Workshop 25: Company Financial Statements Accounting for Pension Plans. Lauren R. Okum, ASA, EA, MAAA, MSPA Premier Actuarial Solutions, Chicago, IL

Transcription

1 Workshop 25: Company Financial Statements Accounting for Pension Plans Lauren R. Okum, ASA, EA, MAAA, MSPA Premier Actuarial Solutions, Chicago, IL

2 Financial Accounting Standards Major FASB provisions affecting pension plans SFAS 87: Rules for determining corporate pension expense and balance sheet liability SFAS 88: Rules for special situations (curtailments and settlements) SFAS 132(R): Rules for disclosure on corporate financial statements 1

3 Financial Accounting Standards Major FASB provisions affecting pension plans SFAS 157: Additional rules for disclosure on corporate financial statements SFAS 158: Updated rules for calculating corporate balance sheet liability ASC 715: New codification of all accounting rules 2

4 The Actuary s Responsibility Must meet the Academy s Qualification Standards consistent with the type of actuarial determination ASOP 21, Responding to or Assisting Auditors or Examiners in Connection with Financial Audits, Financial Review, and Financial Examinations Adopted September 2016 Effective for fiscal years beginning after December 15,

5 ASC 715 Basics What does the ASC 715 valuation do? Determines the expense (or income) that is charged on the company s statement of net income Determines the liability (or asset) that is reported on the company s balance sheet 4

6 ASC 715 Basics Which clients need a FAS valuation? Plan sponsors that are publicly held Private plans that require GAAP accounting Construction companies with bonding requirements Companies with loan covenants Ultimately, the auditor is responsible for determining whether your client needs a FAS valuation 5

7 ASC 715 Basics Pensions are a form of deferred compensation Participants trade compensation today for future pension tomorrow Both pension funding and pension accounting rules require that the cost of deferred compensation be recognized as it is earned 6

8 Income statement ASC 715 Basics Net income = revenue expenses Measured over a period of time Pension expense is called Net Periodic Pension Cost (NPPC) 7

9 Balance sheet ASC 715 Basics Assets liabilities = shareholders equity Measured as a specific point in time Balance sheet liability = PBO assets 8

10 ASC 715 Basics Attribution period Benefits must be expense over the period in which they are earned Not necessarily the same period over which the plan is funded to pay such benefits Measurement date = end of fiscal year Accounting Standards Update (ASU) permits measurement at the end of the month closest to the end of the fiscal year Effective for fiscal years beginning after December 15, 2015 for public entities Effective for fiscal years beginning after December 15, 2016 for other entities 9

11 Comparison of Calculations Funding Valuation ASC 715 Valuation Actuarial Method Traditional Unit Credit Projected Unit Credit Selection of Method Mostly mandated Mandated Selection of Assumptions Some mandated, some by actuary Employer, subject to auditor s approval Contribution Accounting Accrual basis Cash basis 10

12 Projected Unit Credit Projected Unit Credit (PUC) cost method uses: Pay projected to decrement date (e.g. assumed retirement); and Service as of measurement date Rationale for PUC Many pension benefits are based on average pay at retirement A portion of the benefit due to past service already includes expected future pay increases Allows the plan sponsor to recognize the cost of the plan gradually over the participant s lifetime 11

13 Assumptions Economic Based primarily on economy Demographic Based primarily on anticipated employer experience Based on economy and industry as if impacts employer Assumptions must be selected by the employer with approval from their auditor Recommend getting selections in writing What is the actuary s role? 12

14 Assumptions Each assumption should represent the best estimate for that assumption as of the current measurement date (ASC and ASC ) 13

15 Economic Assumptions Discount rate (d) Inflation Salary growth rate Expected long-term rate of return on assets (ROR) 14

16 Assumptions Demographic Salary increases Turnover Retirement Disability Mortality Assumed form of payment Percent married and age difference 15

17 Discount Rate Discount rate (d) Used to calculate the present value of pension benefits Rate at which benefit obligations could effectively be settled (ASC ) Must reflect either: Market rates currently applicable to settling the benefit obligation (e.g. current annuity rates); or Rates of return on high quality fixed income securities at the measurement date 16

18 Discount Rate ASC S99-1: At each measurement date, the SEC staff expects registrants to use discount rates to measure obligations for pension benefits [and OPEB] that reflect the then current level of interest rates. The staff suggests that fixed-income debt securities that receive one of the two highest ratings given by a recognized ratings agency be considered high quality (for example, a fixed income security that receives a rating of Aa or higher from Moody s Investors Service, Inc.). 17

19 Discount Rate Typically, rates of return on Aa bond funds with maturities ranging from years are used Examples Moody s Aa Corporate Bond fund Merrill Lynch U.S. Corporate AA 15 years+ fund Merrill Lynch U.S. Corporate AA/AAA 10 year+ fund Citigroup Pension Liability Index Fund 18

20 Discount Rate Old approaches Look at AA bonds Reflect a corporate bond yield curve, often using an effective interest rate calculation Current approaches Provide projected cash flows to auditor, match them to a selected yield curve, and calculate an effective interest rate to use as the single discount rate Match projected cash flows to a portfolio of zero-coupon, high-quality corporate bonds that generate sufficient cash flows, and use present value of selected bonds impractical for small or mid-sized plans 19

21 New approach Discount Rate Use yield curve directly in interest cost and service cost calculation 20

22 Discount Rate An entity may change its method of selecting the discount rate, provided that the method results in the best estimate of the effective settlement rates as of the measurement date (ASC through 55-28) If change in method results in higher rates than those used by similar entities or that remain constant from year-to-year, it might raise a red flag 21

23 Salary Increases Building Block Method is generally used: Inflation + Productivity growth + Merit increases + Seniority increases Growth rate is long-term, not the upcoming year s budgeted pay increases 22

24 Expected Rate of Return on Assets A long-term assumption that is reviewed regularly Consistent with inflation and salary growth assumptions Changes when long-term view of the market changes or when the plan s investment policy changes 23

25 Expected Rate of Return on Assets ROR assumptions have been trending downward Lower expected inflation Lower expected real returns Lower interest rates 24

26 Expected Rate of Return on Assets Asset Allocation Expected Return Weighted Return Equities 60% 7.5% 4.50% Fixed income 35% 3.0% 1.05% Cash 5% 2.0% 1.00% Total 100% 6.55% 25

27 Discount Rate vs. ROR Discount rate and expected rate of return on asset are not the same Discount rate is based on high quality corporate bonds as of the measurement date ROR is based on plan investments Note: For ASC 960, they are the same because benefits are valued assuming the plan is ongoing 26

28 Mortality GAAP requires consideration of the most recent mortality tables through the date the financial statements are available to be issued Mortality tables and improvement scales should be appropriate for the base covered under the plan RP-2000 is still required for funding purposes, so ASC 715 mortality might be different 27

29 Assumed Form of Payment Traditional DB plans If assuming 100% lump sums, then calculate present value at assumed decrement age using assumed 417(e) segment rates (usually current rates), then discount using ASC 715 discount rate Cash balance plans If assuming 100% lump sums, then project hypothetical balance to assumed decrement age using the assumed interest crediting rate, then discount using ASC 715 discount rate 28

30 Net Periodic Pension Cost Net Periodic Pension Cost (NPPC) = Service cost Present value of benefits expected to be earned during the year + Interest cost Increase in the PBO due to the passage of time - Expected return on assets Increase in the assets due to the passage of time + Amortization of unrecognized amounts: Transition amount Prior service cost Actuarial (gains)/losses Amortization of liabilities due to: Implementation of SFAS 87 Change in liabilities due to plan amendments Asset and liability (gains)/losses 29

31 Net Periodic Pension Cost Service cost Includes interest to EOY SC = SC at BOY * (1 + d) Both liability and interest are based on assumptions disclosure in prior year s financial statements 30

32 Net Periodic Pension Cost Interest cost Should reflect expected benefit payments to be made during the year IC = (PBO at BOY * d) (0.5 * Exp BPs * d) Both liability and interest are based on assumptions disclosure in prior year s financial statements 31

33 Net Periodic Pension Cost Expected return on assets Based on Market-Related Value of Assets (MRVA) Should reflect expected benefit payments and expected contributions to be made during the year EROA = (MRVA at BOY * ROR) (0.5 * Exp BPs * ROR) + interest on expected contributions 32

34 Net Periodic Pension Cost Amortization of unrecognized transition obligation Difference between PBO and assets existing at the date of compliance with SFAS 87 Amortized on a straight-line basis over the average future service of active participants (or life expectancy if all or most are inactive participants) If average future service is less than 15 years, 15 years may be used 33

35 Net Periodic Pension Cost Amortization of unrecognized prior service cost (credit) Change in liability due to plan amendments Generally amortized on a straight-line basis over the average future service of active participants Important to maintain amortization schedule (i.e. amounts, date established, and corresponding periods) Negative plan amendments offset prior positive plan amendments 34

36 Net Periodic Pension Cost Amortization of unrecognized actuarial losses (gains) From experience of assumption changes (including discount rate changes) Methods 10% corridor method: Only amounts in excess of 10% of the greater of PBO or MRVA are subject to amortization Other methods, including immediate recognition ( mark to market ), are permitted Change in method is considered an accounting method change subject to ASC 250 Once changed to more rapid amortization, a subsequent change resulting in slower amortization would be difficult to justify Might consider mark-to-market if plan termination is in the near future Amortized on a straight-line basis over the average future service of active participants (or life expectancy if all or most are inactive participants) 35

37 Net Periodic Pension Cost 1. Service cost a. Amount due as of January 1, b. Interest at 4.50% 0 c. Total service cost: a. + b Interest cost a. Pension benefit obligation (PBO) as of January 1, ,270,642 b. Expected distributions, weighted for timing 123,674 c. Average expected PBO: a. - b. 5,146,968 d. Discount rate 4.50% e. Interest cost: c. x d. 231, Expected return on assets a. Market-related value as of January 1, 2016 (4,258,168) b. Expected distributions, weighted for timing 123,674 c. Expected contributions, weighted for timing 0 d. Average market-related assets: a. + b. + c. (4,134,494) e. Long-term rate of return 7.00% f. Expected return on assets: d. x e. (289,415) 4. Amortization of transition obligation / (asset) 0 5. Amortization of prior service cost / (credit) 0 6. Amortization of net actuarial loss / (gain) 15, Net periodic pension cost for fiscal year ending December 31, c. + 2.e. + 3.f (42,385) 36

38 (Gain) / Loss Determine by source: Liability (gain)/loss = actual PBO expected PBO Asset (gain)/loss = expected assets actual assets Back into: unrecognized (gain)/loss = PBO Minus: Assets Minus: Unrecognized transition obligation/(asset) and prior service costs/(credits) Plus: (Accrued)/prepaid pension cost Do it both ways to check for mistakes 37

39 (Gain) / Loss 1. Liability (gain) or loss a. Projected benefit obligation (PBO) at January 1, ,479,215 b. Service cost 0 c. Interest cost 214,362 d. Participant contributions 0 e. Actual benefit payments (219,851) f. Expected PBO at December 31, 2015: a. + b. + c. + d. + e. 5,473,726 g. Actual PBO at January 1, ,139,532 h. Liability (gain) / loss: g. - f. (334,194) 2. Asset (gain) or loss for year a. Fair value of assets (FVA) at January 1, ,438,165 b. Expected return on assets 301,804 c. Actual contributions 41,329 d. Actual benefit payments (219,851) e. Expected FVA at December 31, 2015: a. + b. + c. + d. 4,561,447 f. Actual FVA at January 1, ,258,168 g. Asset (gain) / loss: e. - f. 303,279 38

40 (Gain) / Loss 3. Cumulative (gain) or loss a. Unrecognized (gain) / loss at January 1, ,128 b. Amount recognized (15,435) c. (Gain) / loss for year: 1.h. + 2.g. (30,915) d. Unrecognized (gain) / loss at January 1, , Amortization of (gain)/loss a. Unrecognized (gain) / loss at January 1, ,778 b. Amount not reflected in market-related value of assets 0 c. (Gain) / loss subject to amortization 920,778 d. 10% corridor: 10% of the greater of 1.g. and 2.f. 513,953 e. (Gain) / Loss subject to amortization: c. - d. 406,825 f. Average life expectancy g. Amortization amount: e. - f. 15, Alternate determination of net unrecognized (gain) or Loss a. Actual PBO at January 1, ,139,532 b. Actual FVA at January 1, ,258,168 c. Unrecognized transition obligation / (asset) 0 d. Unrecognized prior service cost / (credit) 0 e. (Accrued) / prepaid pension cost 39,414 f. Unrecognized net actuarial (gain) / loss: a. - b. - c. - d. + e. 920,778 39

41 Balance Sheet Disclosures Determine PBO as of measurement date (i.e. fiscal year end) using updated discount rate May roll forward BOY PBO to EOY PBO EOY = (PBO BOY + SC BOY ) * (1 + d) Expected BPs * ( *d) PBO EOY = PBO BOY + SC + IC Expected BPs Use actual EOY assets 40

42 Balance Sheet Disclosures Basic accounting equation: Assets = Liabilities + Equity Liability = PBO assets Equity consists of: Retained earnings = NPPC Accumulated other comprehensive income (AOCI) = unrecognized amounts excluded from net income, but are included on the balance sheet because they are in the PBO 41

43 Balance Sheet Disclosures 1. Net balance sheet (liability) / asset Fiscal Year Ending 12/31/ /31/2015 a. Projected benefit obligation (5,448,342) (5,139,532) b. Fair value of plan assets 4,387,740 4,258,168 c. Net balance sheet (liability) / asset: a. + b. (1,060,602) (881,364) 2. Amounts recognized in the statement of financial position consist of: a. Noncurrent assets 0 0 b. Current liabilities 0 0 c. Noncurrent liabilities (1,060,602) (881,364) d. Total (1,060,602) (881,364) 3. Amounts recognized in accumulated other comprehensive income consist of: a. Net transition obligation / (asset) 0 0 b. Prior service cost / (credit) 0 0 c. Net actuarial loss / (gain) 1,142, ,778 d. Total 1,142, ,778 42

44 Balance Sheet Disclosures PBO Assets Liability Equity Asset Net Liability / Retained Accumulated (Asset) Earnings OCI Cash 1. Balance as of December 31, ,139,532 4,258, ,364 (920,778) a. Service cost b. Interest cost 231, ,614 (231,614) 0 0 c. Expected return on assets 0 289,415 (289,415) 289, d. Amortizations (15,416) 15,416 0 e. Contributions f. Benefit payments (218,930) (218,930) g. New gains and losses 296,126 59, ,039 0 (237,039) 0 h. Net change 308, , ,238 42,385 (221,623) 0 2. Balance as of December 31, ,448,342 4,387,740 1,060,602 (1,142,401) Asset = Liability + Equity 43

45 (Accrued)/Prepaid Pension Cost Balance sheet liability prior to SFAS 158 (Accrued)/prepaid EOY = PBO funded status Plus: Unrecognized amounts (Accrued)/prepaid EOY = (Accrued)/prepaid BOY Minus: NPPC Plus: Actual contributions Do it both ways to check for mistakes 44

46 (Accrued)/Prepaid Pension Cost Fiscal Year Ending 12/31/ /31/ Reconciliation of (accrued) / prepaid pension cost a. Funded status at end of year (1,060,602) (881,364) b. Unrecognized transition amount 0 0 c. Unrecognized prior service cost 0 0 d. Unrecognized net actuarial (gain) / loss 1,142, ,778 e. (Accrued) / prepaid pension cost 81,799 39, Alternate reconciliation of (accrued) / prepaid pension cost a. (Accrued) / prepaid pension cost at BOY 39,414 (73,922) b. Net periodic pension (cost) / income 42,385 72,007 c. Cost of FAS 88 events 0 0 d. Employer contributions 0 41,329 e. (Accrued) / prepaid pension cost at EOY 81,799 39, Reconciliation of balance sheet liability under ASC 715 a. (Accrued) / prepaid pension cost at end of year 81,799 39,414 b. Amount recognized in unrestricted net assets (1,142,401) (920,778) c. Net balance sheet (liability) / asset at end of year (1,060,602) (881,364) 45

47 Footnote Disclosures Assets and liabilities, separated for underfunded plans and overfunded plans Reconciliation of various items from prior EOY to current EOY: Change in PBO Change in plan assets Change in OCI 46

48 Footnote Disclosures Amounts expected to be amortized in expense next year Investment policy Asset classes 10-year projection of benefit payments Net Periodic Pension Cost 47

49 Footnote Disclosures Fiscal Year Ending 12/31/ /31/ Information for underfunded plans 1 1 a. Projected benefit obligation 5,448,342 5,139,532 b. Accumulated benefit obligation 5,448,342 5,139,532 c. Fair value of plan assets 4,387,740 4,258, Information for overfunded plans 0 0 a. Projected benefit obligation 0 0 b. Accumulated benefit obligation 0 0 c. Fair value of plan assets Weighted average assumptions a. Discount rate 4.25% 4.50% b. Rate of compensation increases N/A N/A c. Rate of IRS limit increases 2.50% 2.50% 48

50 Footnote Disclosures Fiscal Year Ending 12/31/ /31/ Change in benefit obligation a. Benefit obligation at beginning of year 5,139,532 5,479,215 b. Service cost 0 0 c. Interest cost 231, ,362 d. Participant contributions 0 0 e. Plan amendments 0 0 f. Actuarial (gain) / loss during year 296,126 (334,194) g. Benefits paid (218,930) (219,851) h. Settlements 0 0 i. Curtailments 0 0 j. Special termination benefits 0 0 k. Benefit obligation at end of year 5,448,342 5,139, Change in plan assets a. Fair value of plan assets at beginning of year 4,258,168 4,438,165 b. Actual return on plan assets 348,502 (1,475) c. Employer contributions 0 41,329 d. Participant contributions 0 0 e. Benefits paid (218,930) (219,851) f. Settlements 0 0 g. Fair value of plan assets at end of year 4,387,740 4,258,168 49

51 Footnote Disclosures Fiscal Year Ending 12/31/ /31/ Change in net actuarial (gain) / loss a. Net actuarial (gain) / loss at end of prior year 920, ,128 b. Amount recognized during year (15,416) (15,435) c. Liability (gain) / loss 296,126 (334,194) d. Asset (gain) / loss (59,087) 303,279 e. Recognition of curtailment (gain) / loss 0 0 f. Recognition of settlement (gain) / loss 0 0 g. Net actuarial (gain) / loss at end of year 1,142, , Change in accumulated other comprehensive income a. Accumulated OCI at end of prior year 920, ,128 b. Reclassification of OCI to NPPC i. Amount from transition (obligation) / asset 0 0 ii. Amount from prior service (cost) / credit 0 0 iii. Amount from net actuarial gain / (loss) (15,416) (15,435) c. Adjustment for amounts occuring during year i. Amount from transition obligation / (asset) 0 0 ii. Amount from prior service cost / (credit) 0 0 iii. Amount from net actuarial (gain) / loss 237,039 (30,915) d. Accumulated OCI at end of year 1,142, , Accumulated OCI expected to be reclassified as NPPC during next fiscal year: a. Net transition obligation / (asset) 0 0 b. Prior service cost / (credit) 0 0 c. Net actuarial loss / (gain) 23,000 15,416 50

52 Footnote Disclosures 1. Plan asset information The company s overall investment strategy is to maintain an efficient portfolio in terms of risk/reward tradeoff in a cost-effective manner. This policy is adopted to provide for diversification of assets in an effort to maximize the investment return of the Plan consistent with market conditions. The target asset allocation consists of 60% equities, 34% bonds, and 6% real estate. Total Level 1 Level 2 Level 3 a. Equity securities 2,640,354 2,640, b. Debt securities 1,471,281 1,471, c. Other 276, , d. Total 4,387,740 4,387, Expected contributions to be paid during fiscal year ending December 31, 2017 a. Employer contributions 0 b. Participant contributions 0 c. Total contributions 0 3. Expected future benefit payments a. For fiscal year ending December 31, ,915 b. For fiscal year ending December 31, ,932 c. For fiscal year ending December 31, ,104 d. For fiscal year ending December 31, ,114 e. For fiscal year ending December 31, ,824 f. For fiscal years ending December 31, 2022 through December 31, ,687,893 51

53 Footnote Disclosures 1. Net periodic pension cost Fiscal Year Ending 12/31/ /31/2015 a. Service cost 0 0 b. Interest cost 231, ,362 c. Expected return on assets (289,415) (301,804) d. Amortization of transition obligation / (asset) 0 0 e. Amortization of prior service cost / (credit) 0 0 f. Amortization of unrecognized (gain) / loss 15,416 15,435 g. Net periodic pension cost (42,385) (72,007) 2. Weighted average assumptions a. Discount rate 4.50% 4.00% b. Rate of compensation increases N/A N/A c. Rate of IRS limit increases 2.50% 3.00% d. Expected return on plan assets 7.00% 7.00% 52

54 Relationship of Expense and Disclosure Use prior year s disclosure assumptions for current year s expense E.g. Use December 31, 2016 disclosure assumptions for 2017 expense PBO for disclosure is generally not the same as the PBO for next year s expense E.g. PBO for December 31, 2016 disclosure is based on January 1, 2016 census, but PBO as of January 1, 2017 for interest cost is based on January 1, 2017 census 53

55 Alternative Cost Approaches Traditional approach A single discount rate used to calculate SC and IC Equivalent rate that produces the same obligations as the full corporate bond yield curve 54

56 Alternative Cost Approaches Spot rate approach Discount rate is viewed as the full yield curve rather than the single equivalent rate Each spot rate along the yield curve is applied to each corresponding benefit cash flow Service cost changes due to interest rate used to project to EOY No change to PBO Affects the gain or loss when obligations are remeasured at year-end 55

57 Alternative Cost Approaches Spot rate approach (continued) With upward sloping yield curve, this approach will reduce current period SC and IC Differences between the two approaches with flow into future accounting periods reducing the gain or increasing the loss May be applied prospectively treated as a change in estimate Probably cannot change back, since it s presumably considered more precise 56

58 Alternative Cost Approaches Spot rate approach (continued) SEC approved method when corporate yield curve is used SEC was silent on whether spot rate approach could be used with a bond matching model Might be difficult to justify 57

59 Alternative Cost Approaches Potential concerns with spot rate approach Higher expense if corporate bond yield curve becomes inverted Increased volatility and yield curve changes Lower settlement threshold when SC and IC are lower Might be viewed as backloading the cost recognition in comparison to the traditional approach 58

60 Alternative Cost Approaches Cash Spot PV of Cash Flow Year Flow Rate Single Rate Yield Curve % % % % % % % % % Total 1, , Cash flow is benefit for PBO purposes, reflecting current service and projected pay Effective interest rate = 2.37% Single Rate Year 0: / (1.00) 0 = Year 1: / (1.0237) 1 = Year 10: / (1.0237) 10 = Yield Curve Year 0: / (1.00) 0 = Year 1: / (1.010) 1 = Year 10: / (1.019) 10 = Thanks to Richard Kutikoff and John Markley for this example! 59

61 Alternative Cost Approaches Cash Spot PV of Cash Flow Interest Cost Year Flow Rate Single Rate Yield Curve Single Rate Yield Curve % % % % % % % % % Total 1, , Single Rate Year 0: 2.37% * = 2.37 Year 1: 2.37% * = 2.25 Year 10: 2.37% * = 1.31 Yield Curve Year 0: 0.00% * 100 = 0 Year 1: 1.00% * = 0.96 Year 10: 1.90% * =

62 Plan Terminations Special events can trigger one-time pension expense that lead to accelerated recognition of liabilities Recognize some previously deferred liabilities in net income Transfer equity from AOCI to Retained Earnings 61

63 Plan Terminations Curtailment Significantly reduces expected years of future service of present employees; or Eliminates the accrual of defined benefits for some/all future service for significant number of employees Settlement Irrevocable action; and Relieves employer/plan of primary benefit responsibility; and Eliminates significant risks related to obligations and assets 62

64 Plan Terminations Plan freeze will trigger a curtailment Curtailment loss may be recognized when probable Curtailment gain may be recognized when employees terminate or plan change is adopted Lump sum payments and annuity purchases may trigger a settlement Settlement accounting required when lump sums and/or annuity purchases > SC + IC Settlements cannot be measured until assets have been paid out 63

65 Plan Terminations ASC : The basis for estimated the discount rate for a plan may change if the facts/circumstances for the plan change The determining factor is the interest rates that would be inherent in an effective settlement of the pension benefit are now more closely reflected by rates implicit in current prices of annuity contracts 64

66 Accounting Standards Update ASU changes the presentation and capitalization of NPPC, but it does not change the calculation of it Effective for fiscal years beginning after December 15, 2017 for public entities Effective for fiscal years beginning after December 15, 2018 for other entities Summary of changes Service cost must be included in operating costs Other expense components must be presented separately Only service cost component would be eligible to be capitalized 65