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Recent developments in pension accounting: the FASB and IASB move toward convergence.

The economic crisis of the past few years has focused attention upon both the financial management of and the accounting for pension plans. Many employers face significantly underfunded defined benefit pension plans. The Pension Protection Act of 2006 (PPA) mandates increased funding and requires plans to achieve a target of 100% funding in 2011. Corporations have been lobbying Congress for relief from what they claim are onerous pension funding requirements.

In April 2004, the FASB and the IASB identified pension benefits as a topic they should both address as part of their convergence effort. The FASB added this topic to its agenda in November 2005, and the IASB followed in July 2006 with a similar project. The IASB project, like the FASB project, is being conducted in phases.


In September 2006, the FASB issued SFAS 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans, requiring employers to recognize the overfunded or underfunded status of defined benefit plans on their balance sheet. On December 30, 2008, the FASB issued FASB Staff Position (FSP) 132(R)-1, Employers' Disclosures About Postretirement Benefit Plan Assets, to provide guidance on an employer's disclosures about plan assets of a defined benefit pension or other postretirement plan, effective for fiscal years ending after December 15, 2009. FSP 132(R)-1 was issued because of users' concerns that disclosures lacked transparency with respect to the following:

* The types of plan assets,

* The risks associated with those assets, and

* The effect of the economy and markets on the value of plan assets.

The issuance of SFAS 158 and FSP 132(R)-1 marks the completion of phase one of the FASB's project to comprehensively reconsider employers' accounting for pension plans.

Benefit Versus Contribution

Qualified pension plans can be divided into two major 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. In this type of plan, no explicit promise is made about the size of 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 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.

In a defined benefit plan, a formula is specified for determining pension payouts for employees upon retirement. 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. Defined benefit plans raise many financial reporting complications. The primary difficulty is determining how much should be charged to pension expense in 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 requires estimates of the following five factors:

* What 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 increase of salaries until retirement?

* Over what length of time will the benefits be paid?

* What rate of return will be earned by the pension fund's investments?

* What discount rate should be used to reflect the present value of the benefits?

The required disclosures are designed to minimize volatility in the recognition of pension expenses. The objective of avoiding volatility is strongly supported by financial managers, who are extremely reluctant to have pension expense affected by the vagaries of the investment markets. This objective is achieved by employing numerous smoothing devices and deferrals in computing pension expense. The resulting rules are some of the most technically challenging and confusing in the accounting literature.

The number of defined benefit plans has declined substantially over the past two decades. The U.S. Government Accountability Office (GAO) in March 2009 published the results of a survey of private defined benefit plans. The GAO found that about 92,000 single-employer defined benefit plans existed in 1990, compared to just under 29,000 single-employer plans today. The survey was conducted in response to the desire of the U.S. Senate to know what changes employers have made to their pension and benefit offerings, and what changes employers might make in the future, as well as how these changes might be influenced by changes in legislation and accounting rules.

To gather information about defined benefit plans, the GAO asked 94 of the nation's largest defined benefit sponsors to participate in a survey. Responses were received from 44 companies that sponsor a total of 169 plans. These responding sponsors represented about one-quarter of the total liabilities in the nation's single-employer insured defined plan system as of 2004. The survey was substantially completed prior to the financial meltdown of late 2008. According to the GAO report, almost three-quarters of the respondents would not consider launching a new defined benefit plan. The remaining 26% of the respondents might consider starting a new defined benefit plan if regulatory and funding requirements were eased. Eighty-one percent of the respondents reported that they modified the formula for computing benefits for one or more of their defined benefit plans. Of the 169 plans reported by respondents, 47 (28%) were under a plan freeze.

FASB Plans

On November 10, 2005, the FASB voted to add a project to its agenda to consider revising the amounts reported for pension assets and obligations on the balance sheet and pension expense on the income statement. The board expected to conduct the project in two phases.

The first phase sought to address the concern that the funded or unfunded status of the plan should be recognized on the face of the financial statements rather than in the notes. In addition, the FASB hoped to improve the quality of information provided to users by expanding the disclosures required for postretirement benefit plan assets. With the issuance of SFAS 158 and FSP 132(R)-1, the board has now completed the objectives of phase one.

The second and more comprehensive phase will 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, particularly the obligations under 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.

Like the FASB, the IASB is engaged in an ongoing project to answer the above questions. Each board is currently working separately, but they intend to assess the opportunity for convergence as the work on each of the projects progresses. Both the FASB and the IASB have expressed their intention to create high-quality accounting standards that address presentation and disclosure of information about pensions.

IASB Rules

The IASB's International Financial Reporting Standards (IFRS) are similar to U.S. GAAP when it comes to the accounting for pension plans. For example, both IFRS and U.S. GAAP recognize the funded status of defined benefit plans (netting pension assets and obligations) on the balance sheet. But there are some notable differences. Unlike U.S. GAAP, IFRS does not recognize prior service costs on the balance sheet. Under International Accounting Standard (IAS) 19, Employee Benefits, any prior service cost is expensed immediately if it relates to benefits that have vested. The amount not vested is reported as an increase or deduction from the defined benefit obligation. In addition, IFRS allows the components of pension expense to be reported differently on the income statement. For example, the interest cost component of pension expense may be included with other expenses on the income statement. Finally, IFRS allows companies the choice of recognizing actuarial gains and losses in income immediately or amortizing them over the remaining service lives of employees. U.S. GAAP requires the recognition of actuarial gains and losses in "accumulated other comprehensive income" and amortized to income over remaining service lives of employees.

2009 Funded Status

A recent Watson Wyatt Worldwide analysis of pension disclosures for the 100 largest U.S. pension sponsors uncovered disquieting information about the current funding status of pension plans ("U.S. Pension Plan Funding Plunged by More Than $300 Billion in 2008, Watson Wyatt Analysis Finds," Watson Wyatt press release, March 11, 2009). Aggregate funding fell by $303 billion in 2008, dropping from an $86 billion surplus at the end of 2007 to a $217 billion deficit at the end of 2008. In total, funding levels decreased from 109% funded at the end of 2007 to 79% funded at the end of 2008.

The severe stock market decline is an obvious explanation of these findings, but the requirements of the Pension Protection Act of 2006 (PPA) exacerbated the problem. The PPA requires companies with underfunded plans to make additional payments and closed some loopholes that permitted companies to skip payments. Beginning in 2009, the PPA requires companies to increase their funding of pension plans to reduce the likelihood of plans failing. Before 2009, the funding ratio (percentage of future obligations funded) was about 90%. The PPA established a new funding ratio of 94% by the end of 2009, 96% by the end of 2010, and 100% by the end of 2011. Failure to meet these benchmarks would force a company to fully fund their pensions immediately.

The survey disclosed a decline in pension assets of 26% in 2008, largely inflicted by the depressed stock market. The larger the percentage of assets invested in equities, the greater the investment losses. Pension plans that had less than 20% of their portfolios invested in equities lost an average of 6%, while those plans that allocated from 55% to 59.9% declined by 23.6%. A further indication of the difficulty faced by companies in funding their pension plans is the significant deterioration in the funding ratio over the past year. The survey revealed that 80% of plan sponsors had funded at least 90% of their pension obligations by the end of 2007. Only 14% were more than 90% funded by the end of 2008. This deterioration in the funding ratio does not seem to have affected the commitment to equities. The survey found that the average target equity allocation is 55%, as compared to 58% for 2008.

An additional interesting finding is the disparity among assumptions as to the discount rate used by different companies. The average discount rate used to calculate the pension obligation at the end of 2008 was 6.36%. While more than half (55%) of plan sponsors used a higher discount rate in 2008 as compared to 2007, 19% used the same rate and 26% used a lower rate.

With so many pension plans seriously underfunded, many companies--including Pfizer, IBM, and United Parcel Service--petitioned Congress for relief from the provisions of the PPA in late 2008. Congress responded in December 2008 by eliminating the punitive requirement of 100% funding for failure to meet the benchmark. Congress made no change in the benchmarks, however: This year, 94% is still required, and 100% will be required in 2011.

FASB Staff Position

On December 30, 2008, the FASB issued FSP 132(R)-1, which requires employers to make additional disclosures about plan assets for defined benefit pension and other postretirement benefit plans for years ending after December 15, 2009. The objectives of the disclosures are to provide users of financial statements with an understanding of the following:

* How investment allocation decisions are made,

* The major categories of plan assets,

* The inputs and valuation techniques used to measure the fair value of plan assets,

* The impact of fair value measurements that use significant unobservable inputs on changes in plan assets for the period, and

* Significant concentrations of risk within plan assets.

To achieve these objectives, the board amended SFAS 132(R), Employers' Disclosures About Pensions and Other Postretirement Benefits--an Amendment of FASB Statements No. 87, 88, and 106, and established new reporting requirements in FSP 132(R)-1.

Specific Disclosures

FSP 132(R)-1 requires disclosures about how investment allocation decisions are made, including factors that are pertinent to an understanding of investment policies and strategies. To meet that objective, employers must describe the investment policies and strategies, including target allocation percentages or ranges and other important facts, such as investment goals and risk-management practices that are either permitted or prohibited (including the use of derivatives), diversification, and the relationship between plan assets and benefit obligations (see Exhibit 1).


Narrative Description of Investment Allocation Strategy

The company's overall investment strategy is to achieve a mix of approximately 60% of investments for long-term growth and 40% for near-term benefit payments, with a wide diversification of asset types, fund strategies, and fund managers. The target allocations for plan assets are 40% equity securities, 40% corporate bonds and U.S. Treasury securities, and 20% all other types of investments. Equity securities primarily include investments in large-cap and mid-cap companies mainly located in the United States. Fixed-income securities include corporate bonds of companies from diversified industries, mortgage-backed securities, and U.S. Treasuries. Other types of investments include those in hedge funds and private equity funds that follow several different strategies.

Source: Financial Accounting Standards Board, adapted from FASB Staff Position (FSP) 132(R)-1, page 23.

Under FSP 132(R)-1, employers are to disclose separately the fair value of each major category of plan assets at each balance sheet date according to the three-level fair value hierarchy for classifying fair value measurements under SFAS 157, Fair Value Measurements. Level 1 uses quoted prices for identical assets in active markets. Level 2 includes quoted prices for similar items in active markets or for identical or similar items in inactive markets. Level 3 includes unobservable inputs, such as management's estimates of future cash flows that cannot be confirmed with observable market data, a method that is often referred to as mark-to-model.

FSP 132(R)-1 expands the number of major asset categories in SFAS 132(R) to include the following:

* Cash and cash equivalents;

* Equity securities;

* Debt securities issued by national, state, and local governments;

* Corporate debt securities;

* Asset-backed securities;

* Structured debt;

* Derivatives segregated by type of underlying risk in the contract (e.g., interest-rate, foreign-exchange, equity, commodity, and credit contracts); and

* Real estate.

The information disclosed about fair value measurements should enable users of financial statements to assess the inputs and valuation techniques used to develop fair value measurements of plan assets at the annual reporting date. To meet this objective, an employer must disclose the level within the fair value hierarchy (Level 1, 2, or 3), a reconciliation of the beginning and ending balances for Level 3 fair value measurements, information about the valuation techniques and inputs used at the balance sheet date, and any changes to those techniques and inputs made during the year (see Exhibit 2).

Fair Value Measurements

                                Fair Value Measurements at December
                                      31, 20XX (in millions)
Asset Category          Total  Quoted Prices  Significant  Significant
                                 in Active    Observable   Unobservable
                                Markets for     Inputs       Inputs
                                 Identical    (Level 2)     (Level 3)
                               Assets (Level

Cash                    $ 150       $ 150

Equity securities:

  U.S. large-cap (a)      550         550

  U.S. mid-cap growth     100         100

  International           325         325
  large-cap value

  Emerging markets         75          25           $ 50

  Domestic real           100          20             80


  U.S. Treasuries         200         200

  Corporate bonds (b)     200                        200

  Mortgage-backed          50                         50

Other types of

  Equity long/short        55                                  $ 55
  hedge funds (c)

  Event-driven hedge       45                                    45
  funds (d)

  Global opportunities     35                                    35
  hedge funds (e)

  Multistrategy hedge      40                                    40
  funds (f)

  Private equity funds     47                                    47

Real estate                75                                    75

Total                 $ 2,047     $ 1,370          $ 380      $ 297

(a) This category comprises low-cost equity index funds not actively
managed that track the S&P 500.
(b) This category represents investment-grade bonds of U.S. issuers
from diverse industries.
(c) This category includes hedge funds that invest both long and short
in primarily U.S. common stocks. Management of the hedge funds has the
ability to shift investments from value to growth strategies, from
small to large capitalization stocks, and from a net long position to a
net short position.
(d) This category includes investments in approximately 60% equities
and 40% bonds to profit from economic, political, and government-driven
events. A majority of the investments are targeted at economic policy
(e) This category includes approximately 80% investments in non-U.S.
common stocks in the healthcare, energy, information technology,
utilities, and telecommunications sectors and approximately 20%
investments in diversified currencies.
(f) This category invests in multiple strategies to diversify risks and
reduce volatility. It includes investments in approximately 50% U.S.
common stocks, 30% global real estate projects, and 20% arbitrage
(g) This category includes several private equity funds that invest
primarily in U.S. commercial real estate.
Source: Financial Accounting Standards Board, FASB Staff Position (FSP)
132(R)-1, pages 24-25.

Under FSP 132(R)-1, a company should provide users of financial statements with sufficient information to evaluate a significant concentration of risk in plan assets. Examples of concentration of risk include significant investments in a single entity, industry, country, commodity, or investment fund.

Focusing on the End Goal

The accounting for pension plans continues to be a controversial topic. The FASB has initiated a two-phase project that would provide guidance for disclosing annual pension expenses on the income statement and plan assets and liabilities on the balance sheet and footnotes. Phase one of the project resulted in SFAS 158, which required the disclosure of pension plan surpluses or deficits on the balance sheet. The FASB followed up with FSP 132(R)-1, which dramatically increased disclosures related to the types of plan assets, measurement of such assets, and the risks associated with such assets. This marks the end of the first phase of the project to comprehensively reconsider the rules for accounting for pensions. In the second phase, the FASB has indicated its intention to change the measurement of pension expenses on the income statement and pursue the goal of convergence with the IASB.

Barbara Apostolou, PhD, CPA, and Nicholas G. Apostolou, DBA, CPA, are both professors in the division of accounting at West Virginia University, Morgantown, W.Va.
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Title Annotation:employee benefit plans; Financial Accounting Standards Board, International Accounting Standards Board
Author:Apostolou, Barbara; Apostotou, Nicholas G.
Publication:The CPA Journal
Geographic Code:1USA
Date:Nov 1, 2009
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