Pension Accounting Rules: Defusing The Retirement Time Bomb
Nicholas Apostolou and D. Larry Crumbley
2006 - The SEC and FASB have recently directed their attention
to improving the rules for pension accounting. On October
18, 2004, the SEC announced that it was investigating whether
six large companies had manipulated earnings when calculating
their costs for pensions and retiree health benefits. (The
companies were not identified by name.) In particular, the
SEC intended to focus on assumptions companies use to calculate
current pension expenses. The SEC also planned to examine
how companies can use qualified retirement plans to create
“cookie jar” reserves that could boost future
November 10, 2005, FASB voted to add a project to its agenda
that revised SFAS 87, Employers’ Accounting for
Pensions, and SFAS 106, Employers’ Accounting for
Postretirement Benefits Other Than Pensions. In its
statement, FASB said that it had received many requests
to make information about pension obligations and assets
more useful and transparent for investors. FASB expects
to conduct the project in two phases. The first phase will
seek to address the concern that, under current accounting
standards, important information about the funded status
of a company’s plan is reported in the footnotes but
not in the body of the financial statements. The second,
more comprehensive phase would address the following issues:
How to best recognize and display in earnings and other
comprehensive income the various elements that affect
the cost of providing postretirement benefits;
How to best measure the obligation; in particular, plans
with lump-sum settlement options;
Whether more, or different, guidance should be provided
regarding measurement assumptions; and
Whether postretirement benefit trusts should be consolidated
by the plan sponsor.
has addressed the first phase by issuing SFAS 158, Employers’
Accounting for Defined Benefit Pension and Other Postretirement
Plans, an amendment of SFASs 87, 88, 106, and 132(R).
This statement requires employers to recognize the overfunded
or underfunded positions of defined benefit postretirement
plans, including pension plans, in their balance sheets.
Previously, this information was recognized only in the
footnotes. Calendar-year public companies will have to apply
this requirement when preparing their balance sheet as of
December 31, 2006.
statement requires employers to measure plan assets and
obligations as of the date of the financial statements.
Companies previously measured benefit obligations as of
the balance sheet date or three months earlier. However,
the new measurement date requirement will not be effective
until fiscal years ending after December 15, 2008.
article reviews the current rules governing pension accounting
and reporting. Because the rules have the overriding goal
of minimizing volatility in the periodic measure of pension
expense, pension accounting has been strongly pervaded by
estimates, a result that has significant consequences for
financial statement users. The authors also present a sample
of large companies to illustrate how the funded status of
a plan was not disclosed in the financial statements and
could be determined only by reference to the footnotes.
plans can be divided into two broad categories: defined
contribution plans and defined benefit plans. Defined contribution
plans specify the amount of money an employer puts into
the plan for the benefit of employees. No explicit promise
is made about the periodic payments the employee will receive
upon retirement. Once an employer has paid the defined contribution,
there is no additional liability to provide pension benefits.
The amount ultimately paid out is determined by the accumulated
value at retirement of the total contributed by the employer
and by the employee over the term of employment. When employees
retire, they receive their share of the accumulated balance
from the investments. Accounting for such plans is simple.
Each year, the employer records pension expense equal to
the amount of the annual contribution.
a defined benefit plan, the formula for determining pension
payouts is specified. The risk in these benefit plans is
borne by the employer, who must accurately estimate the
amount that must be contributed to fund the plan and make
future payouts. Defined benefit plans raise many financial
reporting complications. The primary difficulty is determining
how much should be charged to pension expense each year
while covered employees are working. Additional complications
result because only the benefit formula is specified, not
the benefit amount. Determining the periodic pension expense
to be assigned requires the estimation of these factors:
proportion of the workforce will qualify for benefits under
the plan? This forecast requires actuarial assumptions regarding
personnel turnover, mortality rates, and disability.
What is the rate of salary increases until retirement?
Over what length of time will the benefits be paid?
What rate of return will be earned by the investments
made using the assets of the pension fund?
What discount rate should be used to reflect the present
value of future benefits?
required disclosure rules are designed to minimize volatility
in the recognition of pension expense. Financial managers
have traditionally been extremely reluctant to have pension
expense affected by the vagaries of investment markets.
This objective is achieved through numerous smoothing devices
and deferrals when computing pension expense. The resulting
rules are some of the most technically challenging and confusing
in the accounting literature.
for pension plans requires the measurement of pension cost
and then the allocation of such cost to appropriate time
periods. The determination of pension cost is a complicated
task because it is calculated by netting five factors:
Interest on the projected benefit obligation;
Expected return on plan assets;
Amortization of prior service cost; and
Effects of gains and losses.
income statement reports the net amount as pension expense.
Each of the components is disclosed in the footnotes accompanying
the financial statements.
cost. Service cost is defined as the actuarial
present value of projected benefits earned by employees
in the current accounting period. In other words, it is
the increase in pension benefits payable to employees because
of services performed during the current year. Future salary
levels must be taken into consideration when calculating
service cost. The measurement of service cost depends upon
the assumptions made in estimating the increases in future
pension benefits, such as turnover, early retirement, salary
increases, and promotion. Revisions in these assumptions
can substantially affect the valuation of service cost.
on the projected benefit obligation. The interest
on the projected benefit obligation is the increase in the
amount of the projected benefit obligation due to the passage
of time. A liability results because pensions are a deferred
compensation arrangement. Because a liability is not eliminated
until the benefits are paid during retirement, it is recorded
on a discounted basis. The discount rate chosen is determined
by market interest rates on high-quality investments or
the implicit rate of return on retirement annuities. Each
year, the plan’s obligation increases by the amount
of interest that accrues based upon the selected discount
return on plan assets. Pension plan assets
usually consist of stocks, bonds, and other investments.
The expected rate of return on plan assets is the anticipated
increase in the plan assets due to investment activities.
The expected return is calculated by multiplying the fair
value of the plan assets at the beginning of the period
by the expected long-term rate of return on plan assets.
This number is subtracted in the computation of pension
of prior service cost. When pension plans
are adopted or amended, credit is often given to employees
for service performed prior to adoption or amendment. The
cost of this service is called prior service cost. FASB
requires the allocation of this cost to be expensed over
the remaining service lives of the covered employees. The
amount of the prior service cost is measured by the increase
in the projected benefit obligation due to the adoption
or amendment of the plan. The rationale for delaying recognition
of prior service cost is the assumption that the adoption
or amendment was made with the expectation of receiving
benefits in the future.
of gains and losses. FASB was concerned about
how pension expense can be affected by large changes in
the market value of plan assets and by changes in the actuarial
assumptions that affect the calculation of the projected
benefit obligation. Wide fluctuations in pension expense
would, of course, enhance the volatility of reported net
income. As a result, FASB introduced several provisions
intended to reduce the likelihood of significant variation
in pension expense from period to period.
of the most volatile components of pension expense is the
actual return on plan assets. Fluctuations in the securities
markets create volatility. To dampen its effects, FASB requires
the expected return on plan assets to be included as a component
of pension expense. This amount is computed by multiplying
the expected rate of return (developed by an actuary) by
the fair value or the market-related asset value of the
plan assets. The market-related asset value of plan assets
can be either fair market value or any calculated value
that recognizes changes in fair value in a rational and
systematic manner over not more than five years. This procedure
reduces the volatility of the return on plan assets because
it can employ both an expected rate of return and a market-related
between expected returns and actual returns are called “asset
gains and losses” by FASB. Asset gains (actual returns
exceed expected returns) and asset losses (actual returns
are less than expected returns) are combined with liability
gains and losses, discussed below.
In a similar vein, the projected benefit obligation is based
upon actuarial assumptions about such items as mortality
rates, future salary levels, and employee turnover. Changes
in these actuarial assumptions change the projected benefit
obligation. Because the expectation for the projected benefit
obligation will seldom equal actual experience, unexpected
gains and losses result from changes in the projected benefit
obligation and are called “liability gains and losses”
by FASB. Liability gains (unexpected decreases in the liability
balance) and liability losses (unexpected increases in the
liability balance) are combined with asset gains and losses
to calculate the net gain or loss.
summarize, the last component of pension cost, net gain
or loss, is defined as the change in the amount of the projected
benefit obligation, as well as the change in the value of
plan assets, changes which occur when experience differs
from expectations. Pension expenses are determined by summing
these five components that affect the overall amount:
of Impact on Pension Expense
on the obligation
return on plan assets
with a pension plan (the plan sponsor) recognizes on its
books only the pension expense and the cash paid out when
funding the pension. Nevertheless, a company is not required
to fund the full amount of the pension expense recognized
each period. The amount funded is dependent upon legislation,
income tax rules, and working capital needs. A plan sponsor
is required to fund at least the annual service cost computed
under the plan. If the amount funded exceeds the pension
expense recognized on the income statement, the difference
is an asset called “prepaid pension cost.” If
the amount funded is less than the expense recognized, this
difference is a liability called “accrued pension
cost.” A company may choose to pay more than the calculated
pension expense to pay down an accrued pension liability,
or it may pay less to take advantage of prepaid pension
assets and liabilities of a pension plan are not included
in the plan sponsor’s financial statements. The plan
trustee receives the contributions to the pension plan and
pays out the pension benefits. Pension plans are separate
legal entities, which present their own financial statements
and file their own tax returns (Form 5500).
off–balance sheet pension assets and liabilities will
usually differ. When pension assets are larger than liabilities,
a plan is overfunded. If pension liabilities exceed pension
assets, a plan is underfunded.
of Pension Disclosures
a declining stock market (2000–2002) and with interest
rates at an all-time low, many companies had pension plans
that were underfunded. Major debt agencies began lowering
their bond ratings on companies with the most severe problems.
General Motors and Ford both had their bond ratings reduced.
Fortune, in its December 9, 2002, issue, expressed
alarm over the deteriorating finances of many companies,
likening it to a horror movie. More recent advances in the
stock market have calmed some of the concerns (the S&P
500 Stock Index gained 26% in 2003, 9% in 2004, and 3% in
2005), but many of the country’s largest corporations
face serious problems funding their pension commitments.
illustrate pension disclosures, the authors examined eight
large companies with defined benefit plans, along with Berkshire-Hathaway,
for purposes of comparison. The results are presented in
IBM and Verizon were included even though both recently
announced their intention to freeze their defined benefit
pension plans and increase their contributions to their
workers’ defined contribution plans. These freezes
are emblematic of the trend among U.S. corporations to switch
from defined benefit plans to defined contribution plans.
The percentage of companies offering defined benefit plans
has dropped from 83% in 1990 to 45% as of 2005.
current funded status of a pension plan as of a given date
is the difference between the fair value of the plan assets
at that date and the discounted present value of the expected
liability. This liability is the previously mentioned projected
benefit obligation (PBO), and is computed using future compensation
example, Ford’s pension plan had a PBO of $74.595
billion as of December 31, 2005. Meanwhile, the fair value
of its plan assets on the same date was $63.784 billion.
Therefore, Ford’s pension plan was underfunded to
the tune of $10.811 billion ($74.595 -- $63.784). This $10.811
billion deficit represents the current funded status of
the pension plan on December 31, 2005. Nowhere is this important
number reflected on the balance sheet. Only by reading the
footnotes can this huge amount be determined.
interesting disclosure in the Exhibit is the expected rate
of return that each company expects to earn on its pension
plan investments. This number can be used as a simple measure
of how aggressive a company is in its pension accounting.
Recall the expected—not the actual—rate of return
is used in calculating pension expense on the income statement.
This calculation is another example of the effort to insulate
pension expense from the vagaries of the stock market.
companies surveyed used expected returns anywhere from 6.40%
to 9.00%. Warren Buffett lowered Berkshire-Hathaway’s
rate of return from 8.3% to 6.5% in 2001, and that assumed
rate of return was lowered slightly to 6.4% in 2005. Buffett
has repeatedly stated that investors should expect rates
of return significantly lower in this decade as compared
to the previous two decades. In response, companies cite
the long-term rate of return on common stock of 10%, on
corporate bonds of 6%, and on government bonds of 5.5% as
justification for their high expected rate of return. Return
rates have fallen since 2002, with General Motors lowering
its expected rate of return from 10% in 2002 to 9% in 2005,
Ford lowering its rate from 9.5% to 8.75%, and IBM lowering
its rate from 9.5% to 8.0%. However, with interest rates
trending upward, budget deficits soaring, and the economy
softening, a strong case can be made that expected return
rates are still too high. Incidentally, Standard & Poor’s
500 Stock Index returned 3.0% in 2005.
Exhibit also includes the discount rate that companies use
to calculate their pension benefit obligation. When the
discount rate declines, the pension obligation rises, and
conversely, if the discount rate rises, the pension obligation
drops. Companies do not have as much flexibility in choosing
the discount rate as in choosing the expected return rate,
but investors should pay attention. In 2003, the SEC was
pressured by corporations to allow them to use a higher
discount rate that would reduce their pension obligations.
Fortunately, the SEC stood fast. On March 4, 2005, the SEC
issued a pronouncement that included a discussion of its
position on pension accounting (search for “pension
accounting” on www.sec.gov).
Uncertainty of Estimates
accounting for pensions involves the estimation of a number
of factors that are highly uncertain. The computation of
pension expense requires estimates of future discount rates,
expected return on plan assets, and future events such as
employee turnover and employee mortality. Pension accounting
is replete with estimates. When the estimates do not conform
to reality, adjustments have to be made. Recording these
adjustments in a single year was unacceptable to FASB, which
chose to defer their effect and allocate the difference
between expected and actual amounts over a series of future
years. The goal of smoothing the effect of expensing pension
on income is producing financial statements that seriously
understate the cost of pensions and exclude the bulk of
pension assets and liabilities. The only way to truly understand
pension costs and the extent of over- or underfunding is
to examine the pension footnotes in a company’s Form
10-K. The issuance of SFAS 158 will require that the funded
status of a pension plan be reflected on a company’s
balance sheet as of December 31, 2006. SFAS 158 does not,
however, change how pensions are accounted for and reported
in the income statement.
Pension Benefit Guaranty Corporation (PBGC), the federal
agency responsible for insuring private-sector pension plans,
reported a deficit of $22.8 billion as of September 30,
2005. Executive Director Bradley D. Belt stated that “the
money available to pay benefits is eventually going to run
out unless Congress enacts comprehensive pension reform
to get plans better funded and provide the insurance program
with additional resources.” The pension insurance
program’s exposure to future losses was estimated
to be a staggering $108 billion in 2005, up from $96 billion
in 2004 and $82 billion in 2003. In its 2004 fiscal year,
the agency took over 192 pension plans, up from 155 the
previous year. Problems are particularly acute in the airline
industry and the manufacturing sector, especially the steel
industry. Experts expect the problem to worsen as companies
with defined benefit plans attempt to reduce or even eliminate
their pension obligations.
PBGC’s looming funding crisis was one of the reasons
behind the Pension Protection Act of 2006, signed into law
by President Bush on August 17, 2006. This legislation will
give most companies seven years to fully fund their pension
plans and will require accelerated payments from those companies
whose plans are seriously underfunded. But the compromises
made to get support for the bill will likely limit its effectiveness.
The rules don’t become effective until 2008, meaning
that most companies won’t be required to fully cover
their liabilities until 2015. The longer it might take for
companies to fully fund their pension plans, the more important
it is for investors to become familiar with how these liabilities
are calculated and accounted for.
Apostolou, DBA, CPA, is the LeGrange Professor, and
D. Larry Crumbley, PhD, CPA, is the KPMG
Endowed Professor, both in the department of accounting at
Louisiana State University, Baton Rouge, La.