to present these buy-in assets, the accounting literature is not clear. Accordingly, we believe that the following two approaches are acceptable. Under the first approach, the fair value of the buy-in contract is directly measured at each plan measurement date. Initially, this fair value would be based on the purchase price of the contract. In subsequent measurements, fair value would be estimated based on the contract's 'exit price' 2, or the amount at which the contract could be sold to a willing third- 2 As defined in ASC 820, Fair Value Measurements and Disclosures

4 party buyer. Estimating this value would likely include similar considerations as were used by the insurer when originally pricing the buy-in contract, including factors based on assumptions about the plan participants covered under the contract, such as changes in expected mortality. It would also be based on the current discount rate inherent in the contract. This rate would likely be the same rate used by an insurerr in the current price of a buy-out annuity, often using the PBGC published rate for single-employer pension annuities 3. The second approach is based on the guidance in the accounting literature addressing valuation of insurance contracts that are not annuities 4. This guidance notes that such contracts should be reflected at fair value, but indicates that if the contract has a stated cash surrender value, this can be used as a proxy for fair value. For many insurance contracts held in a pension trust, the cash surrender value (if any) is considered to be reflective of fair value and thus is used for reporting purposes. In the case of buy-in arrangements, however, while a cash-out formula may exist, this value generally incorporates a fairly sizeable termination penalty. Based on this, while use of the surrender value would be acceptable, we believe it is not required since the surrender value generally would not represent a good proxy for fair value due to the penalty provision. 3 The Pension Benefit Guarantee Corporation (PBGC) publishes monthly rates used in valuing single-employer annuity benefits on its website at 4 ASC discusses valuation of insurance contracts that are not annuities Ongoing Accounting for the Pension Benefit Obligation When a buy-in contract is acquired, there is a question as to whether any adjustment in the measurement of the associated benefit obligation is necessary. Again, the accounting literature is not clear and therefore we believe that two approaches are acceptable. Under the first alternative, the benefit obligation covered by the buy-in contract would continue to be measured with the traditional discount rate and mortality assumptions used by the employer. The discount rate is generally based on yields of high-quality corporate bonds at each measurement date. We would expect the value of the buy-in contract asset to exceed the value of the benefit obligation under this approach; while both would be based on similar participant demographics, the discount rate used in valuing the obligation would likely be higher than the rate inherent in the buy-in contract (which, as discussed above, is likely based on lower PBGC annuity rates). In addition, the value of the buy-in contract may be based on different mortality assumptions. Under the second alternative, the value of the benefit obligation associated with the participants covered by the contract would be set equal to the fair value of the buy-in contract at each measurement date. This approach is considered supportable because the guidance on establishing discount rates 5 calls for the rate at which the obligation could be 'effectively settled.' While purchase of the buy-in contract does not result in an actual settlement, it can be viewed to result in an effective settlement since 5 ASC

5 the majority of the risks and rewards associated with the benefit obligation and related assets has been eliminated. As a result, the discount rate used in pricing the buy-in contract also represents the rate at which the obligation can be effectively settled. Under this approach, it is also considered acceptable to change the mortality assumption to that reflected in the value of the buy-in contract. If this second alternative is followed, an actuarial loss will need to be recognized at the next plan measurement date, since the benefit obligation will be increased to match the (generally higher) purchase price of the buy-in contract. For example, if the benefit obligation was $100 before purchasing a buy-in contract for $105, the obligation would be reset to $105, and a $5 actuarial losss would be reflected in other comprehensive income. After this initial Summary of Reporting Impact remeasurement, the fair value of the buy-in asset and the associated benefit obligation should be equal, other than potential breakage due to changes in credit quality of the insurer. Going forward, we would generally expect the asset and obligation to continue to move in tandem. Likewise, the expected return on plan assets related to the buy-in contract and the related interest cost on the associated benefit obligation recognized as components of net periodic benefit cost should be equal and offsetting. Observation: If the buy-in contract covers only a portion of the plan obligation and participants, determination of the appropriate discount rate and expected return on assets to use may be more complex. The following table provides a high-level summary of the financial reporting impact of a decision to purchase a buy-in contract, a buy-out annuity, or maintaining current status quo.

6 Balance Sheet Impact Current Income Statement Impact Future Income Statement Impact Buy-in contract No change. Pension obligation remains. Buy-in contract is plan asset. No settlement gain/loss Continued amortization of gain/loss deferred in AOCI. Expense could increase if expected return on buy-in asset is less than previous assumed return, but expense will be less volatile. Buy-out annuity Remove pension obligation and related plan assets Recognize settlement gain/loss on recognition of amounts deferred in AOCI, including the gain/loss arising on purchase of annuity No future amortization of gain/loss deferred in AOCI. No expense volatility going forward Status quo No change in pension obligation and plan assets No settlement gain/loss Continued amortization of gain/loss deferred in AOCI and continued application of expected return assumption to plan assets How PwC Can Help PwC has considerable expertise with respect to the accounting and disclosure for pension and OPEB plans. In addition, we can help you better understand the complex issues related to pension investment strategies, actuarial measurements, taxation and funding. Please contact one of the individuals listed below, or your local engagement partner, to further discuss how PwC can help.

7 For more information, please do not hesitate to contact your local PwC professional: Charlie Yovino Ed Donovan Matthew Cowell Pat Meyer Jack Abraham Paul Perry Terry Richardson Cindy Fraterrigo Brandon Yerre Theresa Gee Todd Hoffman Carrie Duarte John Caplan Scott Olsen Bruce Clouser Bill Dunn Amy Lynn Flood Sandra Hunt Julie Rumberger Scott Pollack Jeff Davis Nik Shah (678) Atlanta, GA (704) Charlotte, NC (617) Boston, MA (646) New York Metro (617) Boston, MA (312) Chicago, IL (312) Chicago, IL (312) Chicago, IL (312) Chicago, IL Kansas City, MO St. Louis, MO (312) Chicago, IL (214) Dallas, TX (312) Detroit, MI (713) Houston, TX (213) Los Angeles, CA (646) New York Metro (646) New York Metro (267) Philadelphia, PA (267) Philadelphia, PA (267) Philadelphia, PA (415) San Francisco, CA (408) San Francisco, CA San Jose, CA (408) San Jose, CA (202) Washington, DC (202) Washington, DC This document is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. SOLICITATION 2011 PricewaterhouseCoopers s LLP. All rights reserved. In this document, "PwC" refers to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of whichh is a separate legal entity.