Pension accounting primer

Understanding Actuarial Results A Pension Accounting Primer Johnson, West & Co., PLC Van Iwaarden Associates June 16, 2010 Mark Schulte, FSA, EA, MAAA 612.596.5971 [email_address]

Outline
Goals of the presentation
Orientation
DB pension plans
Strings attached
Actuarial speed dating
Actuarial Results
Summary/Q&A

Presentation Goals
Basic understanding of:
How pension liabilities are calculated
What pension liabilities mean and how they are similar/different
How to convert liabilities in to “usable” results
What to do with the results.
Become conversant/comfortable with:
What actuaries are preparing for you
What accountants want from you
Explaining it all to your peers
Know when to get involved and when to let actuaries and auditors “hash it out”.

Non-Aspirations
Make you all actuaries
Details are important for actuaries; clients usually just need to understand the concepts
But maybe you can be an armchair actuary
Make actuarial science exciting
Simply not possible in many situations
It should be understandable
Make me an accountant
I have never been an accountant, and likely never will be
All statements in this presentation will be from an actuarial perspective

We’re all here because you sponsor a DB pension plan or are involved with these plans.
Defined Benefit (DB) vs. Defined Contribution (DC)
DB : Employer has promised a benefit and must make variable contributions .
DC : Employer has promised a contribution and employee gets variable benefits .
Orientation

Purposes of pension plan
Attract and retain employees; reward service to company
Orderly succession of employees
Tax deductions
Paternalism (?)
Since tax deductions are involved and promises are being made, DB pension plans come with “strings attached”
The “strings” are usually the aggravating part of a DB plan, but all qualified retirement plans have them in some form.
Fiduciary responsibilities for fund selection
ADP/ACP testing
Orientation

Orientation Pension Plan
IRS
Benefit Equality
Plan design (benefit accruals)
Nondiscrimination in coverage and benefits
Annual Contributions
Minimum required
Maximum deductible
Reporting (Form 5500, participants)
PBGC
Pension insurance premiums
Flat rate
Variable rate (VRP)
Reporting (to PBGC, to participants)
Accounting/FASB
Company liability for benefit promises
Many nuances to accrual accounting
“ Strings Attached”

Actuarial Speed Dating
A promise has been made to make a stream of payments (or lump sum) at some point in the future.
Given assumptions about projected benefit amount and likelihood of receiving payments, what is the value of the benefit in today’s dollars?
Basic Premise of All Actuarial Pension Calculations

D ata
A ssumptions
M ethods
P lan Provisions
Actuarial Speed Dating Census data for all participants
Economic:
Discount rate(s)
Expected return on assets
Pay increases
Inflation
Regulatory (wage base, comp limits)
Demographic:
Turnover, disability, retirement, death
Marriage, spouse age
Form of payment
Participation (OPEB)
Asset methods Liability methods How benefits are defined

The Actuarial Model Plan Provisions Assumptions Data Methods Actuarial Model Funding Accounting
Other
PBGC
Benefit Restrictions
Nondiscrimination compliance
Benefit distributions
Liabilities Accrued Projected Future Costs Present Value of Benefits

Actuarial Speed Dating Determining the value of pension payments Start Working Current Age Retirement Age Death Period of Annuity Payments 35 45 65 95

Actuarial Speed Dating Term structure of interest rates Time Return 5 years 3% 6% 30 years

Actuarial Speed Dating Time Return Segment 1 2% 6% Segment 3 4% Segment interest rates Segment 2

Actuarial Speed Dating Calculating the present value of benefits Hire Age Current Age Retirement Age Death 4% 6% Example: $100 x (1+.04)^(-20) = $46 $100 x (1+.06)^(-50) = $5 35 45 65 95

Actuarial Speed Dating
We can calculate a present value – Now what?
Liability calculations:
VBO ABO PBO PVB Acronym Vested Current Vested Benefit Obligation Current Current Accrued Benefit Obligation Current Projected Projected Benefit Obligation Projected Projected Present Value of Benefits Service Pay Liability Measure

Actuarial Results
We now know the basic process for calculating liabilities
Similarities for most actuarial calculations:
Data
Assumptions: Demographic
Assumptions: Some economic
Plan provisions
Differences between actuarial calculations
Assumptions: Certain economic
Discount rates /segment rates/yield curves
Inflation/regulatory increases/salary scale
Methods
Liability methods (i.e., pattern for recognizing liabilities)
Asset methods (smoothing)

Actuarial Results
Funding
IRS requirements (most methods mandated)
Funding policy (often overlooked due to PPA requirements)
Accounting
GAAP accounting for plan sponsor/employer (ASC 715)
FAS 87 expense
FAS 158 disclosures
FAS 88 curtailment/settlements
FAS 35 accounting for Plan
Other
PBGC variable rate premiums
Plan benefit calculations
Nondiscrimination testing

Actuarial Results Same Plan Provisions
VBO
MVA
ABO, VBO
MVA
PBO, ABO
MVA, MRVA
ABO
MVA, AVA
Methods - Liability - Asset
PBGC segment rates (snapshot)
Option to use funding rates
Expected return on plan assets
Single rate
Pay increases
Regulatory
EROA
Segment rates (24 month avg.)
- Economic Same - Demographic Assumptions Participants on last day of prior plan year Participants at beginning of plan year Data PBGC Premiums FAS 35 Accounting GAAP Accounting PPA Funding Inputs

Actuarial Results
FAS #35 Accounting
Plan Accounting
Focus on long-term COST to Plan of providing benefits
How much money does plan need today to pay benefits, based on assumed return on assets?
Benefit cost perspective means we use Expected Return on Assets as liability discount rate
Disclose:
Benefit liabilities (vested and non-vested) and reconciliation
Funded status
GAAP Accounting
Corporate accounting
Focus on LIABILITY to the plan sponsor
If company was sold, what would be “cost” of pension liability today ?
Liability cost is similar to a plan termination calculation (i.e., cost to purchase bonds or annuity contracts to satisfy liabilities)

Actuarial Results
Balance sheet liability
Also known as Funded Status or Unfunded PBO
Previously known as (accrued)/prepaid pension cost
Move to mark-to-market, but use PBO liability
Change in balance sheet liability
Also known as change in Funded Status
Two components
Amount recognized in earnings (FAS expense); plus
Amount recognized in Other Comprehensive Income
GAAP Accounting Highlights

Actuarial Results
FAS Expense
Amount recognized in earnings each year (accrual accounting)
Liability “earned” during year, plus adjustments for:
Interest on balance sheet liability
Offset for expected return on assets
Amortization of unrecognized prior service costs, gains/losses.
Additions to Other Comprehensive Income
Items not yet recognized in earnings
Includes:
New unrecognized amounts (prior service costs, gains/losses); minus
Amortization of unrecognized amounts
Auditors will check that balance sheet liabilities reconcile!
GAAP Accounting Highlights

Actuarial Results
Sample reconciliation of funded status
GAAP Accounting Highlights H. G. F. E. D. C. B. A. $ (40) (Accrued)/Prepaid Pension Cost (C. – G.) $ (160) Accumulated OCI (D. + E. + F.) (110) Unrecognized gains/(losses) (50) Unrecognized prior service credits/(costs) $ 0 Unrecognized transition obligation $ (200) Funded status (A. + B.) 800 Fair value of assets $ (1,000) Projected Benefit Obligation (PBO)

Actuarial Results
Settlement
Event that eliminates plan sponsor risk and responsibility for PBO
Example: Large lump sum payments (one or many)
PBO reduction > SC + IC
Shortens lifespan of plan
Immediate recognition of UGL, in proportion to reduction in PBO
Example: Settle 20% of PBO, then recognize 20% of UGL
Curtailment
Event that significantly reduces rate of benefit accrual (e.g., plan freeze)
Shortens amount of “future service” over which we amortize prior service costs
Immediate recognition of UPSC, in proportion to reduction in future service
Curtailments and settlements often occur in tandem!
“ Specialty” Accounting Calculations (FAS #88)

DB plans (like any qualified retirement plan) have complexities.
But they don’t need to be overwhelming
Frozen plans have special responsibilities
Most actuarial calculations are based on similar principles, but there are a few adjustments based on the intended use of the result.
If results are unclear, be sure to ask your actuary or auditor!
Summary

Discussion and Questions

Additional Information Contact Information: Mark Schulte, FSA, EA, MAAA [email_address] 612.596.5971 Van Iwaarden Associates 840 Lumber Exchange 10 South Fifth Street Minneapolis, MN 55402 www.vaniwaarden.com 1.888.596.5960

Pension accounting primer

by Jim van Iwaarden

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