TABLE OF CONTENTS – VOLUME I COURSE 8RU – … 8S-40 5-2-06.pdfC. Plan Fund Investments Managing Investment Portfolio (2nd Edition) by Maginn Chapter 14 [also called 8RU-308-04]

TABLE OF CONTENTS – VOLUME I COURSE 8RU – RETIREMENT (FALL 2005)

COMPREHENSIVE SEGMENT – U.S.

A. Retirement Plan Design Page

Fundamentals of Private Pensions, (8th Edition), 2004, by McGill et al Chapter 10 Chapter 11 Chapter 13 Chapter 14 Chapter 15 Chapter 16 Chapter 18 Chapter 20 Chapter 21 (from 7th Edition) [also called 8RU-122-04]

A-1

A-12 A-31 A-39 A-46 A-50 A-58 A-67 A-77

Handbook of Canadian Pension & Benefit Plans (12th Edition) by Greenan Chapter 1 Chapter 2 Chapter 10

A-84 A-91 A-99

Pension Planning (9th Edition) by Allen et al Chapter 19 Chapter 25 (pp. 455-471 only)

A-110 A-114

Pensions in the Public Sector, 2000 by Mitchell et al Chapter 1 Chapter 3 Chapter 5 Chapter 17

A-120 A-124 A-135 A-139

Private Pension Policies in Industrialized Countries – A Comparative Analysis by Turner Chapter 1 Chapter 2 Chapter 3 Chapter 7

A-145 A-147 A-148 A-155

The Handbook of Executive Benefits, 1995 by Towers Perrin [also called 8RU-121-02] Chapter 1 (pp.6-12 only) Chapter 3 (background only) Chapter 5 Chapter 6 (pp. 66-81 only) Chapter 12 (pp.175-184 only) Chapter 15

A-160 A-160 A-161 A-166 A-173 A-178

8RU-101-00 Beyond Pensions: How Should Business Define New Objectives for the Private Retirement System

A-187

8RU-102-00 Caught Between Demographics and the Deficit: How Can Retirement Plans Meet the Challenges Ahead

A-189

8RU-103-00 Should Variable Pay Count Toward Benefits Calculations? A-196 8RU-110-00 Multiemployer Plans A-198 8RU-111-00 Innovations in Canadian Pension Plan Design A-204

8RU-115-04 Design and Funding of Other Post-Employment Benefits A-214 8RU-116-05 Integration with Social Security A-237 8RU-118-03 Social Security: A Primer, Chapters 3 and 4 (remainder for background only) A-240 8RU-120-03 The Globalization of Employee Benefits (Tables for background only) A-253 8RU-123-05 Pension Surplus and Deficit Funding: Funding Multi-Employer Plans A-265

TABLE OF CONTENTS – VOLUME II

COURSE 8RU – RETIREMENT (FALL 2005)

COMPREHENSIVE SEGMENT – U.S.

B. Plan Valuation Issues

Fundamentals of Private Pensions (8th Edition) by McGill et al Chapter 25

B-1

Handbook of Canadian Pension & Benefit Plans (12th Edition) by Greenan Chapter 5

B-11

Pensions in the Public Sector, 2000 by Mitchell et al Chapter 10

B-22

The Handbook of Executive Benefits, 1995 by Towers Perrin [also called 8RU-121-02] Chapter 10

B-29

FASB 87 ( exclude paragraphs 54, 57-62, 76-77, excluding Appendix C) Appendix A (exclude paragraphs 204-210, 231-260) Appendix B (exclude illustrations 2 and 6) Appendix D (background only)

B-38

FASB 88 (exclude paragraphs 19-21) Appendix A (exclude paragraphs 49-56) Appendix B (exclude illustration 6)

B-51

FASB 132(Revised 2003) (exclude paragraphs 12-13) Exclude Appendix B paragraphs 1-8, 21-32, 41-45 Exclude Appendix D

B-58

8RU-201-00 Symposium on Pension Funding Adequacy B-65 8RU-202-00 Pension Projections (background only) B-96 8RU-203-00 An Introduction to Duration for Pension Actuaries B-120 8RU-204-00 Back to the Future B-124 8RU-206-02 Mortality Tables for Pension Plans B-127 8RU-208-02 Selection of Actuarial Assumptions (pp. 1-44 only) B-148 8RU-210-03 Controlling the FAS87 Balance Sheet Impact by Integrating Funding, Expensing

and Asset Policies B-168

8RU-212-03 Pension Accounting, International, US and Canadian Standards B-173 8RU-213-00 IASC Issues Paper – Retirement Benefit and Other Employee Benefit Costs

(paragraphs 1-49 only) B-174

8RU-216-00 Pension Plan Financial Statements, CICA 4100 and FAS35 B-179 8RU-217-05 SEC on Discount Rates B-182 8RU-218-00 Pension Issues in Corporate Sales, Mergers & Acquisitions B-184 8RU-220-00 FAS106 and FAS112 (pp. 14-15, and 20-23 background only) B-188 8RU-225-04 Reinventing Pension Actuarial Science (with discussion) B-206 8RU-226-04 Selection of Valuation Interest Rates for Funding Valuations of Pension Plans –

Traditional Pension Plan Approach Versus Financial Economics Approach B-224

8RU-227-04 CICA Summary of the Canadian Accounting Disclosure Rules B-238

8RU-228-04 FASB Staff Position FAS 106-b (supplement to 8RU-220-00) B-240 ASP No. 4 Measuring Pension Obligation, October 1993, ASB B-242 ASP No. 23 Data Quality, July 1993, ASB B-249 ASP No. 27 Selection of Economic Assumptions for Measuring Pension Obligations,

December 1996 ASB B-252

ASP No. 35 Selection of Demographic and Other Noneconomic Assumptions for Measuring

Pension Obligations, December 1999, ASB B-259

Social Security, Productivity, and Demographics, NAAJ, April 1999 B-264 Asset Valuation Methods under ERISA, Chapters 1, 3, 4, 5 (Chapter 2 and

appendices for background only), Pension Forum, September 2002 B-269

C. Plan Fund Investments

Managing Investment Portfolio (2nd Edition) by Maginn Chapter 14 [also called 8RU-308-04]

C-1

Pension Planning (9th Edition) by Allen et al Chapter 22 Chapter 23

C-14 C-27

Pensions in the Public Sector, 2000 by Mitchell et al Chapter 9

C-34

Private Pension Policies in Industrialized Countries – A Comparative Analysis by Turner Chapter 5 Chapter 6

C-44 C-53

8RU-301-00 Introduction and Overview of Retirement Plan Investment C-56

8RU-302-01 Fiduciary Liability Issues for Selection of Investments C-57

8RU-303-00 Pension Issues for Insurance Companies – GICs and Asset/Liability Matching C-64

8RU-304-00 The Successful Use of Benchmark Portfolios: A Case Study C-70

8RU-305-00 Statement of Investment Policies for Defined-Benefit and Defined Contribution Plans C-73

8RU-306-03 Pension Investment and Corporate Risk Management C-85

8RU-307-05 Asset/Liability Modeling and Asset Allocation for Pension Plans C-92

D. Regulatory Requirements

Handbook of Canadian Pension & Benefit Plans (12th Edition) by Greenan Chapter 7 Chapter 8

D-1 D-2

Pension Planning (9th Edition) by Allen et al Chapter 4 Chapter 5

D-12 D-19

Private Pension Policies in Industrialized Countries – A Comparative Analysis by Turner Chapter 4

D-27

E. Professional Obligation and Standards of Practice

SOA Code of Professional Conduct, Effective Date: January 1, 2001 E-1

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©ACTEX 2005 Course 8R – Retirement Benefits

Chapter 18: Human Resource Incentives in

Employer-Sponsored Retirement Plans

I. INTRODUCTION

1. one theory behind the early development of employer-sponsored pensions is that human capital, like its physical capital counterpart, depreciates over time and that employers should set aside resources during the period over which workers’ human capital is exhausted so retirees will have a means of sustenance at the end of their industrial life

2. an alternative theory is that a pension is merely deferred compensation and that the cost of the retirement program is paid for through the reduction in cash wages during the working career

3. another theory is that pensions represent an attempt by employers to provide for the economic security of the older citizens in an economy dominated by private enterprise

4. one of the earliest motivations for establishing a pension was to provide a mechanism to retire superannuated workers

5. plan sponsors eventually realized that pension plans could be instrumental in attracting workers and encouraging them to remain with a firm

II. THE ROLE OF RETIREMENT PLANS IN ATTRACTING & KEEPING WORKERS

1. important to keep in mind that both workers and employers have created the environment in which these plans are established and maintained

A. WORKERS’ PERSPECTIVES ON RETIREMENT PLANS 1. Tax Incentive Plans

a) in the period which a contribution is made to the plan a dollar of tax-qualified savings is cheaper for the saver than a dollar of nonqualified savings

b) the forgone taxes on original contributions are ultimately collected from individuals who have the same marginal tax rate in retirement as they had during their working careers

c) many workers face reduced tax rates in retirement, which yield significant tax savings over one’s lifetime because of participation in these plans

d) the after-tax returns on retirement plan savings are greater than nonqualified savings for the majority of people who participate in these plans

e) economic theory suggests that the marginal utility of additional consumption declines as income rises, leading higher-income individuals to have a greater propensity to save

2. Pensions as Retirement Income Insurance a) five types of risk that threatens the retirement income security of workers:

i) replacement rate inadequacy ii) social security retrenchment iii) longevity iv) investment risk v) inflation

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b) Zvi Bodie argues that individual workers face a great deal of uncertainty, and that by sponsoring retirement plans employers can use the law of large numbers to do things that each worker covered by the plans cannot Retirement Rate Inadequacy - arises because of the complexity of estimating the level of income that is required in retirement to maintain pre-retirement living standards - employer-sponsored retirement plans can help to ameliorate the risk Social Security Risk - employer-sponsored plans can help ameliorate the risk that the basic underpinning of social security might be changed in ways that are not anticipated - increasing skepticism that Social Security will provide the benefits that are embedded in current law as implied promises to current workers Concerns About Longevity - if people live longer than they anticipate, they will deplete their retirement savings before dying if the regularly scheduled payments from their accumulated wealth reflect their own assumptions as to future longevity - individuals can purchase annuities to deal with this problem Investment Risk - represents the financial risk that individuals face in investing their own liquid assets - in the case of defined contribution plans, all plans offer participant-directed investment the option of at least one relatively risk-free investment choice Exposure to Inflation - Bodie suggests that pensions can also provide insurance against the risk of eroding income levels because of the effects of inflation on nominal annuities - the federal government indexes the retirement benefits for many of its former EEs by the CPI - many state and local governments provide regular cost-of-living adjustments for retirement annuities - virtually no private sector plans provide for automatic increases in retirement benefits to cover the erosive effects of inflation

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B. OTHER EFFICIENCY CONSIDERATIONS 1. the process of sorting out the risk characteristics of various classes of investments,

accumulating market information on specific investment options, and actually investing assets is expensive in time costs

2. as a plan sponsor, an employer can sort out many of the issues relevant to covered workers so as to yield significant economies of scale to participants

3. when retirement assets for investments are placed in large pools, administrative and management fees are generally lower

4. the expertise that professional managers bring to the investment of retirement assets usually means greater risk-adjusted returns over the long term

C. EMPLOYER’S PERSPECTIVE ON RETIREMENT PLANS

1. Defined Benefit Plans ▪ often characterized as creating “golden handcuffs” that restrain workers’

job mobility ▪ the reason that employers might want to restrict workers’ mobility relates

to the investment that they make in their workers and the desire to minimize labor costs over time

▪ majority of defined benefit plans today base retirement benefits on average pay levels in the 3-5 years immediately prior to employment termination

▪ consult Table 18-1 to view an example of a worker’s perspective on the pension plan that her initial employer offers

▪ the plan imposes significant penalties on workers who terminate their jobs prior to retirement eligibility

▪ see Figure 18-1 for the results of the projections for an individual beginning a job at age 25 in 1993 at a starting salary of $28,800 per year, half the Social Security wage base in that year

▪ one theory about the incentives in defined benefit plans is that the differential in the value of the accumulated and projected benefits under the plans is the equivalent of a bond that a worker accepts from the employer as a condition of employment

▪ bonding theory suggests that workers covered by defined benefit plans would less likely shirk on the job and would require less supervision

▪ studies have noted that pension coverage is strongly correlated with lower worker turnover

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2. Defined Contribution Plans ▪ Richard Ippolito’s theoretical model suggests that defined contribution

plans play a significant role in sorting undesirable workers from an employer’s work force

▪ he argues that the rate at which a worker discounts future consumption in relation to current consumption depends on the individual’s marginal productivity

▪ for instance, assume that an individual either has an infinite discount (disc) rate or a disc rate of zero

▪ the individual with the infinite disc rate would never save anything for the future

▪ he/she is also unlikely to be willing to make significant investment in his/ her own human capital through intensive or extended schooling because such investment would suggest deferring the good life - that is, current consumption - until some future time

▪ this individual would not make significant personal investment to become a more productive worker even in cases where the employer facilitated such investments

▪ this type of EE would likely require considerable monitoring to ensure that they were not taking advantage of work rules to maximize personal consumption of leisure and income at the employer’s expense

▪ the person with the zero disc rate would be indifferent between consumption today or in the future

▪ an investment of today’s income that reaps returns in the future would be pursued because the deferral of current consumption would result in added lifetime consumption later and greater lifetime consumption value

▪ such a person would take advantage of an employer’s offer of training because a sacrifice now brings the prospect of future added income

▪ such a worker would be unlikely to take advantage of work rules for fear of losing his/her job and ending up with lower lifetime consumption

▪ to summarize: – a worker’s quality as an EE is inversely correlated with his/her internal disc

rate – many defined contribution plans provide incentives that encourage workers

with high internal disc rates to terminate employment relatively early in their tenure

– they also allow employers to reward the low discounters – thus, defined contribution plans include economic incentives that effectively

remove undesirable workers and the matching rate on voluntary contributions act as an added incentive for low discounters to put money into the plan

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III. RETIREMENT BENEFITS AND CURRENT COMPENSATION

1. economic theory suggests that workers with equal productivity will receive equal compensation

2. economic theory also suggests that in a competitive environment employers will be willing to pay workers up to their marginal contribution to the productivity of the firm

3. to determine a worker’s worth to the organization, all elements of the compensation package must be examined

4. the theory of “equalizing differences” suggests that workers will trade cash wages for non-cash elements of the total compensation package

5. workers can be thought of as paying for their own retirement benefits through reduced wages during their employment years

6. this model of competitive wages and equalizing differences led Jeremy Bulow to challenge the concept of the “stay value” or projected benefit value of defined benefit plans as a meaningful concept in workers’ valuation of their pension accruals

7. he assumed that wages were being set at each of the renegotiations as though labor was being bought and sold in a spot market

8. if the concept of a spot labor market is accurate, the provision of a pension should lower the payment of cash wages by the amount of the accruing quit value of the pension in each year

9. the alternative measure of pension accruals, the stay value, implies that employers compensate workers for their marginal product over their working lives

10. ERISA only requires that an employer pay an EE the present value of accrued benefits at the point of termination

11. see Figure 18-2 for an illustration of average change in quit values and stay values as a multiple of salary

A. EVIDENCE OF A WAGE-PENSION TRADEOFF 1. a number of economic studies conducted during the 1980s attempted to determine

whether workers with pensions paid for their benefits through reduced wages 2. generally, there is weak evidence that workers with pensions pay for benefit

improvements in the form of reduced wages 3. in fact, the empirical evidence supports the proposition that workers covered by

employer-sponsored retirement plans receive a cash wage premium in addition to their retirement benefits when compared with workers not covered by such retirement plans

B. PENSIONS AS A COMPENSATION PREMIUM 1. the implicit contract theory leaves unresolved two important questions:

a) if workers perceive the value of their benefit on a projected basis and employers on a quit basis, would employers not be motivated to implement policies that allow them to realize the difference between the two when they reach their maximum?

b) if pensions are part of compensation, why do cash wages for workers covered by them appear to be too high in relation to workers without pension coverage?

A-63


2. question ‘a’ applies primarily to defined benefit plans and is raised because employers can terminate workers prior to their retirement eligibility

3. referring to Figure 18-1, assume that the hypothetical worker has concluded that she is being compensated on the basis of her projected pension accrual but her employer can terminate her prior to retirement eligibility and only legally pay the accumulated benefit

4. at age 50, the difference in the implicit contract value of the benefit and the legal obligation of the employer would be about ¾ of the worker’s annual cash wage

5. in other words, an employer could reduce the defined benefit obligation to the worker by terminating her before the significant narrowing of difference in the two benefit obligations at the point of early retirement eligibility

6. however, empirical evidence suggests that employers do not take advantage of their workers through this systematic cheating on implied contracts as this form of exploitation would damage the companies’ reputations in which they operate

7. being covered by a pension plan does not increase the risk for older workers 8. responding to question ‘b’ one theory asserts that certain employers pay “efficiency

wages” or premium wages above what the market would normally dictate because workers are more productive when they receive such a premium

9. although the efficiency wage theory offers a credible explanation for relatively high wages, the strong correlation between wage premiums and the prevalence of employer-sponsored retirement programs suggests the employers are offering a double premium in many cases

10. it was discovered that turnover among workers with defined benefit plans was as high as that among workers with defined contribution plans

11. an analysis indicated that the wage premium was the predominant factor in explaining lower turnover among pensioned workers

12. the results have lead people to question why many employers would offer both a wage premium and a retirement plan

13. Richard Ippolito has attempted to theoretically reconcile this widely observed phenomenon by beginning with the assumption that some firms are more productive if they can establish enduring relationships with their workers

14. the task is to design a compensation scheme that pays the worker his/her lifetime expected wage, but in a manner that discourages premature employment termination

15. to accomplish this, certain conditions must be met: a) lifetime compensation offered by the firm has to at least equal the expected

lifetime pay a worker can receive outside the firm b) the cash wage the firm pays a worker early in his/her career will be less than

total compensation, or workers covered by defined benefit plans would not face a capital loss for leaving the firm

c) once a worker has some tenure in a job, the combination of expected future cash wages plus expected pension benefits has to equal or exceed alternative compensation offers

16. once a worker is covered by a defined benefit plan, the plan can deter some workers from exploring other employment offers where marginal increases in lifetime compensation would be minimal

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17. however, Gustman and Steinmeier found that many workers can overcome their pension loss by realizing a 2 or 3 percent increase in their lifetime wage levels through a job change

18. therefore, even firms with defined benefit plans that wish to maintain long-tenure relationships with workers are forced to pay efficiency cash wages in addition to the indenture premiums embodied in their pension systems

19. this theory of pensions and wages has not been tested empirically but it does conceptually reconcile a few inconsistencies that have been identified: a) it suggests that a combination of premium wages and retirement benefits is

compatible, which is wholly consistent with the broad body of empirical research that finds little evidence of compensating reductions in cash wages among employers offering retirement plans in comparison with those not offering them

b) it suggests that the seemingly inconsistent findings of Montgomery and his associates make sense because they limited their analysis to firms offering only defined benefit plans

c) it offers a rationale for why different firms might offer defined benefit versus defined contribution plans and why observed turnover under them might be comparable

IV. EMPLOYER-SPONSORED RETIREMENT PROGRAMS & THE RETIREMENT OF OLDER WORKERS

1. these programs are generally perceived to contain more effective retirement incentives than defined contribution programs

2. most defined benefit plans today include incentives that encourage workers to retire before they reach the normal retirement ages specified in the plans

3. the value of benefits paid on a lifetime basis by the majority of defined benefit plans will be higher for many workers who retire prior to the normal retirement age specified in their plan than if they were to retire at the normal retirement age or later

A. RETIREMENT INCENTIVES IN TYPICAL RETIREMENT PLANS 1. Laurence Kotlikoff and David Wise used the 1979 Level of Benefits Survey done by

the U.S. Department of Labour to develop an analytical presentation showing how defined benefit accruals late in the career can provide strong incentives for workers to retire

2. they postulated that the annual accrual in the pension at age a, I(a), is equal to the difference between the pension wealth based on the accrued vested benefit at age a+1, Pw(a+1) and pension wealth at age a, Pw(a), accumulated to age a+1 at the normal interest rate r.

3. expressed in a formula as: I(a)= Pw(a+1) - Pw(a)(1+r)

4. see Figure 18-4 for the average accrual pattern under 513 defined benefit plans 5. defined benefit plans do not exactly operate as Kotlikoff and Wise analyzed them

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6. most plans do not pass on early retirement supplements to workers terminating prior to early retirement eligibility

7. in addition, most plans do not provide the terminating worker with the opportunity of taking a lump-sum distribution prior to retirement eligibility unless it is a nominal amount

8. consult Table 18-2 for an illustration of accrual rate as a fraction of earnings for three defined benefit plans in 1993, with decreasing pay increases after age 55

9. Table 18-3 is developed on similar grounds as Table 18-2 except that we assumed our hypothetical worker would continue to receive 5.5% per year pay increases beyond age 55 up to age 70

10. in providing an incentive to retire, the defined benefit plan has the advantage that each year a benefit is forgone is a year’s worth of benefits that will not be paid

11. in the case of a defined contribution plan, a year in which a benefit is not paid out of the plan means that the accumulated benefit accrues interest for another year, and the larger accumulation will be paid out over a shorter remaining life expectancy at retirement

B. A CASE STUDY OF RETIREMENT INCENTIVE IN HIGHER EDUCATION 1. the majority of EEs working in public institutions are required to participate in a

defined benefit plan or to be covered under such a plan 2. as with the plans sponsored by private industry, the defined benefit and defined

contribution plans sponsored by academic employers have different incentives for workers to continue active employment or retire once eligible

3. regular contributions to the plans are made based on the covered EEs’ pay levels 4. a comparison between 2 hypothetical EEs, one age 55 and one age 70, are made with

C. RETIREMENT PLAN INCENTIVES AND RETIREMENT BEHAVIOUR 1. retirement patterns under the two kinds of plans are different 2. Gregory Lozier and Michael Dooris provide evidence that higher education faculty

retirement patterns are affected by the basic structure of the retirement program offered by academic employers

3. faculty retirement ages in institutions with a defined benefit plan are two to two-and-one-half years younger than at institutions with only a defined contribution program

4. reasons why workers who enjoy relatively strong financial incentives to continue working might choose to retire: a) even many prestigious jobs include some amount of disutility b) participants can accumulate sufficient resources to maintain or increase their

standards of living while being able to enjoy increased leisure c) Social Security includes its own set of retirement incentives which offers an

income stream that is itself conditional on work reductions for most people who might work between the ages of 62 and 70

5. Social Security has not equally rewarded people who delayed retirement before the stipulated age

6. on January 1, 1994, the special provisions that allowed academic institutions to mandate faculty retirements at age 70 expired

7. in response, employers implemented early retirement incentive programs to encourage older faculty members to retire voluntarily

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8. these plans offer to continue to pay for some period of time a share of the salary of faculty members meeting the age and service eligibility requirements

9. early retirement incentives strengthened during the late 1960s and throughout the 1970s which have sparked several theories as to why this was the case: a) a. one theory is that the baby boom generation entering the work force provided

employers with an ample supply of workers who generally were paid less than older workers but who could often easily be substituted for them

b) another theory is that it became difficult to retire older EEs and retirement incentives became a substitute for the outlawed retirement requirements that many employers had utilized

10. when an employer provides a subsidy to a worker for retiring, it implies that the worker will suffer a penalty for working beyond that point in time

11. empirical studies of the behavioral responses to retirement incentives embedded in pension programs have been generally consistent in finding that these incentives are effective in encouraging retirement

12. in a model developed by Robin Lumsdaine, James Stock, and David Wise, they postulate that an EE compares the expected present value of retiring currently with the value of retiring at future ages

13. they call the maximum of the expected values of retirement at future ages minus the expected value of retiring currently the option value of delaying retirement

14. if the option value is positive, the worker does not retire; if it is negative, he/she does 15. evidence suggests that the structure and generosity of employer-sponsored retirement

programs are imperative in determining the retirement patterns of plan participants 16. the desirability of any retirement pattern depends on the nature of the activities in

which the plan sponsor engages 17. a carefully crafted retirement program can help to meet the needs of both the

employer and workers participating in it

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STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 87: EMPLOYER’S ACCOUNTING FOR PENSIONS

I. INTRODUCTION

1. Statement establishes standards of financial reporting and accounting for an ER that provides pension benefits to its EEs

2. Critics of pre-FAS87 practices claimed that pension costs were not comparable from company to company and often not consistent from period to period a. Also that significant pension-related obligations and assets were not recognized

3. Interesting to note that the FASB at the time believed that pension accounting was still in a transitional stage – of course, with recent events, pension accounting is now again a hot topic

4. Objectives of this Statement are: a. Provide a measure of net periodic pension cost that better reflects plan’s terms and

better approximates the cost of an EE’s pension over his service period b. Provide a measure of net periodic pension cost that is more understandable and

comparable c. Provide disclosures to allow for better understanding of financial consequences of

ER’s provision of pensions to EEs d. Improve reporting of financial position

II. SCOPE

1. Establishes standards for an ER offering pension benefits to its EEs 2. Can be periodic payments, lump sums and other benefits provided by the plan (eg. death

benefits) 3. Applies to any arrangement that is in substance a pension plan

a. Does not matter how plan is financed b. Can take different forms (qualified plans, non-qualified, unwritten, etc.)

4. Does not apply to plans providing only life insurance and/or health insurance to retirees 5. Also does not apply to postemployment health care benefits provided through a pension

plan

III. USE OF REASONABLE ASSUMPTIONS

1. FAS87 is intended to specify accounting objectives and results – not to have specific computational means of getting those results

2. Estimates, averages, or computational shortcuts may be appropriately used if reasonably not expected to give materially different results

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IV. SINGLE-EMPLOYER DEFINED BENEFIT PENSION PLANS

1. Most important part of FAS87 pertains to accounting for a single-ER defined benefit (DB) pension plan

2. Pension benefit is part of the EE’s compensation a. Based on benefit formula, which incorporates service, earnings, etc. b. Cost cannot be determined with certainty, but requires estimates of many factors

3. Any method of pension accounting that recognizes costs before benefits are paid needs to: a. Make assumptions that determine the amount and timing of benefit payments b. Have a way to attribute the cost of benefits to individual years of service

4. FAS87 requires the use of explicit assumptions a. Each of which individually represents the best estimate of a future event

5. Also requires using the terms of the plan (i.e. benefit formula) as a basis for attributing benefits earned and their cost to periods of EE service

V. BASIC ELEMENTS OF PENSION ACCOUNTING

1. Net periodic pension cost (a.k.a. the periodic pension expense) is made up of the following components: a. Service cost – present value of benefits that is expected to be earned in respect of

services rendered during the period b. Interest cost – interest on the projected benefit obligation (“PBO”) c. Actual return on plan assets d. Amortization of unrecognized prior service cost e. Amortization of gain or loss

2. The return on plan assets and interest on the PBO are really financial items – not EE compensation costs

3. The benefit cost can be determined independently of how the plan is financed 4. The PBO is the actuarial present value (“APV”) of all benefits attributed by the plan’s

benefit formula to EE service rendered up to that date a. Assumes that the plan continues in effect and that estimated future events (like future

pay increases, mortality, turnover, etc.) occur 5. The accumulated benefit obligation (“ABO”) is the actuarial present value of benefits

attributed by the plan’s benefit formula to EE service rendered up to that date a. However, is based on current and past compensation levels (i.e. no future pay

increases are recognized) 6. ABO = PBO for plans with flat benefit or non-pay-related benefit formulas 7. Finally the vested benefit obligation (“VBO”) pertains to the obligation the ER would

have if the plan were to be discontinued 8. Plan assets are assets set aside (usually in a trust) to provide for the pension benefits

a. Includes amounts contributed by ER and EEs, plus investment returns thereon less benefits paid out

9. Plan assets normally cannot be withdrawn by the ER 10. Assets that are available to ER for other purposes are not considered plan assets for

FAS87

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VI. RECOGNITION OF NET PERIODIC PENSION COST

A. Service Cost

1. Service cost recognized in a period is the APV of benefits attributed by the pension formula to EE service during that period

2. Need to use assumptions and an attribution method

B. Interest Cost

1. Essentially the assumed discount rate multiplied by the PBO during the period 2. Represents the increase in the PBO due to the passage of time (i.e. time value

concept)

C. Actual Return on Plan Assets

1. Based on the fair value of plan assets at beginning and end of period, adjusted for cont’ns made and benefits paid

2. Will be zero for a non-funded plan

D. Prior Service Cost

1. If plan benefits are increased in respect of services rendered in prior periods, it gives rise to prior service costs a. That is, the increase in the PBO

2. Since ER expects to realize economic benefits of such an increase in future periods, FAS87 does not require recognizing the entire prior service cost in the current period a. Even though these are retroactive benefits

3. Allows recognizing these costs over the future service periods of active EEs at date of amendment who are expected to receive benefits under the plan

4. Prior service cost to be amortized by assigning an equal amount to each future period of service of each EE active at the time of amendment who is expected to receive benefits under the plan a. Conceptually, suppose that the sum of the expected future years of service for all

active employees at the time of amendment is 100 years b. Then an equal amount is allocated to each of those 100 years – whatever pattern

these 100 years take – could be early-loaded or late-loaded or in between c. Practically, often some approximation is used to simplify computations

Comment: Often this makes a good question for exams, because they can usually give a simple enough example of how EEs’ service will be rendered – and then you should be able to determine the allocation of the prior service cost for recognition purposes

5. If all or almost all the participant’s are inactive, then should amortize the prior

service cost affecting the inactive participants over the remaining life expectancy of those participants instead of over the remaining service period

6. Allows for the use (if consistent) of other amortization approaches that amortizes the cost more quickly a. Eg. Straight-line amortization over the average remaining service period of EEs

expected to receive benefits under the plan b. Must disclose alternative method if used

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7. Sometimes, history of regular plan amendments (eg. negotiated plan improvements) or other evidence may point to a shorter period over which ER expects to obtain economic benefits from the amendment a. Should then recognize over the period over which economic benefits are

expected to be derived 8. If a plan amendment reduces the PBO, then first use to reduce any unrecognized

prior service cost a. Any remaining amounts to be amortized the same as for positive prior service

costs

E. Gains and Losses

1. Gains and losses arise from changes in the PBO or plan assets due to: a. Experience different than was assumed b. Changes in assumptions

2. FAS87 does not differentiate between these two sources 3. Because gains and losses theoretically offset each other over time, FAS87 does not

require recognition of gains and losses entirely in the period in which they arise 4. Expected return on plan assets is based on the expected long-term rate of return

on plan assets and the market-related value of plan assets a. Has been quite a bit of press on this particular assumption in the media

5. Market-related value is a value that recognizes changes in the fair value (i.e. market value) systematically and rationally over no more than 5 years a. Can use different methods for different asset classes b. But should be consistent from year to year for each asset class

6. Asset gains and losses are differences between actual and expected returns for a period

7. Asset gains and losses not yet reflected in the market-related value of assets do not need to be amortized

8. Amortization of an unrecognized net gain or loss is one component of pension cost, if it exceeds the greater of 10% of the beginning of year PBO or market-related value of assets a. The excess over the “10% corridor” as it’s called, should be amortized over the

average remaining service of active EEs b. Again, if all or almost all participants are inactive, then can use the average

remaining life expectancy instead c. This is a minimum – can choose to recognize more quickly (again, should be

consistent) d. Any systematic method may be used in lieu of the minimum provided that

i) The minimum is used in any period where it is greater (higher recognition)

ii) It is applied consistently iii) Applied the same way for gains and for losses, and iv) Method used is disclosed

9. Gain and loss component of net periodic pension cost consists of: a. Difference between actual return on plan assets and the expected return b. Amortization of the unrecognized net gain or loss from previous periods

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VII. RECOGNITION OF LIABILITIES AND ASSETS

Comment: Note that the reference to assets and liabilities here does not refer to our day-to-day

business of determining a pension plan’s assets and liabilities. Rather it refers to the assets and liabilities that gets recorded on an entity’s financial statements. When we do actuarial valuations, we come up with the plan’s balance sheet (on various bases perhaps). However FAS87 deals with how to recognize assets or liabilities on the entity’s balance sheet.

1. A liability (unfunded accrued pension cost) is recognized if the net periodic pension

cost recorded to date exceeds the amounts contributed by the ER to the plan 2. An asset (prepaid pension cost) is recognized if the net periodic pension cost recorded to

date is less than the ER cont’ns to the plan 3. If the ABO exceeds the fair value of plan assets, ER shall recognize on their balance

sheet a liability (inclusive of any unfunded accrued pension cost) at least equal to the unfunded ABO (i.e. excess of ABO over fair value of plan assets) a. Requires recognizing an additional minimum liability if:

i) An asset has been recorded as a prepaid pension cost ii) The unfunded accrued pension cost is less than the unfunded ABO, or iii) No accrued or prepaid pension costs have been recorded

4. If an additional minimum liability is needed, the offsetting debit is to an “intangible asset” account a. This asset cannot exceed the unrecognized prior service cost

i) In this case a reduction in equity would be required 5. When a new calculation is made of the additional minimum liability, the related

intangible asset and equity component should be adjusted or eliminated as needed

VIII. MEASUREMENT OF COST AND OBLIGATIONS

1. The service cost, PBO and ABO are all based on: a. an attribution of pension benefits to periods of EE service b. the use of actuarial assumptions to determine the present value of those benefits

IX. ATTRIBUTION

1. Attribution to be based on the benefit formula to the extent that it implies it 2. If formula defines benefits similarly for all years of service, then attribution is

a. “benefit/years-of-service” approach b. For final-pay and career-average-pay plans, this is the same as “projected unit credit”

or “unit credit with service prorate” actuarial cost method c. For flat benefit plans, it is the same as the “unit credit” actuarial cost method

3. If ER demonstrates a “commitment” to make regular amendments to improve benefits in non-pay-related or career-average-pay plans, then a. The substance of the plan may be to provide benefits that are better than the written

terms of the plan b. Such a “substantive” commitment may form the basis of the accounting – and would

therefore need to reflect that future amendments may be required, with adequate disclosure as to how it has been reflected

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4. Where the formula attributes benefits disproportionately to the years worked a. Attribution will be in proportion to the ratio of number of years to date over the

number of years that will have been completed when the benefit is fully vested b. If benefits are not includable in vested benefits, then use completed years to the total

projected years of service X. ASSUMPTIONS

1. Each significant assumption should be the best estimate on an individual basis 2. Plan is assumed to continue (unless evidence to the contrary) 3. Discount rates should be rates at which the pension benefits could be effectively settled

a. In practice, this is often based on the yields on high-quality bonds with cash flows similar to the benefit cash flows; bonds used are typically AA or better

b. Can also look to rates published by the Pension Benefit Guaranty Corporation 4. Expected long-term rate of return on plan assets reflects the average expected rate of

return on the funds invested a. Consider current returns and also future reinvestment rates, etc.

5. If benefit formula uses future compensation as a component, then need an assumption for future pay levels a. Consider general price levels, productivity, seniority, promotion, etc.

6. All assumptions should be consistent with each other (internally consistent) 7. The ABO is measured based on historical service and compensation – no estimate of

future compensation is used a. Projected service is only relevant for determining eligibility for benefits b. Eg. early retirement, death, disability

8. Automatic benefit increases specified by the plan are to be reflected in all measures 9. Retroactive plan amendments are reflected once committed to, even if provisions are

effective at a future date

XI. MEASUREMENT OF PLAN ASSETS

1. Use fair value for purposes of determining the minimum liability and for disclosures under paragraph 54 (not covered in required material)

2. Market-related value can be used for determining expected return on plan assets and calculating gains and losses

3. Plan asset used in plan operations are measured at cost less accumulated depreciation or amortization for all purposes

XII. MEASUREMENT DATES

1. Date of the financial statements or, if used consistently, a date not more than 3 months prior to the date

2. Much of the information can be prepared prior to the chosen date a. Projected forward to account for subsequent events

3. Additional minimum liability is adjusted for subsequent accruals and contributions 4. Determination of periodic pension cost for a period should be based on the assumptions

used for the previous year-end measurements a. Unless more recent measurements are available b. Or a significant event occurs (eg. amendment) that requires re-measurement

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XIII. EMPLOYERS WITH TWO OR MORE PLANS

1. Determine pension cost, liabilities and assets separately for each plan by applying this Statement

2. A liability (i.e. on the balance sheet) required to be recognized for one plan shall not be reduced or eliminated because another plan has assets > ABO or ER has prepaid pension cost related to another plan a. Unless clear entitlement to use assets of one plan to pay the benefits of the other

3. Disclosures may be aggregated for all of an ER’s single-ER DB plans 4. Alternatively, may separate in groups to provide more meaningful information 5. Plans with assets > ABO shall not be aggregated with plans with assets < ABO 6. Disclosures for plans outside the US shall not be combined with those for US plans

a. Unless those plans use similar economic assumptions

XIV. DEFINED CONTRIBUTION PLANS

1. Pension benefits will depend on the amounts contributed and investment returns earned 2. Net pension cost for a period will be the contributions for the period 3. ERs need to disclose separately from it’s DB plan disclosures:

a. Description of plan (EEs covered, cont’n formula, nature and effect of significant matters affecting comparability of information)

b. The amount of cost recognized during the period 4. Plans with both DB and DC characteristics need careful analysis

a. Look to the substance of the plan to determine whether DB treatment or DC

XV. MULTIEMPLOYER PLANS 1. Multiemployer plan is a pension plan to which 2 or more unrelated ERs contribute

a. Often pursuant to one or more collective bargaining agreements 2. No segregation of assets by ER – therefore can use to provide benefits to EEs of other

ERs 3. Net pension cost = the required contribution for the period 4. Recognize as a liability any contributions due and unpaid 5. If ER participates in more than 1 multiemployer plan, disclose separately from

disclosures for a single-ER plan: a. Description of the multiemployer plan(s) (eg. EEs covered, type of benefits, nature

and effect of significant matters affecting comparability of info b. The amount of cost recognized during the period

6. Sometimes withdrawal from a multiemployer plan results in ER being liable to the plan for a portion of its unfunded benefit obligations a. If probable or reasonably possible, need to apply FASB Statement No. 5

A. Multiple-Employer Plans

1. Different than multiemployer plans in that in substance, they are an aggregation of single-ER plans combined for the purposes of: a. Pooling assets for investment purposes b. Reducing plan administration costs

2. Usually do not involve collective bargaining agreements

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3. May also have different benefit formulas for different ERs 4. ER’s cont’ns to plan may depend on the formula 5. FAS87 treats such plans as single-ER plans and each ER’s accounting shall be based

on its respective interest in the plan

XVI. NON-US PENSION PLANS

1. FAS87 has no special provisions to non-US pension arrangements 2. If substance of those arrangements are similar to pension plans in the US, then they are

subject to FAS87 for purposes of preparing financial statements in accordance with US GAAP

3. Not dependent on whether arrangement is funded, payable in installments or as lump sum, mandatory or voluntary

XVII. BUSINESS COMBINATIONS

1. If ER is acquired and the accounting method used for reporting is the purchase method under Opinion 16, a. If ER has a single-ER DB pension plan, purchase price shall include a liability for the

PBO in excess of the plan assets (or an asset if plan assets exceed PBO) b. Eliminates any previously existing unrecognized net gain/loss, unrecognized prior

service cost, or unrecognized net transition obligation or net transition asset

XVIII. AMENDMENT TO OPINION 16

1. Makes certain changes to Opinion 16, including addition of following words:

“Paragraph 74 of FASB Statement No. 87, Employers’ Accounting for Pensions, specifies how the general guidelines of this paragraph shall be applied to assets and liabilities related to pension plans.”

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ASSET VALUATION METHODS UNDER ERISA

By Paulette Tino, ASA and Edward Sypher, FSA I. ABSTRACT

1. ERISA’s minimum funding requirements permit the use of asset values that differ from the fair market value (“FMV”)

2. Paper discusses various methods (asset valuation methods) that are possible 3. Also discusses statutory and regulatory requirements for asset valuation methods under

ERISA

Chapter 1: Introduction

I. INTRODUCTION

1. All pension funding methods reflect the value of plan assets in some way to in determining the required contributions

2. Pension actuaries have established reasons why using the FMV may not always be the most appropriate choice a. Some assets do not have a readily available market value b. Volatility in market values can result in undesirable volatility in annual contributions

3. Asset valuation methods (“AVMs”) are used to determine actuarial value of assets 4. All rational AVMs share common goal of limiting extent that fluctuations in market

values will affect required contributions a. By “smoothing out” recognition (basically deferring recognition) of investment

earnings 5. Jackson and Hamilton’s The Valuation of Pension Fund Assets (1968) set out a 6-fold

classification of methods, as follows: A. Initial Cost

1. Value assets at their initial price (may make ad hoc adjustments if appropriate)

B. Initial Cost With Formula Modifications

1. Values based on initial cost, but modified according to some pre-set formula 2. Example would be the use of amortized book values for bonds 3. Another example is to increase the initial cost at an assumed rate

C. Combination of Initial Cost and Current Market Value

1. Assign values based on both the initial cost and the current market value 2. May be a simple average of the two or something more sophisticated

a. Eg. use a “write-up” based on a function of unrealized capital appreciation

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D. Current Market Value

1. Valued at current FMV or at a “realizable” value (current market value less cost of liquidation)

E. Adjusted Market Value

1. Establishes an “adjustment account” 2. When market value increases faster (slower) than a specified rate, then some of the

difference is held in the adjustment account and not reflected in the actuarial value of assets a. Actuarial value of assets = FMV less adjustment account b. If adjustment account is negative, then actuarial value is > FMV

3. Different methods will result in different amounts credited into or out of the adjustment account

F. Present Value

1. Each asset is give a value equal to the present value of its anticipated cash flows

(present values based on valuation interest rate) 2. Also called a “discounted cash flow” basis 3. May not work with certain assets

6. In the 1998 SOA survey of AVMs, FMV was the most common for large US plans a. Second most popular was the “write-up” method b. Also popular were the deferred recognition and contract value (i.e. insurance

contracts) c. For small plans, FMV was used in 2/3 of the cases, and contract value used by most

of the remainder

Documents

TABLE OF CONTENTS – VOLUME I COURSE 8RU – … 8S-40 5-2-06.pdfC. Plan Fund Investments Managing Investment Portfolio (2nd Edition) by Maginn Chapter 14 [also called 8RU-308-04]