This Briefing Paper provides an introduction to the recent changes in Cost Accounting Standards 412 1

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1 This material from Briefing Papers has been reproduced with the permission of the publisher, Thomson Reuters. Further use without the permission of the publisher is prohibited. For additional information or to subscribe, call or visit west.thomson.com/fedpub. Briefing Papers is now available on Westlaw. Visit westlaw.com Briefing papers Second Series practical tight-knit briefings including action guidelines on government contract topics A Brief Guide To Pension Harmonization By Cheryl A. LeeVan and Martin P. Willard This Briefing Paper provides an introduction to the recent changes in Cost Accounting Standards and known as the pension harmonization rule. 3 The CAS Board promulgated its harmonization rule in late 2011 to harmonize the CAS with the Pension Protection Act of 2006, 4 which Congress had enacted to strengthen employee pension plans. Pension costs are a significant cost for many federal contractors, and although the Federal Acquisition Regulation generally addresses allowability of contractor costs, 5 CAS 412 and 413 have, since the mid-1970s, provided specific guidance to contractors regarding the proper measurement, assignment, and allocation of pension costs. As a result, CAS 412 and 413 provide the criteria for determining whether and how contractors may recover pension costs under their federal contracts. 6 Because this Briefing Paper is intended as an introduction to CAS harmonization, it begins with a brief discussion of the CAS generally and the origins and goals of CAS 412 and 413 prior to harmonization. The Paper then addresses the PPA, the CAS Board s recent harmonization rule, critiques of the rule, actions contractors need to take as a result of the rule, and underlying policy considerations. IN BRIEF CAS 412 & CAS 413 Prior To Harmonization The Pension Protection Act Of 2006 The CAS Board s Harmonization Rule Did The CAS Board Get It Right? What s Next For Contractors? The Policies Underlying The Harmonization Rule CAS 412 & CAS 413 Prior To Harmonization In 1970, Congress created the CAS Board and authorized it to promulgate cost accounting standards designed to achieve uniformity and consistency in Cheryl A. LeeVan is a Vice President and founding member of TM Financial Forensics, LLC. Martin P. Willard is a partner in the Washington, D.C. office of Wiley Rein LLP. The authors wish to thank Lawrence S. Rabyne for his helpful suggestions. Mr. Rabyne is not responsible for the views expressed herein, which are solely those of the authors. NO AUGUST 2012 THOMSON REUTERS COPYRIGHT 2012 ALL RIGHTS RESERVED

2 costs accounting principles followed by defense contractors and subcontractors. 7 Despite having established several key accounting principles for use in cost reimbursable contracts in its first 10 years, in 1980, Congress did not provide an appropriation for the CAS Board, and it ceased functioning. 8 The Office of Federal Procurement Policy Act Amendments of 1988 amended the 1974 OFPP Act to establish the CAS Board as an independent board within the Office of Federal Procurement Policy 9 and, in the process, repealed the 1970 statute that established the original CAS Board. 10 The 1988 statute gives the revived CAS Board exclusive authority to make, promulgate, amend, and rescind cost accounting standards and interpretations thereof designed to achieve uniformity and consistency in the cost accounting standards governing measurement, assignment, and allocation of costs to contracts with the United States. 11 The CAS promulgated under this authority are, with certain statutory exceptions and exemptions defined by the CAS Board, mandatory for use by all executive agencies and by contractors and subcontractors in estimating, accumulating, and reporting costs in connection with pricing and administration of, and settlement of disputes concerning [certain contract and subcontract procurements]. 12 The newly formed board adopted and recodified all of the previously adopted CAS in 1992 in Title 48, Chapter 99, of the Code of Federal Regulations. 13 The CAS apply to certain negotiated Government contracts and subcontracts. 14 CAS-covered contracts contain the Cost Accounting Standards clause, which requires the contractor to comply with all CAS in effect and with any later modifications or amendments. 15 Contractors not subject to full CAS may be subject to modified CAS a smaller subset of the CAS applicable to contractors that do not meet all the conditions for full CAS coverage C.F.R specifies which types of contracts are exempt from the CAS, and 48 C.F.R describes whether a business unit is subject to full or modified CAS, depending upon the size and quantity of CAS-covered contracts awarded to that unit. In general, large federal contractors are subject to full CAS coverage, 17 and CAS 412 and 413, the focus of this Paper, are elements of this coverage. The CAS are often viewed as a complement to FAR cost principles: while the CAS address the allocability of costs to cost objectives, they do not regulate issues of cost allowability or contract pricing. 18 On the other hand, the concept of allowability is a procurement concept affecting contract price and in most cases is established in regulatory or contractual provisions. 19 One of the costs incurred by federal contractors is the cost of maintaining defined benefit pension plans. Under a defined benefit pension plan, a contractor guarantees payment of future benefits to current and former employees. 20 The costs incurred by contractors are the payments that contractors make to ensure that money is available to make the guaranteed payments at a later date. These costs are a function of a number of variables, including the rate of return for assets deposited for purposes of making the future payments and the estimated beginning and end dates of the payments made to pension plan participants. CAS 412, Cost Accounting Standard for Composition and Measurement of Pension Cost, 21 Briefing Papers (ISSN ) is published monthly except January (two issues) and copyrighted 2012 Valerie L. Gross, Editor Periodicals postage paid at St. Paul, MN Published by Thomson Reuters / 610 Opperman Drive, P.O. Box / St. Paul, MN west. thomson.com Customer Service: (800) Postmaster: Send address changes to Briefing Papers / PO Box / St. Paul, MN BRIEFING PAPERS This publication was created to provide you with accurate and authoritative information concerning the subject matter covered; however, this publication was not necessarily prepared by persons licensed to practice law in a particular jurisdiction. The publisher is not engaged in rendering legal or other professional advice, and this publication is not a substitute for the advice of an attorney. If you require legal or other expert advice, you should seek the services of a competent attorney or other professional. Briefing Papers is a registered trademark used herein under license. All rights reserved. Reproduction, storage in a retrieval system, or transmission of this publication or any portion of it in any form or by any means, electronic, mechanical, photocopy, xerography, facsimile, recording or otherwise, without the written permission of Thomson Reuters is prohibited. For authorization to photocopy, please contact the Copyright Clearance Center at 222 Rosewood Drive, Danvers, MA 01923, (978) ; fax (978) or West s Copyright Services at 610 Opperman Drive, Eagan, MN 55123, fax (651)

3 instructs contractors how to measure current pension costs, at least for purposes of their federal contract accounting. Originally promulgated in 1975, 22 CAS 412 in general requires contractors to measure those costs using best actuarial estimates of the pension plan s earnings and benefit payments, taking into account the plan s past experience and reasonable expectations. 23 CAS 412 further requires that [a]ctuarial assumptions shall reflect long-term trends so as to avoid distortions caused by short-term fluctuations. 24 For purposes of allocation to federal contracts, the contractor determines the pension cost as a whole, allocates the costs among its various divisions or segments, and then further allocates them among the various contracts. 25 CAS 413, Adjustment and Allocation of Pension Cost, 26 was originally promulgated in 1977, effective in It provides for certain adjustments in a contractor s pension costs. The first adjustment accounts for a pension plan s actuarial gains and losses. 28 When a contractor s cost experience differs from its estimates, the differences (whether they are gains or losses) were under the original CAS 413 to be amortized in equal installments over a 15-year period. 29 Actuarial gains and losses are to be calculated annually and are to be assigned to the cost accounting period for which the actuarial valuation is made and subsequent accounting periods. 30 CAS 413 also addresses the adjustments available to the contractor when a segment is closed. In the event of a segment closing that is, a closing of a one of two or more divisions, product departments, plants, or other subdivisions of an organization reporting directly to a home office, 31 the difference between the market value of the assets in the pension plan and the actuarial liability of the plan as of the date of the event that caused the segment closing represents an adjustment of previously-determined pension costs. 32 In the preamble to the original CAS 413, the CAS Board stated the rule s purpose as follows: 33 As a general rule, [CAS 413] is based on the concept that material actuarial gains and losses applicable to a segment will be taken into account in future cost accounting periods in determining costs for the segment. However, a problem arises in cases where a segment is closed. Because there are no future periods in which to adjust previously determined pension costs applicable to that segment, a means must be developed to provide a basis for adjusting such costs. CAS 412 and 413 have, historically, borne a relation to the Employee Retirement Security Act of The original CAS 412 and 413 were promulgated in direct response to ERISA. 35 The CAS Board was concerned that ERISA did not adequately or fully address issues that might arise for federal contractors how to assign pension costs to cost accounting periods and allocate them among their various contracts. 36 CAS 412 and 413 sought to provide additional guidance to contractors in this regard. The CAS Board has said that the distinct purposes of financial accounting under ERISA and Government contract cost accounting may result in different rules. In General Electric Co. v. United States, the U.S. Court of Federal Claims described the differences between ERISA and the CAS: 37 In its promulgation comments, the CAS Board explained that CAS 412 was intended to fill in gaps not established by ERISA and to identify the differences between the financial accounting of pensions and the cost accounting of pensions. For example, the promulgation comments state that ERISA does not provide for the measurement of pension costs for assignment among cost accounting periods or for the subsequent allocation of such costs to contracts. Accordingly, CAS 412 contains requirements not contained in ERISA to accomplish these purposes. 40 Fed. Reg. 43,873, Pt. 412, Preamble A. The CAS Board also stated in the promulgation comments that the financial accounting of pension costs and the cost accounting of pension costs serve different purposes and therefore financial accounting principles are not necessarily applicable to cost accounting. The court then contrasted the assumptions underlying CAS 412 with those underlying financial accounting: 38 It is plain from the language of CAS 412 that contractors are expected to use different assumptions for CAS 412 purposes than they are to use for [financial accounting] purposes. CAS 412 actuarial assumptions are to be developed based on the contractor s past experience as well as reasonable expectations for the future. The interest rate assumption for [financial accounting], in contrast, is to be developed based on the returns being earned by the plan assets in the fund and the rates of return expected to be available for reinvestment. Thus, the focus of the [financial accounting] determination is plainly 3

4 on the plan s current returns as opposed to rates that were obtained in the past. As discussed below, differences in the treatment of pension costs under ERISA and the CAS persist to this day, even after the CAS Board s harmonization rule. Over the years, contractors and the Federal Government have disputed, and litigated, a wide variety of issues relating to the proper interpretation and application of the original CAS 412 and 413. They argued about whether the termination of a pension plan is a segment closing under original CAS 413. (It is not.) 39 They debated whether the sale of a subsidiary is a segment closing under the original CAS 413. (It is.) 40 They argued about whether the original CAS 413 requires an adjustment of fixedprice as well as flexibly priced contracts in the segment closing adjustment. (It does not.) 41 They litigated whether the segment closing adjustment applies only to contracts to which CAS 413 applies. (It does.) 42 And they debated whether the segment closing adjustment must be made in the year of the closure. (It must.) 43 In 1995, the new CAS Board revisited and revised CAS 412 and 413. In response to concerns about over-funded pension plans, 44 the CAS Board provided a more specific definition of segment closing and added a formula for allocating pension surpluses and deficits between the contractor and the Government. 45 One significant change was that CAS 413 now permitted the adjustment due to a surplus or deficit of Government pension plan contributions to include both fixed-price and flexibly priced contracts, rather than flexibly priced contracts alone. 46 Regarding the definition of a segment closure, under CAS 413 as revised in 1995 (and currently), a segment closure occurs when a segment has been sold or transferred, when operations are discontinued, or when the segment stops doing or seeking Government contracts. 47 However, no adjustment is required when a segment is sold and all of pension assets and liabilities attributable to the sold segment are transferred to the buyer. 48 Segment closures also extended, under the 1995 CAS 413 rewrite, to pension plan terminations or the curtailment of plan benefits. 49 Finally, the CAS 413 rewrite required the adjustment in the period when the event triggering the segment closure occurred. 50 The CAS Board revised CAS 412 in 1995 as well. Prior practices varied as to whether contractors with fully funded pension plans (for tax purposes) could continue to accrue and charge pension costs under CAS Under the 1995 CAS 412 rewrite, CAS 412 established a four-step process of computing, assigning, funding, and allocating pension costs. One important result was that contractors were able to reassign accruals of pension costs, including an interest adjustment, to later cost accounting periods, when funded. 52 Additionally, each actuarial assumption, which could be validated on an aggregate (rather than on assumptionby-assumption) basis under the old CAS 412, was now required to be validated solely with respect to that assumption. 53 As revised in 1995, the requirements of the CAS 412 and 413 remained distinct from the U.S. generally accepted accounting principles rules or financial reporting rules. Current financial reporting of pension costs includes detailed, lengthy required disclosures with respect to key assumptions and variables and valuations. In addition to these required disclosures, Government contractors may provide information in their public filings regarding differences between their financial accounting for pension costs and their Government or CAS accounting for pension costs. In general, the difference is one of timing of allocations rather than the overall amount of pension costs. There will be times when a contractor s funded pension costs are in excess of its CAS costs creating prepayment credits under the CAS. Prepayment credit is defined in CAS 412 as the amount funded in excess of the pension cost assigned to a cost accounting period that is carried forward for future recognition. 54 Essentially, a contractor has funded more pension costs than it can recover under its CAS contracts for that time period. The amount of funding excess, along with any valuation adjustment, is carried forward to future periods. Conversely, there will be times when CAS costs will be in excess of pension costs for GAAP purposes; in these instances, the prepayment credits will be used by the contractor. Many of the disputed issues relating to segment closures have been resolved by case law and 4

5 the CAS 412 and 413 rewrite in However, significant changes in the economic climate between 1995 and 2005 created new issues under the CAS. 55 New issues arose, and may continue to arise, about pension deficits as opposed to pension surpluses under the CAS. This is likely to lead to more challenges to actuarial assumptions, more allegations of CAS noncompliances, and more litigation. 56 One of the most significant issues arising from changes in the economic climate is pension harmonization. As discussed in the following sections of this Briefing Paper, pension harmonization stems from the 2006 amendments to ERISA and the efforts the CAS Board has undertaken to address those amendments and reconcile CAS 412 and 413 to these new statutory provisions. The Pension Protection Act Of 2006 ERISA 57 was enacted in 1974 to provide federal standards for the establishment and maintenance of employee pension plans. 58 ERISA regulates two types of employee benefit plans: employee pension benefit plans ( pension plans ) and employee welfare benefit plans ( welfare plans ). 59 The distinction between pension plans and welfare plans is significant because an employer is generally free to terminate a welfare plan at any time and for any reason, but it cannot modify or terminate a pension plan at any time or for any reason because pension plans generally require funding and provide lifetime benefits to employees. 60 Within the category of pension plans, there are two kinds defined benefit plans 61 and defined contribution plans. 62 From an estimating or measurement perspective, defined benefit plans are quite complex, while the estimating and measurement issues for defined contribution plans are more straightforward. The risk of changes in plan asset values and actuarial assumptions remains with the company under defined benefit plans, while those risks are mostly shifted to employees under defined contribution plans. This, in part, explains why an increasing number of companies offer defined contribution plans and have reduced their offerings of defined benefit plans. Indeed, a spokesman for Lockheed Martin Corporation recently stated that the company had phased out its defined benefit pension plan for new hires starting in 2006 and, instead, employees were offered a defined contribution type plan. 63 One of the more significant reforms to ERISA occurred in August 2006 when Congress enacted the Pension Protection Act 64 in part to address concerns about the reported underfunding of many defined benefit pension plans. In the PPA, Congress sought to reduce the Government s risk of liability for bailouts of underfunded defined benefit pension plans while at the same time strengthening the pension insurance system. 65 The PPA established new rules for assessing whether a plan was fully funded, as well as the additional adjustments required to the plan if previously earned benefits were not fully funded. The PPA was intended to address several perceived weaknesses in existing pension laws, including that underfunded pension plans did not have to make additional pension contributions as long as their plans were 90% funded, plans had very long periods (over 30 years for some adjustments) 66 over which to make up any funding shortfalls, and plans could use so-called credit balances to avoid making current year contributions. 67 The PPA resulted in changes (i.e., increases) to minimum funding requirements for defined benefit plans, and it shortened the period for amortizing actuarial gains and losses. Specifically, the minimum contribution was to be computed using an interest rate assumption based on corporate bond rates of return (instead of the expected return of pension assets) and required a seven-year amortization period for actuarial gains and losses instead of longer periods. 68 The PPA also addressed the determination of the value of plan assets. In general, plan assets were to be valued at fair market value, but other actuarial methods were permitted. For example, the determination of fair market value could be based on averages over a five-year period. The PPA reduced the acceptable time period for averaging from five years to two years. 69 In addition to the use of averaging over time, the regulations had permitted a range or corridor of acceptable valuations of fair market values. The PPA changed the so-called corridor 5

6 above and below fair market value at which a plan s assets could be measured. Previously, an acceptable range of 80% to 120% of the fair market value was permitted. In other words, if the market value of a plan s assets was $1,000, a valuation within the range of $800 to $1,200 could be used. The PPA reduced the acceptable range of differences from fair market value that could be considered to 90% to 110%. 70 The anticipated net effect of these changes was increased pension contributions under ERISA. It also was anticipated that the revised minimum funding requirements would typically exceed Government contractors recovery of pension costs under their federal contracts. The PPA was expected to have negative cash flow consequences for contractors because increased pension contributions were expected to be made by contractors, but their federal contracts would not provide recovery at the same level as payments made under the PPA. To address issues specific to Government contractors, Congress delayed the applicability of the minimum funding requirement of the PPA to certain large defense contractors until January 1, 2011, at the latest, from the earlier applicability beginning in 2008 for other companies, to give time for the CAS Board to harmonize CAS 412 and 413 with the minimum funding requirements of ERISA as amended. 71 The PPA directed the CAS Board to issue a final rule to be deemed the Cost Accounting Standards Pension Harmonization Rule revising CAS 412 and 413 not later than January 1, A review of financial reporting disclosure from U.S. defense contractors confirms the expected consequences of the PPA (along with management funding decisions) for selected contractors for some, their contributions to pension plans greatly exceeded their CAS recovery. For example, in its K, Lockheed Martin disclosed that it contributed $2.3 billion to its qualified defined benefit pension plans while recovering just $899 million in 2011 under its federal contracts. 73 Amounts contributed in excess of CAS funding requirements were considered prepayment credits. 74 As discussed below, the CAS Board did not issue a final rule regarding pension harmonization prior to January 1, 2010, the deadline identified in the PPA. As a result, Government contractors were required to comply with the PPA before its requirements were harmonized with CAS 412 and CAS 413. The delay in issuing the harmonization rule, coupled with the CAS Board s decision to phase in harmonization 75 (which will be addressed in more detail below) resulted in negative cash flow for some contractors, and it has increased timing issues resulting from the difference between the date the pension contributions are made and the date they are recovered under federal contracts. The CAS Board s Harmonization Rule The PPA did not define harmonize. 76 The CAS Board ultimately adopted the following criteria for harmonizing the minimum required contribution under ERISA as amended by the PPA: 77 (1) Accounting rules must satisfy the CAS Board s Statement of Objectives, Policies, and Concepts; 78 (2) Accounting rules must promote fairness and equity to both contracting parties; (3) Measurement of pension costs must be objectively verifiable; (4) Accounting rules must keep volatility to a minimum in the pricing of Government contracts; and (5) Accounting rules must be understandable, particularly given the complexity of CAS 412. On December 27, 2011, the CAS Board published its long-awaited harmonization rule, which it implemented through amendments to CAS 412 and The basic rule is stated at 48 C.F.R (b)(7). The amendments to CAS 412 and 413 became effective February 27, Prior to harmonization, CAS 412 defined the components of pension cost for defined benefit pension plans to include (a) the normal cost of the period, (b) a part of any unfunded actuarial liability, (c) an interest equivalent on the unamortized portion of any unfunded actuarial liability, and (d) an adjustment for any actuarial gains and losses. 81 The PPA affected each of these components of pension costs, and each, as a consequence, needed to be harmonized. 6

7 For instance, with respect to the last component an adjustment for actuarial gains and losses the PPA imposed a seven-year amortization period. 82 The harmonization rule reduced the CAS amortization period for actuarial gains and losses from 15 years to 10 years. 83 As will be addressed later in this Paper, some commentators have questioned whether this difference of 7 years in the PPA and 10 years under the CAS in amortization rates satisfies the PPA s requirement for harmonization. With respect to the valuation of the unfunded actuarial liability, in general, the requirements of the PPA led to the use of a mark to market (fair market value) approach with respect to the valuation of the plan s assets, despite the increased volatility that this inevitably brings. This is consistent with the overall theme of the PPA, which was intended to drive increases to the funding of pension liabilities. By contrast, the CAS Board views the CAS as premised on going concerns with multi-year contracts and a longterm relationship between the Government and the Government contractor. 84 The CAS also reflect a preference for increased predictability of costs and less volatility from year to year, as reflected in the stated criteria for harmonization. 85 The CAS pension harmonization rule sought to address these differences in approach. The rule requires contractors to compute pension costs under CAS 412 and 413, and then compare that computed pension cost to that which would be calculated under the PPA or ERISA requirements. Pension cost components under CAS 412 are generally referred to as the actuarial accrued liability and the normal cost. Minimum pension cost components calculated under the PPA or ERISA requirements are generally referred to as minimum actuarial liability and minimum normal cost. The harmonization rule states: 86 In any period that the sum of the minimum actuarial liability and the minimum normal cost exceeds the sum of the actuarial accrued liability and the normal costs, the contractor shall measure and assign the pension costs for the period in accordance with [48 C.F.R. ] and by using the minimum actuarial liability and minimum normal costs as the actuarial accrued liability and normal cost, respectively, for all purposes unless otherwise excepted. Figure 1 below illustrates this calculation. The effect of this change is likely to be higher pension costs during the next several years while CAS pension costs are brought closer to the market-based assumptions reflected in the PPA for ERISA purposes. In addition to its recognition of minimum actuarial liability and minimum normal costs and its accelerated gain and loss amortization, the harmonization rule implemented other changes. The measurement of salary-related Figure 1: Determination of Pension Cost [a] [b] CAS 412 Minimum Liability for Period Actuarial Accrued Liability $ 2,100,000 Minimum Actuarial Liability $ 2,594,000 Normal Cost $ 89,100 Minimum Normal Cost $ 102,000 Expense Load on Normal Cost $ - Expense Load on Normal Cost $ 8,840 Subtotal Cost $ 89,100 Subtotal Cost $ 110,840 Total $ 2,189,100 $ 2,704,840 If [a] is greater than [b], use the actuarial accrued liability and normal cost as CAS 412/413 pension cost If [b] is greater than [a], use the minimum actuarial liability and minimum normal costs, subject to any applicable transition, as CAS 412/413 pension cost. 7

8 benefits remained unchanged under the new rule: it is based on expected salary increases. However, for dollar per year benefits (that is, benefits that pay a flat dollar amount for every year of service under the pension plan), instead of permitting no projection, the harmonization rule permits recognition of increases in benefits (limited to the average increase of such benefits under the previous six years) for benefits based on collective bargaining agreements. 87 Regarding the measure of the accumulated value of prepayment credits that is, amounts funded in excess of the pension cost assigned to the cost accounting period that is carried forward for future recognition CAS 412 and 413 formerly provided for an adjustment using an assumed interest rate based on long-term expectations. The harmonization rule, by contrast, requires an adjustment based on the actual return on investments. 88 This means that the accumulative value of the prepayments may be adjusted for investment decreases, just like the rest of the plan s assets. An additional requirement to allocate all administrative (investment- and benefit-related) expenses to prepayment credits has been the subject of some commentary regarding whether or not there is a proper allocation of costs under the argument that the prepayment credits are for pension costs not yet allocated to a cost accounting period and therefore, should not have to share in the expense of any current benefit administrative costs. 89 To measure the present value of a contribution made after the valuation date, CAS 412 and 413 formerly provided no specific guidance. Under the harmonization rule, the present value must now be discounted using an assumed interest rate based on long-term expectations, which are generally assumed to be higher than the historical low interest rates that the U.S. economy has experienced over the last several years. 90 The harmonization rule also addressed curtailment of benefits. Where there is a mandatory cessation of benefit accruals, CAS 412 and 413 previously required an immediate adjustment equal to the actuarial value minus the market value of the assets without requiring the termination of the pension plan. Under the harmonization rule, these accruals are exempt from immediate recognition to the extent that the benefit curtailment was mandated by ERISA. (An example of a mandated cessation of benefit accruals occurs when the plan s adjusted funding target attainment percentage for the plan year is below 60%.) 91 Instead, they are generally treated as plan amendments unless (1) the plan provides that benefit accruals will be restored and (2) the contractor elects to do so. 92 Importantly, for segment closing, the harmonization rule did not change measurement and allocation of costs. Specifically, CAS 413 requires the contractor to measure the difference between the actuarial accrued liability for that segment and the market value of the assets allocated to the segment. 93 This measured difference becomes an adjustment to previously recognized pension cost. Thus, while for ongoing plans the harmonization rule brought the unfunded liability closer to the fair market value through the requirement to use the greater of actuarial accrued liability and minimum actuarial liability, for segment closings, any adjustment upon closing of a segment will be based solely on the actuarial accrued liability. As many commentators have observed, because it is expected that the actuarial accrued liability will be less than the minimum actuarial liability, the adjustment for segment closings allocable to a contractor s contract will likely be less than if minimum actuarial liability were used as the basis for the segment closing adjustment. Although subject to less commentary, the CAS harmonization rule did not specifically address the PPA s changes with respect to valuation of plan assets. CAS 413 provides for the use of any recognized asset valuation method but retains a corridor of 80% to 120% of market value of asset for asset valuation. 94 As previously described, the PPA narrowed this corridor to 90% to 110%. 95 While the harmonization rule requires the use of minimum actuarial liability and minimum normal costs for measuring and assigning pension costs when those costs exceed the sum of the actuarial accrued liability and the normal costs, there is 8

9 a transition period included under the new rule. The adjustment for differences between CAS pension costs and ERISA pension costs is phased in over a transition period consisting of five cost accounting periods. 96 (Some commentators suggest it is a misnomer to label this a five-year transition period because there is no adjustment for differences between the minimum actuarial liability and the actuarial accrued liability and the difference between the minimum normal cost and the normal costs during the first year of the transition period.) However, the change in the amortization of actuarial gains and losses is effective in the first year. Figure 2 below summarizes the evaluation that is made in each of the succeeding five years and the adjustment that is made the pension costs recorded for CAS purposes: Figure 2: Transition Period Adjustment Accounting Period Percentage of Difference To Be Recognized First Accounting Period 0% Second Accounting Period 25% Third Accounting Period 50% Fourth Accounting Period 75% Fifth Accounting Period 100% Figure 3 below illustrates the calculation in year 2017 (assumed year 4) for the transitional minimum amount. 97 Did The CAS Board Get It Right? The harmonization rule was the last step or, at least, the latest stopping point in a long process that started with the PPA and included the publication of a staff discussion paper, ad- vanced notice of proposed rulemaking, notice of proposed rulemaking, review of numerous comments, and years of debate. After all of this effort, it seems fair to ask: Did the CAS Board get it right? Several criticisms have been leveled against the new rule. 98 Perhaps the most common criticism is that the CAS Board did not, in fact, harmonize CAS 412 and 413 with the PPA at all. As noted above, while the PPA uses a seven-year amortization period for the assignment of actuarial gains and losses to accounting periods, the CAS Board reduced the amortization period for actuarial gains and losses under CAS 412 from 15 years to 10 years. This difference, which results in negative cash flow for contractors, requires contactors with CAS-covered federal contracts to serve (in essence) as lenders to the Federal Government to cover the deferred recognition of pension costs under the rule. Similarly, the lack of harmonization for segment closings is another example of variance from the principles of the PPA. In addition, not only was the CAS Board s action inconsistent with the PPA because it missed by nearly two years the statutory deadline for implementing a harmonized rule, but by creating a five-year transition period recognition of differences between minimum actuarial liability and actuarial accrued liability, the board delayed harmonization even more. Under the rule, it will now be seven years past the statutory deadline before the harmonization rule is fully implemented. (This delay is in addition to any other inconsistencies between the PPA and the harmonization rule that remain after the transition period.) Figure 3: Determination of Transition Minimum Amount [a] [b] [c] = b-a [d] [e] = c x d [f] = a+e Phase In Phase In Transition CAS 412 Minimum Liability for Period Difference Percentage Difference Minimum (Year 4) Actuarial Accrued Liability $ 2,100,000 Minimum Actuarial Liability $ 2,594,000 $ 494,000 75% $ 370,500 $ 2,470,500 Normal Cost $ 89,100 Minimum Normal Cost $ 102,000 Expense Load on Normal Cost $ - Expense Load on Normal Cost $ 8,840 Subtotal Cost $ 89,100 Subtotal Cost $ 110,840 $ 21,740 75% $ 16,305 $ 105,405 Total $ 2,189,100 $ 2,704,840 $ 515,740 75% $ 386,805 $ 2,575,905 9

10 On the other hand, several commentators supported the transition period and the use an accrual period longer than prescribed by the PPA because of the expectation that these differences between the CAS and the PPA will result in less volatility in their forward pricing rates and less of an impact on annual agency budgets. Their concern, shared by federal agencies, is that a sudden and complete reconciliation of the CAS with the PPA could result in unmanageable funding spikes for federal agencies. Harmony also is not achieved in the area of plan terminations and segment closings. The accrued actuarial liability assumptions required for segment closings by the harmonization rule are at odds with the assumptions underlying the PPA. The CAS Board acknowledged these apparent disconnects: 99 [T]he Board s review of the PPA, as well as its legislative history, did not reveal any expression of Congressional intent that harmonize under PPA section 106(d) requires the Board to adopt ERISA s minimum required contribution for measuring, assigning, and allocating pension costs to Government contracts. The Board s historical recognition that financial accounting and tax accounting rules have inherently different goals, that preclude them from being used for Government contract cost accounting, is well established. In the Board s view, PPA section 106 did not seek to change that historical recognition.... The Board noted that the contracting parties directly affected by the CAS Pension Harmonization Rule tended to agree with the general concepts articulated in the NPRM... Whether or not both contracting parties generally agreed with the NPRM, 100 it is doubtful whether their putative agreement could, by itself, alter the terms of the PPA or grant the CAS Board powers that are in fact vested in Congress. What s Next For Contractors? The following areas may require attention by contractors as a result of the pension harmonization rule: preparation of forward pricing rates, submission of a revised CAS Disclosure Statement, determination of applicable interest rates, submission of cost impact proposals, and preparation of requests for equitable adjustment. This section of the Briefing Paper addresses each of these next steps for federal contractors. (1) Preparation of Forward Pricing Rates and Other Indirect Rates. For new work proposed after February 27, 2012, contractors should have developed new forward pricing rates to reflect estimated changes in pension cost as a result of pension harmonization. For many of the large Government contractors, these updated rate forecasts have already been developed and used for pricing purposes. However, it is likely that small- to medium-size contractors may still be in the process of updating their forward pricing rate sets. The development of any rate forecast is complex and requires the use of the contractor s best estimates. The added complexity resulting from pension harmonization has made this process even more difficult. Specifically, as a result of the need to estimate actuarial accrued liability and minimum actuarial liability and the requirement to select the greater of the two, the basis for the rate estimate may, in some years, be the actuarial accrued liability, while in other years it could be the minimum actuarial liability. To perform the calculation, the contractor must develop two actuarial models. One reflects the assumptions contained in prior CAS 412 and the second model is used to estimate the minimum actuarial liability. The contractor must develop both models to compare their results and select the greater of the two. In addition, guidance issued by the Director of Defense Pricing on March 27, 2012 cautions Contracting Officers that they may need to have two sets of indirect rates for certain contractors, what the memorandum refers to as new CAS 412/413 rule and old CAS 412/ The old CAS 412/413 rates would apply, according to the DDP guidance, to non-cas-covered cost type contracts awarded before February 27, 2012, that are expected to continue performance after the change in calculation of annual costs becomes applicable to the contractor. 102 The stated rationale for this guidance is that the Cost and Payment clause in the cost-type contracts specifies that FAR/Defense FAR Supplement cost principles in effect at the time of contract award control

11 (2) Revision of CAS Disclosure Statement. A contractor s actuarial assumptions are typically included in item B of CASB DS-1 Form. In that item, the form requests a description of the events or conditions for which significant actuarial assumptions are made for each plan and directs that contractors not include the current numeric values of the assumptions, but provide a description of the basis used for determining these numeric values. As a result, if a contractor previously disclosed the amortization periods that it used for actuarial gains and losses, for example, the contractor would be required to update its disclosure statement for the new amortization period under the harmonization rule. Similarly, if the contractor disclosed the basis it used for determining the interest rate assumption under 48 C.F.R (b)(7)(iii), and it has changed that basis, the contractor would be required to update its disclosure statement for the new basis. Because the harmonization rule became effective 60 days after promulgation but changes in disclosed practices require 60 days notice prior to implementation, contractors were unable to disclose accounting changes resulting from the harmonization rule in a timely manner. The March 2012 DDP guidance addresses this dilemma by noting that we will extend the 60 days requirement for changes that were required by the final rule to 180 days. 104 (3) Process and Procedures for Determining Applicable Interest Rates. The determination of which interest rates to use to determine CAS 412 pension cost has become more complex as a result of the harmonization rule. As a consequence, this is an area where a contractor should consider having a documented policy to support the determination of applicable interest rates whether or not this is part of the contractor s formal disclosures under item B in the CASB DS-1 Form. This documented policy should be reviewed periodically, more frequently as the guidance in this area is evolving, and can be shared with the cognizant Government team reviewing a contractor s proposal. The contractor may have varying rates for ERISA, GAAP, and the CAS, and these differences could give rise to additional questions and review by the Government team. The DDP issued some guidance on interest rates in the March 2012 memorandum: 105 In calculating the ERISA-like alternative annual costs, the contractor should establish policies to identify the proper short term rate to use for the current year s calculations for estimation of both future costs and for incurred costs. For estimates of cost for pensions for out-years in forward pricing proposals, the contractor should estimate that the short term rates will trend back toward historical averages for such rates (i.e., representing the prior 15 to 20 years (or more) of historical data. The memorandum advised that guidelines would be issued in the coming months regarding safe harbor methods to use in estimates of future short term rates. 106 (4) Preparation and Submission of Cost Impact Proposals. One area that requires special scrutiny by contractors is the distinction between a required change under FAR and a unilateral (i.e., voluntary) change under FAR The distinction is important because, under the CAS clause (and FAR Subpart 30.6), a contractor is entitled to an equitable adjustment in contract price if a required change causes a cost impact to the contractor s existing contracts. 107 Under the FAR , whether the change is required or unilateral, the contractor is to submit a general dollar magnitude (or detailed cost impact ) cost proposal reflecting the overall impact of the change in the contractor s cost accounting practices. The DDP s guidance acknowledges that for [a]ffected CAS covered contracts awarded before February 27, 2012 contractors are eligible for equitable adjustment, to recognize the new CAS 412 and 413 required changes for contract costs incurred on or after that applicability date for the new rules. 108 The guidance, however, flags an issue that could become a source of contention in the coming months and years: Any other changes to the contractor s disclosed practices regarding pension cost measurement made in preparation for the harmonization of pension costs to the provisions of the PPA are likely to be voluntary changes 109 In addition to the distinction, drawn by the DDP memorandum, between changes required by the harmonization rule and changes made in preparation or anticipation of the rule, other issues 11

12 may arise regarding the question whether changes made at the same time as the harmonization rule changes were in fact required by the new rule. If history is any guide, federal contractors should expect Defense Contract Management Agency s Contractor Insurance/Pension Review team as well as the Defense Contract Audit Agency to take a somewhat grudging view of the accounting changes that might qualify as required changes under the new rule. In general, the contractor notifies the Cognizant Federal Agency Official and describes the change in cost accounting practice, and the CFAO reviews the change for adequacy and compliance. The CFAO then requests that the contractor prepare a GDM proposal. (The contractor may be asked to submit a DCI proposal instead of a GDM proposal.) With respect to the GDM proposal, there is latitude in methods used to determine increases or decreases in costs as a result of a cost accounting practice change as well as latitude in format. The format generally includes the GDM estimate of total increase or decrease in cost accumulations by executive agency in various contract groupings. Similar to the latitude in methods used to measure the cost impact, the FAR provides latitude in the method to adjust contracts as a result of the change in cost accounting practice. FAR , Resolving cost impacts, states that [t]he CFAO may resolve a cost impact attributed to a change in cost accounting practice or noncompliance by adjusting a single contract, several but not all contracts, all contracts, or any other suitable method. 110 The CAS pension harmonization final rule deferred providing any guidance for submittal of equitable adjustments and change proposals and concluded that no guidance would be included in the final rule: 111 Whether a particular accounting practice has changed, the actual determination of the cost impact and the processing of equitable adjustments are matters for CAS administration as may be undertaken by the contracting parties for CAS-covered contracts. Therefore, this final rule is limited to contract cost accounting guidance and does not include any guidance on the administration of the change in cost accounting practice; the Board urges the Federal agency heads to issue the necessary policies issued with respect to how to develop equitable adjustments. (5) Preparation of Requests for Equitable Adjustment. REAs should be considered for all contracts entered into before February 27, 2012, the effective date of the harmonization rule, with contract performance periods extending past How any equitable adjustment will be implemented may depend on the contractor s mix of contracts and funding considerations that differ from one contractor to the next. Additionally, the FAR provides guidance to contractors in processing changes, both required and unilateral cost accounting changes. 113 Some limited guidance regarding who has the authority to review and resolve REAs has been issued from the DDP: Where there is a [Corporate Administrative Contracting Officer/Divisional Administrative Contracting Officer/Administrative Contracting Officer] network, the CACO will be responsible for settling the equitable adjustment. Where there is no CACO network, the cognizant [ACO] is responsible for settling the equitable adjustment. 114 The guidance memorandum further states that if a contracting officer who is cognizant of contractor costs for defined benefit pension plans receives a request for equitable adjustment from a contractor, the request should identify all CAS covered contracts by contract type that were awarded before February 27, 2012 and are expected to continue performance after the change in calculation of annual costs become applicable to the contractor. 115 The Policies Underlying The Harmonization Rule While the harmonization rule achieves a certain level of harmony with the Pension Protection Act, it is equally clear that budgetary considerations trumped, to some degree, the goal of harmony in the CAS Board s approach to the new harmonization rule. This means that the PPA s apparent goal of addressing the negative cash flow implications for federal contractors by requiring harmonization of the CAS with the PPA has been thwarted, to some extent, by the CAS Board s harmonization rule. While some contractors endorse an approach that takes into account the real problems of pricing volatility and agency budgetary constraints, it is less certain that the CAS Board had the authority to deviate, as some believe it did, from the requirements of the PPA. 12