Pension accounting primer


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Introduction to pension actuarial calculations for plan sponsors. Explains, reviews, and compares various actuarial liability calculations.

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Pension accounting primer

  1. 1. 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]
  2. 2. Outline <ul><li>Goals of the presentation </li></ul><ul><li>Orientation </li></ul><ul><ul><li>DB pension plans </li></ul></ul><ul><ul><li>Strings attached </li></ul></ul><ul><li>Actuarial speed dating </li></ul><ul><li>Actuarial Results </li></ul><ul><li>Summary/Q&A </li></ul>
  3. 3. Presentation Goals <ul><li>Basic understanding of: </li></ul><ul><ul><li>How pension liabilities are calculated </li></ul></ul><ul><ul><li>What pension liabilities mean and how they are similar/different </li></ul></ul><ul><ul><li>How to convert liabilities in to “usable” results </li></ul></ul><ul><ul><li>What to do with the results. </li></ul></ul><ul><li>Become conversant/comfortable with: </li></ul><ul><ul><li>What actuaries are preparing for you </li></ul></ul><ul><ul><li>What accountants want from you </li></ul></ul><ul><ul><li>Explaining it all to your peers </li></ul></ul><ul><li>Know when to get involved and when to let actuaries and auditors “hash it out”. </li></ul>
  4. 4. Non-Aspirations <ul><li>Make you all actuaries </li></ul><ul><ul><li>Details are important for actuaries; clients usually just need to understand the concepts </li></ul></ul><ul><ul><li>But maybe you can be an armchair actuary </li></ul></ul><ul><li>Make actuarial science exciting </li></ul><ul><ul><li>Simply not possible in many situations </li></ul></ul><ul><ul><li>It should be understandable </li></ul></ul><ul><li>Make me an accountant </li></ul><ul><ul><li>I have never been an accountant, and likely never will be </li></ul></ul><ul><ul><li>All statements in this presentation will be from an actuarial perspective </li></ul></ul>
  5. 5. <ul><li>We’re all here because you sponsor a DB pension plan or are involved with these plans. </li></ul><ul><li>Defined Benefit (DB) vs. Defined Contribution (DC) </li></ul><ul><ul><li>DB : Employer has promised a benefit and must make variable contributions . </li></ul></ul><ul><ul><li>DC : Employer has promised a contribution and employee gets variable benefits . </li></ul></ul>Orientation
  6. 6. <ul><li>Purposes of pension plan </li></ul><ul><ul><li>Attract and retain employees; reward service to company </li></ul></ul><ul><ul><li>Orderly succession of employees </li></ul></ul><ul><ul><li>Tax deductions </li></ul></ul><ul><ul><li>Paternalism (?) </li></ul></ul><ul><li>Since tax deductions are involved and promises are being made, DB pension plans come with “strings attached” </li></ul><ul><li>The “strings” are usually the aggravating part of a DB plan, but all qualified retirement plans have them in some form. </li></ul><ul><ul><li>Fiduciary responsibilities for fund selection </li></ul></ul><ul><ul><li>ADP/ACP testing </li></ul></ul>Orientation
  7. 7. Orientation Pension Plan <ul><li>IRS </li></ul><ul><li>Benefit Equality </li></ul><ul><ul><li>Plan design (benefit accruals) </li></ul></ul><ul><ul><li>Nondiscrimination in coverage and benefits </li></ul></ul><ul><li>Annual Contributions </li></ul><ul><ul><li>Minimum required </li></ul></ul><ul><ul><li>Maximum deductible </li></ul></ul><ul><li>Reporting (Form 5500, participants) </li></ul><ul><li>PBGC </li></ul><ul><li>Pension insurance premiums </li></ul><ul><ul><li>Flat rate </li></ul></ul><ul><ul><li>Variable rate (VRP) </li></ul></ul><ul><li>Reporting (to PBGC, to participants) </li></ul><ul><li>Accounting/FASB </li></ul><ul><li>Company liability for benefit promises </li></ul><ul><li>Many nuances to accrual accounting </li></ul>“ Strings Attached”
  8. 8. Actuarial Speed Dating <ul><li>A promise has been made to make a stream of payments (or lump sum) at some point in the future. </li></ul><ul><li>Given assumptions about projected benefit amount and likelihood of receiving payments, what is the value of the benefit in today’s dollars? </li></ul>Basic Premise of All Actuarial Pension Calculations
  9. 9. <ul><li>D ata </li></ul><ul><li>A ssumptions </li></ul><ul><li>M ethods </li></ul><ul><li>P lan Provisions </li></ul>Actuarial Speed Dating Census data for all participants <ul><li>Economic: </li></ul><ul><li>Discount rate(s) </li></ul><ul><li>Expected return on assets </li></ul><ul><li>Pay increases </li></ul><ul><li>Inflation </li></ul><ul><li>Regulatory (wage base, comp limits) </li></ul><ul><li>Demographic: </li></ul><ul><li>Turnover, disability, retirement, death </li></ul><ul><li>Marriage, spouse age </li></ul><ul><li>Form of payment </li></ul><ul><li>Participation (OPEB) </li></ul>Asset methods Liability methods How benefits are defined
  10. 10. The Actuarial Model Plan Provisions Assumptions Data Methods Actuarial Model Funding Accounting <ul><li>Other </li></ul><ul><li>PBGC </li></ul><ul><li>Benefit Restrictions </li></ul><ul><li>Nondiscrimination compliance </li></ul><ul><li>Benefit distributions </li></ul>Liabilities Accrued Projected Future Costs Present Value of Benefits
  11. 11. Actuarial Speed Dating Determining the value of pension payments Start Working Current Age Retirement Age Death Period of Annuity Payments 35 45 65 95
  12. 12. Actuarial Speed Dating Term structure of interest rates Time Return 5 years 3% 6% 30 years
  13. 13. Actuarial Speed Dating Time Return Segment 1 2% 6% Segment 3 4% Segment interest rates Segment 2
  14. 14. 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
  15. 15. Actuarial Speed Dating <ul><li>We can calculate a present value – Now what? </li></ul><ul><li>Liability calculations: </li></ul>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
  16. 16. Actuarial Results <ul><li>We now know the basic process for calculating liabilities </li></ul><ul><li>Similarities for most actuarial calculations: </li></ul><ul><ul><li>Data </li></ul></ul><ul><ul><li>Assumptions: Demographic </li></ul></ul><ul><ul><li>Assumptions: Some economic </li></ul></ul><ul><ul><li>Plan provisions </li></ul></ul><ul><li>Differences between actuarial calculations </li></ul><ul><ul><li>Assumptions: Certain economic </li></ul></ul><ul><ul><ul><li>Discount rates /segment rates/yield curves </li></ul></ul></ul><ul><ul><ul><li>Inflation/regulatory increases/salary scale </li></ul></ul></ul><ul><ul><li>Methods </li></ul></ul><ul><ul><ul><li>Liability methods (i.e., pattern for recognizing liabilities) </li></ul></ul></ul><ul><ul><ul><li>Asset methods (smoothing) </li></ul></ul></ul>
  17. 17. Actuarial Results <ul><li>Funding </li></ul><ul><ul><li>IRS requirements (most methods mandated) </li></ul></ul><ul><ul><li>Funding policy (often overlooked due to PPA requirements) </li></ul></ul><ul><li>Accounting </li></ul><ul><ul><li>GAAP accounting for plan sponsor/employer (ASC 715) </li></ul></ul><ul><ul><ul><li>FAS 87 expense </li></ul></ul></ul><ul><ul><ul><li>FAS 158 disclosures </li></ul></ul></ul><ul><ul><ul><li>FAS 88 curtailment/settlements </li></ul></ul></ul><ul><ul><li>FAS 35 accounting for Plan </li></ul></ul><ul><li>Other </li></ul><ul><ul><li>PBGC variable rate premiums </li></ul></ul><ul><ul><li>Plan benefit calculations </li></ul></ul><ul><ul><li>Nondiscrimination testing </li></ul></ul>
  18. 18. Actuarial Results Same Plan Provisions <ul><li>VBO </li></ul><ul><li>MVA </li></ul><ul><li>ABO, VBO </li></ul><ul><li>MVA </li></ul><ul><li>PBO, ABO </li></ul><ul><li>MVA, MRVA </li></ul><ul><li>ABO </li></ul><ul><li>MVA, AVA </li></ul>Methods - Liability - Asset <ul><li>PBGC segment rates (snapshot) </li></ul><ul><li>Option to use funding rates </li></ul><ul><li>Expected return on plan assets </li></ul><ul><li>Single rate </li></ul><ul><li>Pay increases </li></ul><ul><li>Regulatory </li></ul><ul><li>EROA </li></ul><ul><li>Segment rates (24 month avg.) </li></ul>- 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
  19. 19. Actuarial Results <ul><li>FAS #35 Accounting </li></ul><ul><ul><li>Plan Accounting </li></ul></ul><ul><ul><li>Focus on long-term COST to Plan of providing benefits </li></ul></ul><ul><ul><ul><li>How much money does plan need today to pay benefits, based on assumed return on assets? </li></ul></ul></ul><ul><ul><ul><li>Benefit cost perspective means we use Expected Return on Assets as liability discount rate </li></ul></ul></ul><ul><ul><li>Disclose: </li></ul></ul><ul><ul><ul><li>Benefit liabilities (vested and non-vested) and reconciliation </li></ul></ul></ul><ul><ul><ul><li>Funded status </li></ul></ul></ul><ul><li>GAAP Accounting </li></ul><ul><ul><li>Corporate accounting </li></ul></ul><ul><ul><li>Focus on LIABILITY to the plan sponsor </li></ul></ul><ul><ul><ul><li>If company was sold, what would be “cost” of pension liability today ? </li></ul></ul></ul><ul><ul><ul><li>Liability cost is similar to a plan termination calculation (i.e., cost to purchase bonds or annuity contracts to satisfy liabilities) </li></ul></ul></ul>
  20. 20. Actuarial Results <ul><li>Balance sheet liability </li></ul><ul><ul><li>Also known as Funded Status or Unfunded PBO </li></ul></ul><ul><ul><li>Previously known as (accrued)/prepaid pension cost </li></ul></ul><ul><ul><li>Move to mark-to-market, but use PBO liability </li></ul></ul><ul><li>Change in balance sheet liability </li></ul><ul><ul><li>Also known as change in Funded Status </li></ul></ul><ul><ul><li>Two components </li></ul></ul><ul><ul><ul><li>Amount recognized in earnings (FAS expense); plus </li></ul></ul></ul><ul><ul><ul><li>Amount recognized in Other Comprehensive Income </li></ul></ul></ul>GAAP Accounting Highlights
  21. 21. Actuarial Results <ul><li>FAS Expense </li></ul><ul><ul><li>Amount recognized in earnings each year (accrual accounting) </li></ul></ul><ul><ul><li>Liability “earned” during year, plus adjustments for: </li></ul></ul><ul><ul><ul><li>Interest on balance sheet liability </li></ul></ul></ul><ul><ul><ul><li>Offset for expected return on assets </li></ul></ul></ul><ul><ul><ul><li>Amortization of unrecognized prior service costs, gains/losses. </li></ul></ul></ul><ul><li>Additions to Other Comprehensive Income </li></ul><ul><ul><li>Items not yet recognized in earnings </li></ul></ul><ul><ul><li>Includes: </li></ul></ul><ul><ul><ul><li>New unrecognized amounts (prior service costs, gains/losses); minus </li></ul></ul></ul><ul><ul><ul><li>Amortization of unrecognized amounts </li></ul></ul></ul><ul><li>Auditors will check that balance sheet liabilities reconcile! </li></ul>GAAP Accounting Highlights
  22. 22. Actuarial Results <ul><li>Sample reconciliation of funded status </li></ul>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)
  23. 23. Actuarial Results <ul><li>Settlement </li></ul><ul><ul><li>Event that eliminates plan sponsor risk and responsibility for PBO </li></ul></ul><ul><ul><ul><li>Example: Large lump sum payments (one or many) </li></ul></ul></ul><ul><ul><ul><li>PBO reduction > SC + IC </li></ul></ul></ul><ul><ul><li>Shortens lifespan of plan </li></ul></ul><ul><ul><li>Immediate recognition of UGL, in proportion to reduction in PBO </li></ul></ul><ul><ul><ul><li>Example: Settle 20% of PBO, then recognize 20% of UGL </li></ul></ul></ul><ul><li>Curtailment </li></ul><ul><ul><li>Event that significantly reduces rate of benefit accrual (e.g., plan freeze) </li></ul></ul><ul><ul><li>Shortens amount of “future service” over which we amortize prior service costs </li></ul></ul><ul><ul><li>Immediate recognition of UPSC, in proportion to reduction in future service </li></ul></ul><ul><li>Curtailments and settlements often occur in tandem! </li></ul>“ Specialty” Accounting Calculations (FAS #88)
  24. 24. <ul><li>DB plans (like any qualified retirement plan) have complexities. </li></ul><ul><ul><li>But they don’t need to be overwhelming </li></ul></ul><ul><ul><li>Frozen plans have special responsibilities </li></ul></ul><ul><li>Most actuarial calculations are based on similar principles, but there are a few adjustments based on the intended use of the result. </li></ul><ul><li>If results are unclear, be sure to ask your actuary or auditor! </li></ul>Summary
  25. 25. Discussion and Questions
  26. 26. 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 1.888.596.5960