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Defined Benefit Pension Plans: understanding the differences between the public and private sector.

Accounting and financial reporting for defined benefit (DB) pension plans provide needed information to a wide variety of corporate and governmental stakeholders, including active workers, retirees, investors, voters, and taxpayers. DB pensions represent an employer's real obligations to its active and retired employees promises that must be honored. Unfortunately, the pension obligations of many organizations are outpacing their ability to fund them. In the case of the American Airlines bankruptcy, the company reported approximately $8 billion in pension assets to cover $18 billion in pension obligations to its employees (Mike Spector, "Filing Puts Pension Benefits at Risk," Wall Street Journal Online, November 30, 2011). The third quarter of 2011 was the second-worst quarter in history for corporate pensions because plunging market prices dramatically devalued invested pension plan assets, creating or exacerbating underfunded pension obligations (Vipal Monga, "The $440 Billion Pension Gap," Wall Street Journal Online, November 30, 2011).


In addition to significant funding problems, accounting professionals and the general public have recently raised concerns that the differences in accounting and reporting rules for DB pensions that exist between FASB and the Governmental Accounting Standards Board (GASB) add unnecessary confusion to stakeholders' attempts to understand an already complex topic. The accounting and financial reporting for pensions under both FASB and GASB are examined below, along with the two key drivers in computing total pension obligations: pension obligation discount rates and expected rates of return on plan assets. These two assumptions play key roles in determining the magnitude and funding status of DB pensions, and corporate and governmental entities make very different assumptions about them.

Scope of the Issue

Millions of active and retired workers rely on DB pension plans to finance their retirement years. In the private sector, many companies offer multiple DB plans covering various groups of employees; in the public sector, individual pension plans for state and local employees are often managed and operated by state pension systems. Most states have one or two public pension systems, but some states have more. (The sample analyzed here includes 10 states with data reported for between three and seven pension systems.) Each public pension system represents at least one--and possibly multiple--individual DB pension plans covering various groups of state and local government employees.

Future pension obligations of both companies and state governments collectively amount to trillions of dollars; obligations of numerous pension plans can be measured individually in billions of dollars. Public sector pension obligations generally dwarf those in the private sector. Exhibit 1 shows that the mean total pension obligation of the private sector has ranged from $0.8 billion in 2001 to $2.1 billion in 2010 and averaged nearly 25% of annual revenues during that time. In Exhibit 2, the mean pension obligations for public employee systems ranged from $20.3 billion to $35.4 billion over the same period; on average, they represent a staggering 350% to 560% of annual state revenues.



While it is true that total pension obligations do not need to be paid out all at once, the exhibits suggest that, compared to the private sector, public sector pension obligations represent a much larger--and quickly growing--demand on available resources. The problem has been worsened by the recent economic downturn: DB pension obligations to employees remain consistent, even as revenues decline.

Comparison of FASB and GASB Rules

Under Accounting Standards Codification (ASC) 715-30-25 (Statement of Financial Accounting Standards [SFAS] 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans), FASB requires that companies report their DB pension funding status on their balance sheet. Funding status is the difference between the pension benefit obligation (PBO) and the fair value of plan assets set aside by a company to meet these obligations to employees. Pension overfunding (underfunding) is reported on the balance sheet as a pension asset (liability). ASC 715-30-35 (SFAS 87, Employers' Accounting for Pensions) requires that companies report DB pension assets at their fair values. Gains and losses (outside of pension expenses) are recognized in other comprehensive income (OCI).

Companies are required to follow Generally Accepted Accounting Principles (GAAP), as promulgated by FASB, but individual states determine whether they and local governments must follow GAAP. A 2008 GASB survey estimated that between 67.3% and 71.5% of state and local governments do follow GAAP ("State and Local Government Use of Generally Accepted Accounting Principles for General Purpose External Financial Reporting," GASB research brief, 2008,

Current GASB accounting and reporting rules for state and local DB pensions are somewhat different from FASB's rules. GASB Statement 25, Financial Reporting for Defined Benefit Pension Plans and Note Disclosures for Defined Contribution Plans, requires that statements of plan assets and changes in plan net assets be presented by administrators of DB pension plans. Exhibit 3 and Exhibit 4 give examples of these financial statements, as presented by the administrator of Wisconsin's public employee pension system (Comprehensive Annual Financial Report, Wisconsin Department of Employee Trust Funds, 2010, Supplemental disclosures for actuarially determined values of pension plan assets and accrued liabilities are also required. GASB Statement 27, Accounting for Pensions by State and Local Governmental Employers, lays out requirements for employers' reporting of pension expenses, as well as related assets and liabilities. Under GASB Statement 27, pension expense includes pension benefits earned by employees during the current period, interest on the total pension obligation, and the net effect of changes in pension assets resulting from paying out benefits and receiving contributions. The effects of projected earnings (losses) on invested pension assets, changes in pension benefit terms, or revised assumptions are not expensed immediately; instead, they are deferred over a period of up to 30 years. GASB Statement 50, Pension Disclosures, requites disclosure of a pension's funded status but, unlike FASB rules, does not require balance sheet reporting of pension assets (or liabilities). The use of actuarial values, rather than fair values, is required for pension assets and liabilities in pension funding status disclosures. Actuarial values might differ significantly from fair values. Disclosing the fair value of pension assets is optional under GASB, reporting pension asset fair values is required under FASB.

Example of a Statement of Plan Net Assets

Wisconsin Department of Employee Trust Funds
Statement of Fiduciary Net Assets
December 31, 2010
(In Thousands)

Assets:                    Wisconsin       Duty    Accumulated
                           Retirement  Disability   Sick Leave
                             System                 Conversion

    Equity in             $2,712,773          $0            $0
    Pooled Cash
    & Cash

    Securities             5,160,488           0             0

    Prepaid                    9,031           0          9,620


         Contributions       147,693       5,554          3,443

         Prior Service       164,583           0              0

         Benefit               3,974         423              0

         Due from Other        4,511           0              3
         Trust Funds

         Rebates                   0           0              0

         Miscellaneous         2,018           0              0

         Interest and        200,085           0              0

         Investment          192,810           0              0

           Total             715,674       5,977          3.446

    Investments at
    Fair Value:

         Stocks           45,551,251           0              0

         Fixed-Income     21,706,552           0              0

         Multiasset          865,905           0              0

         Limited           7,485,977           0              0

         Real Estate         341,290           0              0

         Preferred           131,372           0              0

         Convertible          82,884           0              0

         Mortgages            43,189           0              0

         Foreign              26,739           0              0

         Options               (119)           0              0

         Financial            16,825           0              0

         Investment in             0     396,661      2,032,702
         Core Fund

         Investment in             0           0              0
         Variable Fund

         Investment in             0           0              0
         External Pool

           Total          76,251,865     396,661      2.032,702

    Capital                    2,179           0              0

         Total Assets     84,852,010     402,638      2,045,768


    Core                   3,139,928           0              0
    Investment Due

    Variable                  19,439           0              0
    Investment Due

    Securities             5,160,488           0              0

    Benefits                 269,640       2,526              0

    Other                          0           0      2,214,681

    Unearned                     167           0              0

    Due to Other                  54          26              0
    Trust Funds

    Miscellaneous            118,316           0              0

    Investment               271,906           0              0

         Total             8,979,938       2,552      2,214,681

Net Assets      $75,872,072       $400,086        $(168,913)
Held in Trust
Benefits and

The accompanying notes are an integral part ot the financial

Source: 2010 Comprehensive Annual Financial Report prepared
by the Wisconsin Department of Employee Trust Funds, the
administrator of Wisconsin's public employee pension system


Example of a Statement of Changes in Plan Assets

Wisconsin Department of Employee Trust Funds
Statement of Changes in Fiduciary Net Assets
For the Year Ended December 31, 2010
(In Thousands)

Additions:                       Wisconsin    Duty       Accumulated
                                Retirement  Disability   Sick Leave
                                    System  Conversion


              Employer           $ 679,792     $51,865     $ 32,607

              Employee             787,461           0            0

              Total              1,467,253      51,865       32,607

          Deposits                       0           0            0

          Investment                                 -

              Net                7,430,215           0            0
              in Fair Value
              of investments

              Interest             592,814           0            0

              Dividends            781,206           0            0

              Securities            17,292           0            0
              Lending Income

              Other                 85,509      42,014      223,064


              Investment           338,364           0            0
              Distributed to
              Other Funds

              Investment           245,806           0            0

              Securities             5,431           0            0
              Lending Rebates
              and Fees

          Net Investment         8,317,435      42,014      223,064

          Interest on                9,546           0            0
          Prior Service

          Service                        0           0            0

          Miscellaneous                990           0            0

Total                            9,795,224      93,879      255,671


              Benefits and

              Retirement,        3,875,429      30,338            0
              Disability, and

              Separation            26,415           0            0

              Other Benefit              0           0      130,983

              Distributions              0           0            0

              Carrier                    0           0            0

              Departmental          17,604         441          265

Total                            3,919,448      30,779      131,248

Net Increase                     5,875,776      63,100      124,423

Net Assets    Beginning of      69,996,296     336,986    (293,336)

              End of Year      $75,872,072    $400,086   $(168,913)

The accompanying notes are an integral part of the financial

Source: 2010 Comprehensive Annual financial Report prepared by
the Wisconsin Department of Employee Trust Funds, the administrator
of Wisconsin's public employee pension system

DB pensions are essentially promises to pay compensation in the future; however, there might be substantial uncertainty surrounding the present magnitude of the ultimate liability, its growth rate, and whether existing pension plan assets will sufficiently meet future needs. Employers make numerous choices in actuarial methods and assumptions. The sections below focus on two of the most important: the discount rate used to determine the present value of the pension obligation and the expected rate of return (ERR) on invested pension plan assets.

Pension obligation discount rates. FASB defines the PBO as the present value of the total future pension obligation, using a discount rate at which the obligation could effectively be settled--in other words, how much money an employer would invest today, and at what interest rate, in order to have the necessary funds available to pay future pension benefits promised to retirees. When selecting a discount rate, FASB suggests that employers examine high-quality, fixed-income investment rates (such as those of U.S. Treasuries with maturities matched to the timing of future pension benefit payments) and consider future available reinvestment rates. Employers must evaluate the rate each year and change it if necessary.

Exhibit 5 compares mean discount rates used by companies and public employee retirement systems. The rates used by public pension systems are consistently much higher and vary less than private employers' rates because GASB requires that future pension obligations be discounted at the same rate of return expected to be earned on invested pension assets.


Several researchers and pension analysts claim that GASB's rule presents a serious potential problem. Pension plan assets are invested in mixtures of stocks, bonds, and other financial instruments, and an ERR should appropriately reflect the riskiness of the investment portfolio. Similarly, an appropriate discount rate for DB obligations would properly reflect the risk of the liabilities, which is generally much lower than the risk of invested pension assets, because employers know they must honor their promise to make future pension payments to retired employees. In addition, pensions of some state and local government employees, such as those in Arizona or Illinois, are constitutionally protected from elimination or reduction. This argument implies that a discount rate for pension liabilities should be in the order of a rate on very low-risk instruments--perhaps Treasury bonds--that could be purchased today to meet the nearly certain future liabilities.

Opponents of GASB' s current rule point out that, when determining the present value of a future stream of pension benefit payments, a higher discount rate provides a lower present value. GASB's requirement that an employer use the expected long-term rate of return on invested pension assets to discount a future pension obligation is likely to result in a valuation that is far too low. Using lower discount rates would better reflect the more certain nature of pension obligations, but it would also increase the present value of those obligations. (For example, see the sidebar, The Effect of Interest Rates on Pension Obligation Valuation.) In fact, a study by Robert Novy-Marx and Joshua Rauh argued that GASB's requirement presents a "false equivalence" between the nearly certain obligations to employees and much riskier returns on invested assets ("The Liabilities and Risks of State-Sponsored Pension Plans," Journal of Economic Perspectives, vol. 23, no. 4, pp. 191-210, 2009). This can distort financial statement users' perceptions of how well funded DB pensions for public employees actually are.

Disclosure using (lower) market-based discount rates to determine the present value of pension obligations is permitted under GASB; however, some public pension administrators actively discourage such disclosures, fearing taxpayer reactions if potentially higher pension obligations are reported.

Expected rates of return on invested plan assets. Both GASB and FASB require disclosure of ERR. Companies utilize the expected dollar return on plan assets as a component of pension expense, and the difference between expected and actual return is reported in OCT. A company's managers might try to manage income by opportunistically choosing a high ERR to reduce reported pension expense, but auditors, regulators, and the discipline of capital market investors offset incentives for earnings management.

Under present GASB rules, government employers also have incentives to assume high ERRs--and there seems to be little to discourage them from doing so. A higher ERR means that the expected growth of plan assets is assumed to be better, potentially offering a rationale for cash-strapped state and local governments to make lower (or no) cash contributions to pension funds so that they can address other important budget priorities. GASB currently requires that the pension obligation discount rate equal the ERR; thus, choosing a high ERR has a double benefit because the present value of the reported obligation is lower when a higher ERR/discount rate is used. Exhibit 6 shows that public sector ERRs changed very little over the last decade, while corporate ERRs steadily declined; however, public employee retirement systems are slowly adjusting their ERRs after years of turmoil in financial markets. For example, a March 14, 2012, Wall Street Journal article ("Calpers Lowers Investment Target to 7.5%," by Michael Corkery) described the decision by Calpers' pension and health benefits committee to lower that system's ERR by 0.25%--from 7.75% to 7.5%--for the first s time in nine years. The economic realities of lower market returns on invested pension assets, together with increasing calls to realistically portray the size of public pension obligations, are persuading some state and local pension system managers to reduce ERRs.

What's Next?

GASB and FASB share the goal of providing timely, relevant information to financial statement users. Each has committed significant resources to improving financial reporting and disclosure for DB pensions, supporting research projects and seeking user inputs.

FASB issued SFAS 158 in 2006. A joint project between FASB and the International Accounting Standards Board (IASB) on postretirement benefit obligations, including pensions, was assigned a low priority in 2009 and no further action is expected in the foreseeable future, although FASB and the IASB remain committed to working toward convergence. The IASB issued an amended International Accounting Standard (1AS) 19, Employee Benefits, in 2011.

After researching the need for improvements, GASB added a new project to its agenda in 2008, which resulted in two new standards, approved on June 25, 2012. GASB Statement 67, Financial Reporting for Pension Plans, replaced GASB Statement 25; it establishes definitions for DB pension plans and for qualified trusts that administer them. GASB Statement 67 also sets out revised financial reporting standards for DB pension plans administered through qualified trusts, depending upon the specific type of DB pension plan being administered. Additional note disclosures and required supplementary information are also required. GASB Statement 67 is effective for financial statements for periods beginning after June 15, 2013, and earlier application is encouraged.


The second new standard, GASB Statement 68, Accounting and Financial Reporting for Pensions, is effective for fiscal periods starting after June 15, 2014. It replaces GASB Statements 27 and 50, establishes numerous changes to accounting and reporting for DB pension plans, and applies to government employers that offer such plans. Four of the most significant changes included in this new standard require government employers to do the following:

* Report the net pension liability--that is, the difference between the total pension liability and the value of pension assets dedicated to paying benefits (primarily invested assets reported at their fair values)--as a liability (asset) in the entity's financial statements. Governments participating in cost-sharing multiemployer plans report their proportional share of the total pooled liability. According to GASB, pension obligations meet the definition of a liability and, as such, should be recognized in financial statements.

* Continue discounting projected benefit payments using the ERR, unless plan assets are deemed insufficient to meet future needs. If so, the new rule calls for employers to use a discount rate for projected benefits that blends the ERR with the rate on tax-exempt, high-quality, 30-year municipal bonds. This practice more clearly reflects the resources needed to meet promised benefit payments, according to GASB.

* Apply a uniform method for allocating the present value of benefit payments to employees' present/past service versus future service. Currently, employers can select one of six methods for allocation. This choice affects both the reported pension expense and the size of the total pension liability. Under the new guidance, all employers are required to use the entry age normal method, as a level percentage of payroll; this is already the method most frequently used by government employers, and GASB believes that it best matches pension obligations with the way employees actually earn their pension benefits. Requiring all employers to use the same method should improve the comparability of financial statements for users:

* Change the way that immediate and deferred pension expenses are calculated. At present, pension benefits earned in the current period, interest on the total pension liability, and net effects of contributions/benefit payments are recognized immediately in pension expense. GASB Statement 68 requires immediate recognition of the effects of benefit changes. Effects on the net pension liability of changes in economic and demographic assumptions will be recognized in pension expense over a closed period determined by the average remaining service period of all plan members (including retirees). The effects of differences between expected and actual returns on invested plan assets will be recognized in pension expense over a five-year period. GASB Statement 68 does not require governments to change their annual pension contributions or other arrangements for funding their employees' pensions.

During an extended comment period, the exposure drafts for these two new GASB Statements generated approximately 700 responses from stakeholders--that is, representatives of public employees covered under these pensions, government employers, and the accounting profession. (Comment letters on GASB projects are public records, and can be accessed at Some of these issues were raised in the comment letters; for example, public employees and employers were concerned about potential effects of recognizing larger pension-related liabilities and expenses in the governments' financial statements. Numerous public sector financial professionals expressed apprehension about the cost and complexity of the calculations required under the new guidance and questioned whether financial statement users will really benefit. Comment letters from the accounting profession seemed to generally support GASB's proposals and agree that transparency and financial statement comparability will be improved. Some in the accounting profession thought that the new standards should go further; for example, comment letters submitted by Deloitte & Touche LLP and Ernst & Young LLP advocated a more market-based "settlement" approach for determining the present value of PB0s, rather than continued reliance on ERR. As GASB Statements 67 and 68 are implemented, their effects on all stakeholders can be evaluated.


Consider an employee currently covered under a company's defined benefit pension plan. The employee will retire one year from today and begin receiving annual pension benefit payments of $12,000.

For simplicity, assume that the employee will receive one annual payment each January 1 rather than monthly payments, that the employee's life expectancy after retirement is 20 years, and that there are no cost-of-living or other adjustments. (Changes in these assumptions add to the complexity of the computation, but do not change the discount rate's effect on the pension obligation.)

How much must the employer invest today in order to ensure that enough funds will be on hand to meet this obligation? The following table shows the effect of the selected discount rate on the present value of the pension obligation.
If the discount rate   then this amount must be
is equal to ...                  invested today:

8%                                   $ 117,818

6%                                   $ 137,639

4%                                   $ 163,084

2%                                   $ 187,070

Kathryn E. Easterday, PhD, CPA, is an assistant professor and Tim V. Eaton, PhD, CPA, is an associate professor, both in the department of accountancy at the Farmer School of Business, Miami University, Oxford, Ohio. The authors gratefully acknowledge support from the Farmer School of Business and the assistance of Keith Brainard, research director of the National Association of State Retirement Administrators, who provided detailed survey data on public-sector pensions.
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Title Annotation:government accounting
Author:Easterday, Kathryn E.; Eaton, Tim V.
Publication:The CPA Journal
Geographic Code:1USA
Date:Sep 1, 2012
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