Underfunded pension plans now mean more company liability.
Pension expense for overfunded plans has generally been lower under the Financial Accounting Standards Board's (FASB) Statement 87 than under previous pension accounting rules. However, it has often been higher for underfunded plans, including most collectively bargained plans and supplemental executive retirement plans (SERPs).
Sponsors of underfunded pension plans have yet to feel the full impact of Statement 87, however, due to a dealy in the effective date of one of its harshest requirements. Beginning in 1989, Statement 87 is requiring companies with plans in which the accumulated benefit obligation (ABO) exceeds the sum of pension assets and unfunded accrued pension cost to show additional balance sheet liabilities to account for the deficit. What will be the impact of this new rule on net worth and the ratio of debt to stockholders' equity? And how can companies minimize the negative impact on their balance sheets?
In the past, a company had to include a liability on its balance sheet for any pension costs that were expensed but not funded. (An asset was shown if pension contributions exceeded expensed amounts.) FASB Statement 87 does not change this practice, but it specifies that a company must also report an "additional minimum liability" equal to the difference between the ABO plus the sum of unfunded accrued pension cost and the assets specifically set aside to provide for those benefits. The ABO is the current liability for pension benefits that have already been earned. Thus, a company with a pension plan that is underfunded for accrued benefits may have to report an additional minimum liability.
Some foreseeable problems
Statement 87 strictly defines which assets qualify to offset a company's obligation to pay benefits. Therefore, a company may have an additional minimum liability even though its benefit obligations seem well secured. Assets do not qualify as such under Statement 87 unless they have been specifically segregated and pledged to pay pension plan benefits, usually in a qualified pension trust, even if they were purchased with the intent of funding benefits. For instance, life insurance purchased in connection with SERPs falls into this "intended but not segregated" category. The cash value of the life insurance may be reported as a general asset of the company, but it may not be used as an offset to the obligation to pay SERP benefits.
Assume XYZ Company establishes a new pension plan with a first-year Statement 87 expense of $1,500. The employer's contribution is $1,000. Thus, there is a balance sheet liability for the $500 that is expensed but not funded.
At the end of the year, the plan's ABO is $3,000. Its additional minimum liability is thus $1,500--the amount by which the ABO exceeds the sum of the assets and the unfunded accrued pension cost. The sum of the two balance sheet liabilities is the unfunded ABO.
The following types of plans are likely to produce an additional minimum liability on the balance sheet:
Plans for hourly employees that pay a specified number of dollars per month per year of service.
Recently established pension plans that grant benefit credit for service before the plan was adopted.
Plans that have been amended in the past few years to improve benefits.
Unfunded retirement plans, most commonly SERPs and foreign plans.
When a company reports an additional minimum liability under FASB Statement 87, it will generally be allowed to report an "intangible asset" in an equal amount. For example, an intangible asset of $1,500 would be created for XYZ Company. This effectively "grosses up" the balance sheet to reflect the underfunded pension obligation without changing the company's net worth. However, Statement 87 limits the amount of the intangible asset, and thus any additional minimum liability that a company must recognize above this limit will reduce stockholders' equity.
The intangible asset can be no larger than the amount of unrecognized prior service cost (UPSC) remaining from the transition to the Statement 87 rules and the UPSC from any plan amendments following that transition. The intangible asset limit thus declines each year as these prior service costs are amortized into expense, and increases when the sponsor adopts a plan amendment affecting prior service.
The prior service costs on which the intangible asset limit is based are calculated using projected benefits, which tend to be considerably larger in pay-related pension plans than the accrued benefit obligation on which the additional minimum liability is based. Thus, any additional minimum liability will often be fully offset by an intangible asset, and stockholders' equity will not be affected.
The new requirement will affect stockholders' equity in many instances, but most probably in companies that sponsor dollar-per-month plans, where the projected benefit obligation is equal to the ABO, and other plans whose unfunded ABO rose as a result of actuarial losses, such as declines in asset values stemming from the stock market crash.
Even when the intangible asset preserves stockholders' equity, the ratio of liabilities to stockholders' equity (i.e., the debt/equity ratio) will be affected by an additional minimum liability because liabilities will increase while equity remains unchanged. This can cause several problems, including the following:
Convenants on existing debt often stipulate that the debt/equity ratio may not exceed a certain level. The impact of the additional minimum liability on this ratio may result in a violation of these covenants.
The amount a company can borrow and the rate of interest it must pay often hinge on the relationship of debt to equity: the higher the ratio, the costlier the credit. Many lenders will discount or ignore intangible assets in determining creditworthiness.
An increase in the debt/equity ratio may also affect the price of a company's stock. Moreover, financial analysts may discount intangible assets when making buy or sell recommendations.
What about timing?
The SEC requires a company to publish its annual report within 90 days of the close of the fiscal year. Therefore, the end-of-year pension information provided in the footnotes to the company's annual financial statements must normally be prepared within eight weeks after the fiscal year closes.
However, it is not practical for some companies to generate this information in time for publication. Therefore, it is not uncommon for the footnote to include estimates of the obligation developed from census data as of the beginning of the fiscal year. It also is not unusual for the assets presently included in the footnote to be estimates as well. The use of reasonable estimates is normally acceptable because the assets and obligations shown in the footnote do not have a direct bearing on a company's "real" year-end assets and liabilities.
A higher degree of precision in the estimates is required, however, when the year-end assets and ABO give rise to an additional minimum liability, particularly when that liability will reduce a company's net worth. When this degree of precision is required, a company should consider using a measurement date--the actual date as of which assets and obligations are valued--that falls before the end of the fiscal year. (FASB Statement 87 permits companies to use a measurement date of up to 90 days before the end of the fiscal year, and measurement date figures are not adjusted to the end of the year for presentation in the financial statements.) By using an early measurement date, a company may be able to gather data and determine the appropriate amount of assets and ABO in time for publication in the annual report.
It may be possible for a company to calculate exact year-end amounts for a SERP, even when the measurement date is at the end of the fiscal year, because these plans frequently have few participants and there is rarely any asset data to collect. On the other hand, it may not be practical to collect employee data in time to make precise calculations for other plans. If so, the company's actuary should ensure that as much information as possible is gathered when estimates are made, including:
Information on all plan amendments adopted by the end of the fiscal year. This includes amendments adopted before year-end that are not effective until after the close of the year. The effect of such amendments is part of the year-end ABO, and consequently part of the additional minimum liability.
Information about year-end demographics (e.g., population, salaries). If there has been significant turnover, data on the characteristics of terminating employees (age, service, salaries, sex) is important. It is also helpful to know the average participant's salary increase for the year.
Under Statement 87 in the years to come, during the first quarter of the fiscal year the company's actuary and its chief financial officer should identify all plans that could result in recording an additional minimum liability. Technically, the additional minimum liability applicable at the end of the previous fiscal year must be reported in the interim financial statements. Moreover, by early planning, the company may avoid an unpleasant surprise at the end of the year. It will also be in a position to raise the issue of additional minimum liabilities, and their impact on the company's credit standing, during collective bargaining over pension increases.
SERPs usually will give rise to an additional minimum liability because their obligations are rarely funded by Statement 87 standards. However, it may be possible for a company to meet the Statement's asset test if assets used to fund SERP obligations are segregated in a rabbi trust--something that should be discussed with the company's independent accountants.
Moreover, a SERP's additional minimum liability can often be reduced by careful plan design. Suppose a company wants to establish a SERP that provides executives with a benefit of 60 percent of final earnings at retirement, regardless of service. Most of its executives will have more than 30 years of service at retirement, but a few will have only 20 years. A SERP formula that provides a benefit of 3 percent of salary for the first 20 years of service will achieve the company's goal, as will a formula that merely provides for a normal retirement benefit of 60 percent of salary, with pro rata reductions for early retirement. However, the additional minimum liability associated with the 3-percent-of-salary formula is likely to be much greater than the additional minimum liability associated with the 60-percent formula.
An executive who retires early may not do as well under the 60-percent formula. This problem can be alleviated if the board of directors approves a full benefit for the executive at the time of retirement. Such an approach will allow the company to provide the 60-percent benefit to the executive while reducing the amount of its additional minimum liability. In this situation, of course, the benefit promised at early retirement is smaller. But an executive who is contemplating early retirement may feel less secure with this approach, because the amount of his early pension benefit is at the discretion of the board of directors.
A year of change
FASB Statement 87 has already saddled sponsors of underfunded plans with higher pension costs. Beginning in 1989, some of these companies are having the additional burden of reporting larger liabilities on their balance sheets. The debt/equity ratio will be impacted for all affected companies, and net worth will be reduced for many. By taking the steps outlined above, these companies may be able to minimize the adverse impact of the additional minimum liability requirements.
PHOTO : Covered bowl of soft-paste porcelain, Italy, c. 1750 From the porcelain factory at the Palace of Capodimonte, known for its crisp, thin, and pure white porcelain
PHOTO : Soup plate of hard-paste porcelain, China, 1784/85 Purchased by General George Washington as part of a 306-piece service that sold for $150
PHOTO : Soup plate of hard-paste porcelain, France, 1873 Part of Abraham Lincoln's presidential service, made at Limoges and still represented by numerous pieces at the White House
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|Author:||Levit, Alan D.|
|Date:||May 1, 1989|
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