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HRS Insight 11.11 Final

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HRS Insight 11.11 Final

  1. 1. www.pwc.com HRS Insight Human Resource Services June 27, 2011 HRS Insight 11/11 Accounting for Pension Buy Arrangements Authored by: Ken Stoler, Partner The first pension "buy-purchased -in" contract was recently purchased by a U.S. pension plan. This buy-buy in arrangement is similar to a traditional non non-participating participating annuity (a "buy buy-out"), where a plan transfers future responsibility for promised employee retirement benefits to an insurance company. Under the buy buy-in arrangement, however, the benefit obligation is not transferred rred to the insurer. Instead, the plan remains responsible for paying the benefits, but purchases a contract from the insurer which generates returns designed to equal all future benefits payments to covered participants. participants When accounting for a traditional buy-out annuity, the purchase of the annuity generally triggers settlement accounting, with often a significant income statement effect. The buy buy-in contract, however, typically generates no settlement but retains certain other advantages of an annuity purchase. rchase. This HRS Insight Buy-In explores the advantages and disadvantages, and the accounting implications, of buy buy-in arrangements. Background Purchases of buy-in contracts have been gaining popularity overseas, but until recently had not been sold in the U.S. In May 2011, the first U.S.-based buy buy-in arrangement was completed. This contract offers the employer the ability to "lock in" the cash cost of some of its pension benefit obligation and virtually eliminate future volatility, while continuing to maintain the plan and offer benefits to employees. The buy-in contract is held by the pension plan, and essentially reimburses the plan for all future benefit payments covered by the contract. That is, as benefit payments are made
  2. 2. www.pwc.com by the plan, the insurer will make mak equal payments to the plan under the buy buy-in contract. As a result, the net ongoing cash flow to the plan for the covered participants is nil, and the cost of providing benefits is entirely funded by the buy-in contract. The contract is generally a single-singl premium arrangement, where an upfront payment is made by the pension plan to the insurer in exchange for the contract. The buy-buy in is often priced similar to a buy-buy out annuity, since the economics are nearly the same (insurer taking on responsibility to make annual payments sufficient to cover promised retirement benefits). Generally, the buy buy-in contract also allows the holder to covert the arrangement to a buy-out annuity upon request and for no additional cost. After acquiring the buy buy-in contract, the employer has eliminated the risks associated with changes in the benefit obligation due to changing mortality rates, fluctuating interest rates, etc. However, the employer has not eliminated all risk, because the ability of the insurer to make good on the contract (i.e., the insurer's credit risk) remains. To the extent the insurer is unable to make payment in full on the buy-in contract; the employer would still be responsible for all promised benefit payments. Observation: The buy-buy in contract may cover some or all of the plan's existing benefit obligation, depending on the specific situation. For example, an employer may wish to purchase a contract covering only the benefits currently in payment status to retirees but not cover active employee's future benefits. For frozen plans, some employers may consider a contract that covers the entire benefit obligation. Each employer should assess its specific circumstances, circumstances and the associated benefits or drawbacks, in evaluating whether to purchase a buy- -in contract. Accounting for a Buy-Buy In Arrangement When a traditional non non-participating buy-out annuity is purchased, an employer generally applies settlement accounting. The pension obligation is removed from the books, as are the assets used to purchase the an annuity. If the price of the annuity contract exceeds the carrying value of the obligation, as is often the case, the excess is a loss. Any gains or losses deferred in accumulated other comprehensive income are also recognized in the income statement as part rt of the settlement gain or loss. Special rules apply if only part of the benefit obligation is settled. Observation: Since most plans today have deferred losses reflected in accumulated other comprehensive income, settlement via annuity purchase generally ally results in a significant income statement loss. In order to qualify for a settlement, the accounting literature literature1 requires that three criteria all be met: 1) The action is irrevocable, 2) The employer is relieved of primary responsibility for the obligation, and 1 The US GAAP pension accounting literature addressing settlement accounting is in ASC 20-20. International financial reporting standards (IFRS) related to settlement accounting are generally consistent with US GAAP. 715-
  3. 3. www.pwc.com 3) The transaction eliminates significant risks related to the obligation and assets used to effect the settlement In the case of a buy-in contract, these three criteria are typically y not met. First, the buy-buy in contract is often not irrevocable, as it may include a provision under which the arrangement can be terminated. A pre-pre defined cash surrender value or termination formula may be negotiated up front, and while a significant termination mination penalty may exist, it nonetheless affords the employer the ability to unwind the transaction if desired. Based on this, the arrangement would not qualify for settlement accounting. In addition, settlement accounting is not appropriate because the employer is not relieved of primary responsibility for the obligation. Under the terms of the contract the insurer is not assuming the retirement benefit obligation, and the employer remains responsible for the plan and making benefit payments to the plan an participants. The employer continues to be considered the plan sponsor under ERISA. Unlike an annuity contract, where participants are notified that responsibility for payment of their benefits has been transferred to the insurer and the employer is no longer involved, participants are not notified of the buy-cannot -in arrangement and look to the insurer for payments cannot directly. Furthermore, the employer/plan trustees could decide to use the money received under the buy-in contract for other purposes under er the plan (i.e. to purchase other investments). The buy-in contract effectively is an investment by which the plan can receive payments from the insurer corresponding to the benefits due to the covered participants, but ultimately the primary responsibil Thus, in the event the insurer was unable to make payment under the buy due to bankruptcy), the employer would still be obligated for the promised retirement benefits. Ongoing Pension Accounting for the Buy- Since settlement accounting is not applied and the contract is not considered an annuity, the buy-in contract represents an investment asset of the plan. Typically, the pension trust (and not the employer) would acquire the buy contract, and thus it would be accounted for as a plan asset. Plan assets are recorded at fair value as of each measurement date, and are therefore generally remeasured annually (unless an interim remeasurement is required if a significant event occurs). In presentation the balance sheet the fair value of plan assets is netted against the related pension obligation. In determining the appropriate value at which to present these buy literature is not clear. Accordingly, we believe that the following two approaches are acceptable. Under the first approach, the fair value of the buy-in contract is directly measured at each plan measurement date. Initially, this fair value would be based on the purchase price of the contract. In subsequent value would be estimated based on the contract's 'exit price' the contract could be sold to a willing third responsibility has not been transferred. buy-in (for example, -In Asset 2 As defined in ASC 820, Measurements and Disclosures buy-in us on buy-in assets, the accounting llowing measurements, fair 2, or the amount at which third- Fair Value
  4. 4. www.pwc.com party buyer. Estimating this value would likely include similar considerations as were used by the insurer rer when originally pricing the buy buy-in contract, including factors based on assumptions about the plan participants covered under the contract, such as changes in expected mortality. It would also be based on the current discount rate inherent in the contract. ract. This rate would likely be the same rate used by an insurer in the current price of a buy-out annuity, often using the PBGC published rate for single single-employer pension annuities3. The second approach is based on the guidance in the accounting literatu literature addressing valuation of insurance contracts that are not annuities4. . This guidance notes that such contracts should be reflected at fair value, but indicates that if the contract has a stated cash surrender value, this can be used as a proxy for fair value. For many insurance contracts held in a pension trust, the cash surrender value (if any) is considered to be reflective of fair value and thus is used for reporting purposes. In the case of buy-in arrangements, however, while a cash-out formula may exist, this value generally incorporates a fairly sizeable termination penalty. Based on this, while use of the surrender value would be acceptable, we believe it is not required since the surrender value generally would not represent a good proxy for fair ir value due to the penalty provision. 3 The Pension Benefit Guarantee Corporation (PBGC) publishes hes monthly rates used in valuing single-employer annuity benefits on its website at www.pbgc.gov. 4 ASC 715-30-35-60 discusses valuation of insurance contracts that are not annuities Ongoing Accounting for the Pension Benefit Obligation When a buy-in contract is acquired, there is a question as to whether any adjustment in the measurement of the associated benefit obligation is necessary. Again, literature is not clear and therefore we believe that two approaches are acceptable. Under the first alternative, the benefit obligation covered by the buy continue to be measured with the traditional discount rate and mort by the employer. The discount rate is generally based on yields of high at each measurement date. We would expect the value of the buy the value of the benefit obligation approach; while both would be based on similar participant demographics, the discount rate used in valuing the obligation would likely be higher than the rate inherent in the buy contract (which, as discussed above, is likely based on lower PBGC annui addition, the value of the buy be based on different mortality assumptions. Under the second alternative, the value of the benefit obligation associated with the participants covered by the contract would be set equal to the fair value of the buy at each measurement date. This approach is considered supportable because the guidance on establishing discount rates at which the obligation could be 'effectively settled.' While purchase of the buy does not result in an actual settlement, it can be viewed to result in an effective settlement since 5 ASC 715-30-35-43 the accounting buy-in contract would mortality assumptions used high-quality corporate bonds buy-in contract asset to exceed under this ; buy-in annuity rates). In buy-in contract may buy-in contract rates5 calls for the rate buy-in contract
  5. 5. www.pwc.com the majority of the risks and rewards associated with the benefit obligation and related assets has been eliminated. As a result, the discount rate used in pricing the buy-buy in contract also represents the rate at which the obligation can be effectively settled. Under this approach, it is also considered acceptable to change the mortality assumption to that reflected in the value of the buy-in contract. ntract. If this second alternative is followed, an actuarial loss will need to be recognized at the next plan measurement date, since the benefit obligation will be increased to match the (generally higher) purchase price of the buy-buy in contract. For example, le, if the benefit obligation was $100 before purchasing a buy buy-in contract for $105, the obligation would be reset to $105, and a $5 actuarial loss would be reflected in other comprehensive income. After this initial Summary of Reporting Impact The following table provides a high purchase a buy-in contract, a buy remeasurement, the fair value of the asset and the associated benefit obligation should be equal, other than potential breakage due to changes in credit quality of the insurer. Going forward, we would generally expect the asset and obligation to continue to move in tandem. Likewise, assets related to the buy related interest cost on the associated benefit obligation recognized as components of net periodic benefit cost should be equal and offsetting. Observation: If the buy only a portion of the plan obligation and participants, determination of the appropriate discount rate and expected return on assets to use may be more complex. lowing high-level summary of the financial reporting impact of a buy-out annuity, or maintaining current status quo. buy-in the expected return on plan buy-in contract and the buy-in contract covers ay decision to
  6. 6. www.pwc.com Balance Sheet Impact Buy-in contract No change. Pension obligation remains. Buy contract is plan asset. Buy-out annuity Buy-in Remove pension obligation and related plan assets Status quo No change in pension obligation and plan assets Current Income Statement Impact Future Income Statement Impact No settlement gain/loss Continued amortization of gain/loss deferred in AOCI. Expense could increase if expected return on buy previous expense will be less volatile. Recognize settlement gain/loss on recognition of amounts deferred in AOCI, including the gain/loss arising on purchase of annuity buy-in asset is less than assumed return, but No future futur amortization of gain/loss deferred in AOCI. No expense volatility going forward No settlement gain/loss Continued amortization of gain/loss deferred in AOCI and continued application of return assumption to plan assets expected How PwC Can Help PwC has considerable expertise with respect to the accounting and disclosure for pension and OPEB plans. In addition, we can help you better understand the complex issues related to pension investment stment strategies, actuarial measurements, taxation and funding. Please contact one of the individuals listed below, or your local engagement partner, to further discuss how PwC can help.
  7. 7. www.pwc.com For more information, please do not hesitate to contact professional: Charlie Yovino Ed Donovan Matthew Cowell Pat Meyer Jack Abraham Paul Perry Terry Richardson Cindy Fraterrigo Brandon Yerre Theresa Gee Todd Hoffman Carrie Duarte John Caplan Scott Olsen Bruce Clouser Bill Dunn Amy Lynn Flood Sandra Hunt Julie Rumberger Scott Pollack Jeff Davis Nik Shah your local PwC (678) 419-1330 Atlanta, GA (704) 344-7739 Charlotte, NC (617) 530-4722 Boston, MA (646) 471-8855 New York Metro (617) 530-5694 Boston, MA (312) 298-6229 Chicago, IL (312) 298-2164 Chicago, IL (312) 298-3157 Chicago, IL (312) 298-3717 Chicago, IL Kansas City, MO St. Louis, MO (312) 298-4320 Chicago, IL (214) 999-1406 Dallas, TX (312) 298-4700 Detroit, MI (713) 356-8440 Houston, TX (213) 356-6396 Los Angeles, CA (646) 471-3646 New York Metro (646) 471-0651 New York Metro (267) 330-3194 Philadelphia, PA (267) 330-6105 Philadelphia, PA (267) 330-6247 Philadelphia, PA (415) 498-5365 San Francisco, CA (408) 817-4460 San Francisco, CA San Jose, CA (408) 817-7446 San Jose, CA (202) 414-1857 Washington, DC (202) 918-1208 Washington, DC This document is for general information purposes only, and should not be used as a SOLICITATION © 2011 PricewaterhouseCoopers LLP. All rights reserved. In this document, "PwC" refers to PricewaterhouseCoopers LLP, a Delaw partnership, which is a member firm of substitute for consultation with professional advisors. Delaware limited liability PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity.

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