Audit and Enterprise Risk Services
Financial Reporting Considerations Related to Pension and Other Postretirement Benefits
Financial Reporting Alert 10-11
This Financial Reporting Alert updates Financial Reporting Alert 09-5, Financial Reporting Considerations for Pension and Other Postretirement Benefits, and highlights accounting matters that may affect an entity’s defined benefit pension and other postretirement plan benefit calculations and disclosures. This alert also serves as a reminder for entities to consider the impact on postretirement benefits of the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010 (collectively, the “Act”), enacted on March 23, 2010, and March 30, 2010, respectively.
ASC 715 requires that an entity record the funded status of its defined benefit pension and other postretirement benefit plan(s) as an asset or liability on its balance sheet. Financial statement preparers should focus on how (1) continued volatility in the financial markets and (2) the accounting standards on fair value measurement affect the value of an entity’s plan assets at year-end. Because funded status is computed as the difference between plan assets and the benefit obligation, a decrease (or increase) in a plan’s assets will result in a dollar-for-dollar pretax decline (or increase) in funded status. Accordingly, changes in the fair value of plan assets could have a significant effect on an entity’s postretirement benefit asset or liability. On the other hand, a decrease in the discount rate would result in an increase in the benefit obligation and a decline in the funded status, while an increase in the discount rate would result in a decrease in the benefit obligation and an improvement in funded status. Management should understand and evaluate the potential effect that an increasing postretirement benefit liability (or decreasing postretirement benefit asset) may have on its debt covenant calculations and capital requirements.
In measuring the defined benefit obligation and recording the net periodic benefit cost, financial statement preparers should understand, evaluate, and reach conclusions about the reasonableness of the underlying assumptions that could be affected by continued volatility in the financial markets. ASC 715-30-35-42 states that “each significant assumption used shall reflect the best estimate solely with respect to that individual assumption.”
To support their discount rate, some entities seek advisers for assistance in constructing hypothetical bond portfolios. Others use a yield curve constructed by a third party (e.g., Citigroup or an actuarial firm). Entities that use hypothetical bond portfolios to support the discount rate to measure their postretirement benefit obligations should evaluate the impact of current market conditions on both bond pricing and bond selection.
The discount rate used to measure postretirement benefit obligations should reflect the rate at which defined benefits could be effectively settled. Use of a model that reflects rates of zero-coupon, high-quality corporate bonds is an acceptable method of deriving the assumed discount rate. Since there are a limited number of zero-coupon corporate bonds in the market, models are constructed with coupon-paying bonds whose yields are adjusted to approximate results that would have been obtained through the use of the zero-coupon bonds.
ASC 715-30-35-44 states, in part:
[ASC 715-30-35-43] permits an employer to look to rates of return on high-quality fixed-income investments in determining assumed discount rates. The objective of selecting assumed discount rates using that method is to measure the single amount that, if invested at the measurement date in a portfolio of high-quality debt instruments, would provide the necessary future cash flows to pay the pension benefits when due. Notionally, that single amount, the projected benefit obligation, would equal the current market value of a portfolio of high-quality zero coupon bonds whose maturity dates and amounts would be the same as the timing and amount of the expected future benefit payments.
Constructing a hypothetical portfolio of high-quality instruments with maturities that mirror the postretirement benefit obligation is one method that can be used to achieve this objective; other methods that can be expected to produce results not materially different are also acceptable.
Credit market unrest may affect the level of trading activity for some bonds, resulting in large spreads between the bid and ask prices. Pricing should reflect the amount at which the postretirement benefit obligation could be settled. In the current market, bid price (which is often used because of the availability of data) may not necessarily be representative of the cost of acquiring a hypothetical portfolio. ASC 820-10-35-56 and 35-57 may assist entities in evaluating the appropriateness of bond pricing used in developing their models:
If an input used to measure fair value is based on bid and ask prices (for example, in a dealer market), the price within the bid-ask spread that is most representative of fair value in the circumstances shall be used to measure fair value, regardless of where in the fair value hierarchy the input falls (Level 1, 2, or 3). . . . This Subtopic does not preclude the use of mid-market pricing or other pricing conventions as a practical expedient for fair value measurements within a bid-ask spread.
In developing a hypothetical portfolio, entities are required to exclude certain bonds, known as “outliers,” and must also consider whether there is a sufficient quantity of the selected bonds ("capacity") in the market to cover their postretirement benefit obligations. In other words, the value of the bonds in the hypothetical portfolio must be sufficient to effectively settle the benefit obligation.
The discount rate may be affected by the volatility in the financial markets and downgrades in the bond instruments that are used to develop the rate. Entities should exclude outliers from the hypothetical bond portfolio when developing their postretirement plan discount rates; discount rates derived from hypothetical bond portfolios, which generally include fewer bonds, are more greatly affected than third-party yield curves if outliers are inappropriately included.
Outliers may include bonds that have high yields because:
· The issuer is on review for possible downgrade by one of the major rating agencies (i.e., only if the downgrade would result in the bond no longer being considered a high-quality bond).
· Recent events have caused significant price volatility and the rating agencies have not yet reacted.
· Lack of liquidity on the bonds has caused price quotes to vary significantly from broker to broker.
Management should understand and evaluate the bonds in its hypothetical bond portfolios to ensure that all outliers have been identified and excluded. Rating agencies have downgraded a number of bonds during the last two years. Downgrades from high quality to less than high quality that occur shortly after the balance sheet date may indicate that a bond was an outlier on the balance sheet date, particularly if the bond was subject to a downgrade watch. Even after identifying and excluding outliers, entities should select a discount rate that is appropriate. Use of an inappropriately high discount rate could result in an understatement of the benefit obligation and, consequently, an overstatement of the plan assets.
An entity must consider capacity when assembling a hypothetical portfolio. ASC 715-60-35-79 states that discount rate assumptions should reflect “the present value of future cash outflows currently expected to be required to satisfy [the obligation and that the rates of return should reflect] investments currently available whose cash flows match the timing and amount of expected benefit payments” (emphasis added).
The objective of selecting assumed discount rates . . . is to measure the single amount that, if invested at the measurement date in a portfolio of high-quality debt instruments, would provide the necessary future cash flows to pay the [accumulated] benefits when due. Notionally, that single amount, the [accumulated postretirement] benefit obligation, would equal the current market value of a portfolio of high-quality zero coupon bonds, whose maturity dates and amounts would be the same as the timing and amount of the expected future benefit payments.
Some actuarial firms include collateralized bonds in the construction of hypothetical bond portfolios (HBPs) related to the determination of a discount rate for pension and other postretirement plans. The interest rates and yields on these collateralized bonds may be higher than other comparably rated securities with the same duration. The rating of the bond and the related cash flows may achieve a rating of high quality due, in part, to the collateral feature. Or, said differently, the bond may not be rated high quality in the absence of the collateral feature. Depending on the facts and circumstances related to the terms of the bond, the collateral, and the issuer, collateralized bonds may be considered outliers. As a result, entities may need to remove these bonds from the HBP to achieve the appropriate discount rate. Evaluating whether collateralized bonds could be included in an HBP or whether a yield adjustment would be required for bonds included in an HBP requires judgment. Entities should consider all of the facts and circumstances in making conclusions about whether it is appropriate to include collateralized bonds in an HBP, and, if a yield adjustment is required, whether such adjustment may be objectively determinable.
As previously mentioned, an entity may elect to use a yield curve that was constructed by a third party to support its discount rate. We have been advised by some third parties, in particular those constructing yield curves for non-U.S. markets (e.g., eurozone and Canada), that because of a lack of sufficient high-quality instruments with longer maturities, they have employed a method in which they determine an estimated credit spread, which is added to or subtracted from yields of bonds not rated AA, to adjust the bond to a representative AA-quality bond. This bond, as adjusted, is included in the bond universe when the third party constructs its yield curve. Many yield curves constructed by third parties are supported by a white paper or other documentation that discusses how the yield curves are constructed. Management should understand how the yield curve it has used to develop its discount rate was constructed and understand the universe of bonds included in the analysis and, if applicable, evaluate and reach conclusions about the reasonableness of the method and approach the third party applied to adjust the bonds in the bond universe that were used to develop the yield curve. In evaluating the inclusion of such bonds in a yield curve analysis, entities should also consider the discussion above related to inclusion of collateralized bonds in an HBP. Collateralized bonds may qualify for inclusion in a yield curve bond universe if an entity can demonstrate that the collateralized bonds have been appropriately adjusted for, if necessary, or that the impact of the inclusion of the collateralized bonds does not significantly affect the discount rate derived from the yield curve.
An entity may also select a discount rate by referring to index rates as long as the entity can demonstrate that the timing and amount of cash flows related to the bonds included in the indices match its estimated defined benefit payments. In the current economic environment, entities should consider whether the specific index reflects the market in a manner consistent with other similar indices and whether market conditions have affected the level of trading activity for bonds included in the index (large spreads between the bid and ask prices). As noted above, pricing should reflect the amount at which the postretirement benefit obligation could be settled. The practice of using indices (with appropriate adjustments) is more prevalent for U.K. and other European plans because the high-quality bond universe in Europe is smaller than that in the United States; consequently, hypothetical bond portfolios and yield curves are more difficult to construct for these plans.
Entities that refer to indices when selecting their discount rate should determine whether using them is still appropriate or whether the indices require adjustments in addition to those made to reflect differences in timing of cash flows (e.g., removal of outliers and adjustments for callable bonds). In addition, management must be able to conclude that the results of using a shortcut to calculate its discount rate, such as an index, are reasonably expected not to be materially different from the results of using a discount rate calculated from a hypothetical portfolio of high-quality bonds. In measuring the benefit obligations, management should understand, evaluate, and reach conclusions about the reasonableness of the underlying assumptions that could be affected by unrest in the credit markets.
The expected long-term rate of return on plan assets6 is a component of an entity’s net periodic benefit cost. The expected long-term rate of return should represent the average rate of earnings expected over the long term on the funds invested to provide future benefits. The long-term rate of return is set at the beginning of an entity’s fiscal year (e.g., January 1, 2010, for a calendar-year-end entity). Because of market performance or other factors, an entity’s plan assets may no longer be allocated in a manner that is consistent with its target allocation. If the entity has not taken action and does not plan to take action to reallocate its plan assets, it is likely that an adjustment to the long-term rate of return will be necessary.
Some entities use an external investment adviser to actively manage their portfolio of plan assets. In calculating the expected long-term rate of return, such entities will include an adjustment (“alpha” adjustment) to increase the rate of return when plan assets are actively managed by the investment adviser. This adjustment reflects the entity’s expectations that an actively managed portfolio will generate higher returns. In situations in which the entity is adjusting for “alpha,” management should support its assumption that returns will exceed overall market performance plus management fees. Such support would most likely include an analysis of the historical performance for plan assets.
As with the discount rate, an entity should understand, evaluate, and reach conclusions about the reasonableness of the expected rate of return on plan assets.
Entities should consider the effect that decreases in plan assets and changes in postretirement benefit obligations could have on the computation of the gain or loss amortization component of net periodic benefit cost. Many entities record the minimum amortization amount (the excess outside the “corridor”).7 In the current environment, many entities have experienced a decline in both the benefit obligation and the asset value, resulting in a tighter corridor, and accumulated losses may have increased. Accordingly, this component of net periodic benefit cost may be greater than previously estimated.
In accordance with the defined-benefit subsequent-measurement guidance in ASC 715-30-35-63, plan assets and benefit obligations must be measured as of the entity’s fiscal year-end for fiscal years ending after December 15, 2008.
Preparers should ensure that they use actual market values as of the measurement date (e.g., their fiscal year-end) for assets with readily determinable fair values.
Entities should value assets without readily determinable fair values (e.g., alternative investments) as of the measurement date by using principles from ASC 820 on estimating the fair value of financial assets in inactive markets. In April 2009, the FASB issued FSP FAS 157-48 (codified in ASC 820) to provide financial statement preparers with additional guidance on (1) estimating the fair value of an asset or liability when the volume and level of activity for the asset or liability have significantly decreased and (2) identifying transactions that are not orderly. For more information on this guidance, see Deloitte’s April 14, 2009, Heads Up. In addition, ASU 2009-12,9 provides guidance on using net asset value per share (provided by an investee) to estimate the fair value of an alternative investment when (1) the fair value of the investment is not readily determinable and (2) the investment is in an entity that has all the attributes of an investment company as specified in ASC 946-10-15-2 or, for an entity that lacks one or more of the attributes specified in ASC 946-10-15-2, it is industry practice to issue financial statements in accordance with the measurement principles for investment companies in ASC 946 (e.g., certain investments in real estate funds that measure investment assets at fair value on a recurring basis). For more information on this guidance, see Deloitte’s October 1, 2009, Heads Up.
Entities may also want to consider the press release issued jointly by the SEC’s Office of the Chief Accountant and the FASB staff on September 30, 2008, which contains questions and answers aimed at clarifying fair value measurement practices.
As noted above, plan assets and benefit obligations must be measured as of the entity’s fiscal year-end. The discount rate used in the calculation of the benefit obligation should be the rate on the measurement date. Because of market volatility, it may be difficult for preparers to demonstrate that an adjusted discount rate based on a rollforward of a discount rate from an earlier date would meet the requirements of ASC 715-30-35-1. Some entities may have changed their method for estimating the discount rate to align the measurement date with the fiscal year-end date or because of other changes in the basis of estimating assumed discount rates. Under ASC 715-30-35-1, an entity may employ computational shortcuts if the results are “reasonably expected not to be materially different from the results of a detailed application.” In addition, ASC 715-30-55-26 through 55-28 state that an entity may change its method of selecting discount rates provided the change results in “the best estimate of the effective settlement rates.” Accordingly, preparers should maintain sufficient support to establish that the requirements of ASC 715-30-35-1 have been met, including a calculation of the benefit obligation, as of the measurement date, that uses a discount rate that reflects inputs as of the measurement date. Any material difference not recorded by the entity would be deemed an error.
U.K. Inflation Rate Adjustment for Postretirement Benefits
The U.K. government recently announced its intention to change the inflation rate index it uses for determination of pension benefit increases from the retail prices index (RPI) to the consumer prices index (CPI). This change is expected to affect pension benefits paid by some private-sector and all public-sector defined benefit plans. In the U.K., general price changes indexed to the CPI are typically lower than those indexed to the RPI.
An entity should assess the inflation rate index described in its plan document and determine whether a legal or constructive obligation exists to increase pension benefits by the RPI. Note that a feature of a constructive obligation is that agreement by the plan administrator would generally be necessary before a change could be made to the plan. Factors to consider in the evaluation of whether a constructive obligation exists include:
· Whether there is a general understanding by plan participants that the RPI will be used to calculate increases in pension benefits.
· Whether the RPI is referred to in company literature, even if it is not specifically included in the plan documents.
An entity’s use of the CPI instead of the RPI as the inflation index assumption for pension benefits should be evaluated in light of its specific facts and circumstances.
If an entity determines that the benefit obligation is linked to the RPI (either legally or constructively) or to another specified inflation metric, replacement of the index with the CPI would represent a plan amendment. As a result, prior service costs would be recognized in the period the change has been agreed to and announced by the plan. If an entity determines that there is no legal or constructive obligation to pay pension benefits on the basis of the RPI or another specified inflation metric, then a change to the CPI is considered a change in actuarial assumption. That is, it is a change in the assumption about inflation used to measure the liability, which represents an actuarial gain or loss.
Entities contemplating a replacement of the RPI with the CPI should consult with their actuaries, accounting advisers, and auditors.
Over the past few years, many entities have sought to reduce operating costs by amending their defined benefit plans to eliminate benefits. This elimination of benefits could be classified as either of the following:
· Hard freeze — an amendment to a defined benefit plan that permanently eliminates future benefit accruals.
· Soft freeze — an amendment to a defined benefit plan that may eliminate benefits for future service, but takes into account salary increases in the determination of the benefit obligation for prior service.
The FASB Codification defines a plan curtailment as “[a]n event that significantly reduces the [aggregate] expected years of future service of present employees or eliminates for a significant number of employees the accrual of defined benefits for some or all of their future services.” Generally, a hard freeze that represents a permanent suspension of benefits is treated as a curtailment for accounting purposes. The guidance on accounting for soft freezes is unclear, and we understand that entities differ on whether to treat a soft freeze as a plan amendment or a curtailment. Those that treat the soft freeze as a curtailment note that the measurement of the projected benefit obligation takes into account salary increases. We believe that an entity may treat a soft freeze as either a plan amendment or a curtailment. An entity should choose one of these two alternatives as an accounting policy and consistently apply its accounting election.
Other events such as corporate restructurings or plant shutdowns could also trigger curtailment accounting. An entity should assess each of these events on the basis of the particular facts and circumstances. Curtailments generally trigger an interim remeasurement date in a manner similar to other significant events that occur during a fiscal year.
In response to the current economic challenges, some entities may have instituted restructuring programs that include a reduction in work force. Such entities may have pension plans that permit employees to elect to receive their pension benefit in a lump sum, which could result in multiple lump-sum payments over the course of the year. Accordingly, settlement accounting could be required under ASC 715-30-25-82.
The FASB Codification defines a settlement of a pension or other postemployment benefit as “[a] transaction that is an irrevocable action, relieves the employer (or the plan) of primary responsibility for a pension or postretirement benefit obligation, and eliminates significant risks related to the obligation and the assets used to effect the settlement.”
If a settlement has occurred, ASC 715-30-35-82 requires recognition in earnings for any gain or loss from the settlement “if the cost of all settlements during a year is greater than the sum of the service cost and interest cost components of net periodic pension cost for the pension plan for the year.” If a company adopts an accounting policy to apply settlement accounting for a settlement or settlements that are below the service and interest cost threshold, the policy must be applied to all settlements.
Questions have arisen about the appropriate accounting treatment for settlements that occur in an interim period during a year when it is probable that the cumulative settlements for the year are expected to exceed the service-cost-plus-interest-cost threshold. On at least a quarterly basis, an entity should assess whether it is probable that the criteria for settlement accounting will be met (e.g., the total settlements will exceed the threshold). If the entity concludes it is probable that the threshold will be exceeded during the year, the entity should apply settlement accounting on at least a quarterly basis rather than wait for the threshold to be exceeded on a year-to-date basis. Accordingly, as the settlements occur, and at least quarterly, the entity should complete a full remeasurement of its pension obligations and plan assets in accordance with ASC 715-30-35. Recognizing settlement accounting at quarter-end would be an acceptable practical accommodation unless, under the circumstances, the assumptions and resulting calculations indicate that use of the exact date within the quarter would result in a materially different outcome.
In December 2008, the FASB issued FSP FAS 132(R)-1,10 which amended postretirement benefit plan asset disclosures. This amended disclosure guidance is codified in ASC 715-20-50. The amendments require more detailed disclosures about plan assets, concentrations of risk within plan assets, and fair value measurements associated with plan assets. An entity must provide these additional or amended disclosures in financial statements for fiscal years ending after December 15, 2009.
Entities will now need to disclose, in a narrative form, a description of their investment policies and strategies. This description must include information about target allocations (or ranges) for the classes of plan assets and additional information that would help financial statement users understand investment policies and strategies associated with the plan assets.
Paragraph A8 of the Basis for Conclusions of FSP FAS 132(R)-1 states that entities are required to provide plan asset disclosures on the basis of the “nature and risks of assets in an employer’s plan.” In addition, the paragraph notes that “management’s investment policies and strategies should be considered in determining how to identify categories of plan assets.”
Employers must also disclose significant concentrations of risk in the plan assets.
Applying the plan asset disclosure requirements can be challenging, particularly when there are investment funds or other investment vehicles such as trusts that hold underlying investments. This “look-through” issue was raised during the comment letter process for the proposed FSP and was discussed in subsequent Board meetings. The Board concluded that it would not prescribe how an employer should determine its categorization for these types of investments. The Board ultimately concluded that “employers should consider the examples of categories of plan assets listed in the FSP, the illustrations in Appendix C of Statement 132(R) [as amended and codified in ASC 715-20-55-17], and the overall objectives of the FSP [as noted above] in determining what major categories of plan assets to disclose.” As indicated above, plan asset disclosures must provide transparency about the nature and risks associated with the plan assets held by the plan. Note that for a master trust, ASC 960-30-50-1 requires entities to look through to the underlying assets held by the trust.
Because a sponsor’s disclosures for fair value measurements for postretirement plans are excluded from the scope of ASC 820, the FASB’s fair value measurement disclosures project addressed the sponsor’s fair value disclosures that are specific to postretirement plans.
In accordance with ASC 715-20-50-5(c)(5)(iv), the sponsor is required to disclose information about the fair value measurements of plans assets separately for each annual period for each class of plan assets.
Implementation issues have arisen, primarily about the Level 3 reconciliation disclosure. The FASB’s rationale for requiring this disclosure is identical to its rationale for requiring the Level 3 reconciliation under ASC 820, except that gains and losses reported in earnings during the period must be presented separately from those recognized in other comprehensive income. Our understanding is that the FASB will accept presentation alternatives as long as the rollforward disclosure meets the objective under ASC 715-20-50-1(d)(4) of showing the “effect of fair value measurements using significant unobservable inputs (Level 3) on changes in plan assets for the period” (emphasis added).
For titles of FASB Accounting Standards Codification (“Codification” or ASC) references, see Deloitte’s "Titles of Topics and Subtopics in the FASB Accounting Standards Codification."
ASC 715-30-35-24 provides guidance on net periodic pension benefit cost and defines the corridor as “10 percent of the greater of the projected benefit obligation or the market-related value of plan assets.” Likewise, ASC 715-60-35-29 provides guidance on net periodic postretirement benefit cost and defines the corridor as “10 percent of the greater of the accumulated postretirement benefit obligation or the market-related value of plan assets.”
FASB Staff Position No. FAS 157-4, “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly.”