Financial reporting considerations related to pension and other postretirement benefits
Financial Reporting Alert 15-4
This alert highlights some of the more important accounting considerations related to the calculations and disclosures entities provide under U.S. GAAP in connection with their defined benefit pension and other postretirement benefit plans.
Over the past few years, we have provided insights into the assumptions used for discount rates for defined benefit plans. Specifically, we have discussed the different methods of developing discount rates (e.g., hypothetical bond portfolio, yield curve, index-based discount rate) and considerations related to how the discount rates should be applied when an entity measures its benefit obligation. In the current year, the most discussed emerging issue related to discount rates is the use of individual spot rates along the yield curve (as opposed to the traditional single weighted-average rate) to measure the service cost and interest cost components of net periodic benefit cost. Also highlighted below are (1) the discount rate selection method, (2) bond pricing and bond selection used in a hypothetical bond portfolio to support the discount rate used, (3) yield curves developed by a third party to support a discount rate, and (4) the relationship between the health care trend rate and the discount rate used in postretirement benefit plans other than pension plans.
Many entities rely on their actuarial firms for advice or recommendations related to demographic assumptions, such as the mortality assumption. Frequently, actuaries recommend published tables that reflect broad-based studies of mortality. Under ASC 715-30 and ASC 715-60, each assumption should represent the “best estimate” for that assumption as of the current measurement date. The mortality tables used and adjustments made (e.g., for longevity improvements) should be appropriate for the employee base covered under the plan.
Last year, the Retirement Plans Experience Committee of the Society of Actuaries (SOA) released a new set of mortality tables (RP-2014) and a new companion mortality improvement scale (MP-2014). Further, on October 8, 2105, the SOA released an updated mortality improvement scale, MP-2015, which shows a decline in the recently observed longevity improvements. Although entities are not required to use SOA mortality tables, the SOA is a leading provider of actuarial research, and its mortality tables and mortality improvement scales are widely used by plan sponsors as a starting point for developing their mortality assumptions. Accordingly, it is advisable for entities, with the help of their actuaries, to (1) continue monitoring the availability of updates to mortality tables and experience studies and (2) consider whether these updates should be incorporated in the current-year mortality assumption.
Expected Long-Term Rate of Return
The expected long-term rate of return on plan assets is a component of an entity’s net periodic benefit cost and should represent the average rate of earnings expected over the long term on the funds invested to provide future benefits (existing plan assets and contributions expected during the current year). The long-term rate of return is set as of the beginning of an entity’s fiscal year (e.g., January 1, 2015, for a calendar-year-end entity). If the target allocation of plan assets to different investment categories has changed from the prior year, an entity should consider whether adjusting its assumption about the long-term rate of return is warranted.
Some entities engage an external investment adviser to actively manage their portfolios of plan assets. In calculating the expected long-term rate of return, such entities may include an adjustment (“alpha” adjustment) to increase the rate of return to reflect their expectations that actively managed portfolios will generate higher returns than portfolios that are not actively managed. If an entity adjusts for “alpha,” management should support its assumption that returns will exceed overall market performance plus management fees. Such support would most likely include a robust analysis of the historical performance of the plan assets.
Accounting Policies for Gains and Losses and Market-Related Value of Plan Assets
Many entities record the minimum amortization amount (reflecting the excess outside the “corridor”). The amortization is based on accumulated gain or loss as of the beginning of the year. Accordingly, the change in discount rates and the difference between actual and expected asset returns in the current year will not affect net periodic benefit cost until the following year.
An entity may consider moving to a “mark-to-market” approach in which it immediately recognizes actuarial gains and losses as a component of net periodic benefit cost. Any change in the amortization method selected for gains and losses is considered a change in accounting policy accounted for in accordance with ASC 250. Once an entity changes to an approach in which net gains and losses are more rapidly amortized, the preferability of a subsequent change to a method that results in slower amortization would be difficult to support. However, if an entity plans to terminate its defined benefit retirement plan in the near term, a change in the amortization method to mark-to-market may not be preferable under ASC 250-10-45 depending on the facts and circumstances. Accordingly, an entity should consider consulting with its independent auditors.
As with all defined benefit retirement plans, plan sponsors’ use of computational shortcuts and estimates is appropriate “provided the results are reasonably expected not to be materially different from the results of a detailed application.” Entities that use the mark-to-market approach should be vigilant when using shortcuts and approximations, since all changes in the measurement of the benefit obligation and plan assets immediately affect net periodic benefit cost.
Editor’s Note: When entities adopt a policy to immediately recognize actuarial gains and losses as a component of net periodic pension cost, they may have presented non-GAAP financial measures that “remove the actual gain or loss from the performance measure and include an expected long-term rate of return.” The SEC staff has noted that in the absence of sufficient quantitative context about the nature of the adjustment, such measures may confuse investors. The staff has suggested that registrants clearly label such adjustments and avoid the use of confusing or unclear terms in their disclosures.
Measurement Date of Plan Assets — Employer-Sponsored Pension Plan
In April 2015, as part of its simplification initiative, the FASB issued ASU 2015-04 to amend the measurement-date guidance in ASC 715. The ASU contains a practical expedient that would allow an employer whose fiscal year-end does not fall on a calendar month-end (e.g., an entity that has a 52- or 53-week fiscal year) to measure retirement benefit obligations and related plan assets as of the month-end that is closest to the employer’s fiscal year-end. The expedient would need to be elected as an accounting policy and be consistently applied to all plans if the entity has more than one plan. Because third-party plan asset custodians often provide information about fair value and classes of assets only as of the month-end, such an accounting policy would relieve the employer from adjusting the asset information to the appropriate fair values as of its fiscal year-end. Further, if the occurrence of a significant event (e.g., curtailment or settlement) during the interim period requires an entity to remeasure its defined plan assets and obligations, the practical expedient would allow the entity to remeasure its defined plan assets and obligations by using the month-end that is closest to the date of the significant event.
The ASU should be applied prospectively. For public business entities, the ASU is effective for financial statements issued for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years. For all other entities, the ASU is effective for financial statements issued for fiscal years beginning after December 15, 2016, and interim periods within fiscal years beginning after December 15, 2017. Earlier adoption is permitted.
Editor’s Note: An entity that has a 52- or 53-week fiscal year may find that the fiscal year in which it is required to adopt the ASU has a year-end that coincides with a month-end. For example, December 31, 2016, falls on a Saturday and may be the fiscal year-end for a 52- or 53-week fiscal year that ends in December. In these circumstances, an entity may need to disclose that it has elected the practical expedient for the year-end measurement date even though in that particular year, the measurement date under the practical expedient is no different from the entity’s fiscal year-end.
Other Considerations Related to Assumptions
In measuring each plan’s 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, particularly those that could be affected by continuing financial market volatility. ASC 715-30-35-42 states that “each significant assumption used shall reflect the best estimate solely with respect to that individual assumption.”
Entities should comprehensively assess the relevancy and reasonableness of each significant assumption on an ongoing basis (e.g., by considering the impact of significant developments that have occurred in the entity’s business). Management should establish processes and internal controls to ensure that the entity appropriately selects each of the assumptions used in accounting for its defined benefit plans. The internal controls should be designed to ensure that the amounts reported in the financial statements properly reflect the underlying assumptions (e.g., discount rate, estimated long-term rate of return, mortality, turnover, health care costs) and that the documentation maintained in the entity’s accounting records sufficiently demonstrates management’s understanding of and reasons for using certain assumptions and methods (e.g., the method for determining the discount rate). Management should also document the key assumptions used and the reasons why certain assumptions may have changed from the prior reporting period. A leading practice is for management to prepare a memo supporting (1) the basis for each important assumption used and (2) how management determined which assumptions were important.
Recent SEC Staff Views
The SEC staff continues to emphasize the disclosures related to how registrants account for pension and other postretirement benefit plans and how key assumptions and investment strategies affect their financial statements. Further, registrants may be asked how they concluded that assumptions used for their pension and other postretirement benefit accounting are reasonable relative to (1) current market trends and (2) assumptions used by other registrants with similar characteristics.
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