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The Ohio State University. Key Issues Impacting Employer- Provided Pension Plans April 11, 2006 Gary Price. As The Old Saying Goes…. “Retirement is the time when you never do all the things you intended to do when you have the time.” Anonymous. Agenda. - PowerPoint PPT Presentation
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The Ohio State University
Key Issues Impacting Employer- Provided Pension Plans
April 11, 2006
Gary Price
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As The Old Saying Goes…
“Retirement is the time when you never do all the things you intended to do when you have the time.” Anonymous
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Agenda
Defined-benefit plans…what are they
Defined-benefit plans…the current environment
The role of the PBGC
The airline industry
Accounting for defined benefit plans
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Defined Benefit (DB) Pension Plans
DB pension plans promise a benefit that is generally based on an employee’s salary and years of service, with the employer being responsible to fund the benefit, invest and manage plan assets, and bear investment risk.
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The Basic Issue
A number of factors have thrown the DB pension plan system into financial turmoil, including:
-declining equity markets
-low interest rates
-financially weak industries
The combination of the three has resulted in significant underfunding.
Some parties have also suggested that funding rules (dictated by the
IRS and ERISA) and accounting rules (dictated by the SEC and FASB)are also major contributors to the problems- creating the “perfect storm.”
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Defined Benefit Pension Plans – Some Facts
Over $2 trillion worth of benefits covering over 44 million participants
Peaked at roughly 112,000 plans in the mid-1980s…today roughly 30,000 plans exist
Many of the plans that exist today are in our oldest, most mature industries (automotive, airlines, steel, etc.)
Benefits are generally not portable as they are in 401-K plans
Historically, these plans were the favored retirement plans of
the Ozzie and Harriet generation
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Defined Benefit Plans - Funding
Today’s rules (created in 1974) that govern how much money an employer must put into a pension plan are complex, confusing and do not ensure that plans become well funded
Current measures of assets and liabilities are not accurate & meaningful
Underfuned plans have too long to make up shortfalls and employers can take “funding holidays” without regard to a plan’s funding level
Maximum deductible contributions are set too low
Underfunded plans are allowed to increase benefits
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Defined Benefit Plans – Funding
The dilemma is that in 1980 there were about 28 million participants – today there are over 35 million participants
These numbers mask the downward trend in the DB system, as the numbers reflect not only active workers but also retirees, surviving spouses and separated vested participants.
So active participants today make up less than 50% of the total
Today nearly $500 billion of pension underfunding must be
spread over a base of declining active workers!
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Defined Benefit Plans - Funding
In 1999, the Pension Benefit Guaranty Corporation estimated total underfunding at approximately $30 billion…at the end of 2004 that number was over $450 billion
While many employers are financially healthy and should be capable of meeting their obligations, the amount of underfunding in plans sponsored by financially weaker employers has never been higher.
Reasonably Possible Exposure(Dollars in Billions)
Principal Industry Categories FY 2003 FY 2004
Manufacturing $ 39.5 $ 48.4
Transportation, Communication & Utilities 32.9 30.5
Services & Other 2.5 7.9
Wholesale and Retail Trade 4.3 5.8
Agriculture, Mining & Construction 1.8 1.9
Finance, Insurance & Real Estate 1.1 1.2
Total $ 82.1 $ 95.7
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The Role of the Pension Benefit Guaranty Corp.
This is the federal agency that insures private pensions
Privately funded by sponsors…essentially a per head tax of $19 that has not increased in 15 years and are not risk-based
Some retirees lose benefits when the PBGC steps in due to limits established in law by Congress (for example, workers at United Airlines will receive 80% of their accrued benefits, the shortfall being more than $3 billion) and other provisions.
Some have also put forward the notion that the PBGC
system creates a “moral hazard.” In other words, the
presence of PBGC insurance may create incentives for
struggling companies to place other financial obligations first.
PBGC Net PositionSingle-Employer Program
FY 1980 – FY 2004
-$25
-$20
-$15
-$10
-$5
$0
$5
$10
Billions$9.7
-$3.6
-$11.2
-$23.3
$7.7
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PBGC
The PBGC currently has approximately $40 billion in assets
The PBGC currently has over $62 billion in liabilities with nearly $100 billion of new exposure from financially weak sponsors (it is estimated that GM’s pension obligations are underfunded by $31 billion)
The PBGC currently has over 350 active bankruptcy cases…37 of those have underfunding claims of $100 million or more, including seven in excess of $500 million
In May 2005, United Airlines pension promises were assumed by the PBGC at a then estimated nearly $10 billion
The PBGC is clearly at risk…and with it the pension
security of 44 million Americans.
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The Airline Industry - A Perfect Storm
Mature industry, heavily unionized, significant pension promises
Major airlines have reported losses over $30 billion over the past four years
Congress during this time has provided approximately $9 billion in financial assistance
In total, airline sponsored plans are estimated to be underfuned by over $30 billion
It should be noted that automotive related firms may represent
the greatest risk…with over $60 billion in underfunding.
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Delta Air Lines
The Company is currently operating under Chapter 11 of the US Bankruptcy Code
At 12/31/00, Delta reported plan assets of $10.4 billion to cover liabilities of $9.2 billion
At 12/31/05, Delta reported plan assets of $6.5 billion to cover liabilities of $12.8 billion
WHAT HAPPENED IN FIVE YEARS?
Significant decrease in long-term interest rates (250 bp)
Decline in returns in equity markets (100 bp)
Financially troubled company with weak cash flows from operations
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Delta Air Lines
Most importantly, a major business risk has emerged for Delta. Under the pilot plan, Delta pilots who retire can elect to receive 50% of their benefit currently and the other 50% as an annuity. Many pilots have elected to do this over concerns that the Plan might be terminated in bankruptcy.
As of 1/31/06, 1,700 of Delta’s 5,900 pilots are at or over age 50 and thus eligible to retire at the beginning of February 2006. Delta could have a temporary or even longer-term shortage of pilots.
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Delta Air Lines
The pension issue poses also poses a major liquidity issue for the Company. In 2005, Delta contributed $325 million to its DB plans.
Under current funding rules, Delta estimates that its funding requirements under its plans in 2006, 2007 and 2008 to be approximately $3.4 billion! It is questionable whether Delta could make
these payments currently or even when it emerges from bankruptcy.
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Accounting for DB Plans - FASB Guidance
SFAS 87, Employers’ Accounting for Pensions
SFAS 88, Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits
SFAS 132, Employers’ Disclosures about Pensions and Other Postretirement Benefits
Special Report, A Guide to Implementation of Statement 87 on Employers’ Accounting for Pensions
Special Report, A Guide to Implementation of Statement 88 on Employers Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits
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SFAS 87 Objectives
To provide a measure that– Reflects the terms of plan– Better approximates cost recognition– Is more understandable and comparable
To provide users with better information through more disclosures
To improve reporting of financial position– Minimum liability for under funded plans
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SFAS 87 Impact of Funding
Generally broke the direct linkage between funding and expense
Actuarial assumptions (principally economic) may differ for funding and accounting
• SFAS 87 methods for amortization not allowed for tax purposes
SFAS 87 expense (income) may be• Less than minimum ERISA contribution• Greater than maximum tax deduction
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SFAS 87 Scope Establishes standards for employers who offer
pension benefits
Applies to all pension plans, except those offering only life or health insurance benefits
Principal focus is on defined benefit plans • Funded and unfunded• Domestic and foreign• Qualified and nonqualified• Defined contribution and multiemployer plans
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SFAS 87 Overview
Requires single (actuarial) cost methodProvides guidance on selection of assumptionsRequires amortization of (actuarial) gains and losses in
excess of a prescribed minimumLimits methods and time periods for amortization of prior
service costRequires transition amount computation and
amortizationRequires balance sheet reflection of additional minimum
liabilityExpands disclosure requirements
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SFAS 87 Attribution Benefits approach (projected unit credit method) -- required
for accounting purposes• Total benefit projected for each participant• Pro rata portion of benefit for each year of service (Actuarial) PV of benefit is service cost
Cost approach (e.g., entry age normal or aggregate method) -- may be used for funding purposes
• Total benefit projected• Cost of benefit is discounted• Result is allocated to each year of prospective service
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SFAS 87 Benefit Obligations
SFAS 87 requires computation and disclosure of:• Vested benefit obligation (VBO)• Accumulated benefit obligation (ABO)• Projected benefit obligation (PBO)
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Component of Periodic Cost
Periodic cost equals:• The sum of:
Service costInterest costAmortization of:
-- Transition obligation -- Prior service cost -- Gains and losses
• Minus:Expected return on plan assetsAmortization of transition asset
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Illustration of Expense vs. Disclosure
Determined Prior to Year End Based on Expected Return on Assets
Year-End Disclosure Using Actual Return on Plan Assets
Service cost $ 20 Service cost $ 20Interest cost 100 Interest cost 100Expected return on assets (140) Actual return on assets (300)
Amortization of Unrecognized: Amortization of Unrecognized:
Transition (asset) (300) Transition (asset) (300)Prior service cost 50 Prior service cost 50(Gains)/losses 200 (Gains)/losses 200Subtotal amortization ( 50) Subtotal amortization ( 50) Deferral of gains/losses on
plan assets during prior year 160
Net amortizationand deferral 110
Total expense (70) Total expense (70)
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SFAS 87 Service Cost
Actuarial present value of benefits attributed to services rendered during the year
Comparable to normal cost used for funding purposes
Represents the increase in PBO/APBO attributable to employee service for the period
Unaffected by plan's funded status
Flexibility: Assumption changes that increase PBO/APBO directly increase service cost
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SFAS 87 Interest Cost
PBO/APBO $10,000,000(beginning of year*)
Discount rate assumption X 7%(beginning of year)
Interest cost $ 700,000 * Adjusted for benefit payments during the year
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SFAS 87 Interest Cost(continued)
Example: Non-discount
Rate ChangeDiscount
Rate Change
PBO/APBO Before $ 1,000 $1,000 After 940 940 Discount rate Before 7 1/2% 7 1/2% After 7 1/2% 8% Interest cost Before $ 75.0 $75.0 After 70.5 75.2
Change in discount rate has relatively little impact on interest cost in most cases
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SFAS 87 Return on Plan Assets
Market-related value of assets $3,000,000(generally beginning of year)
Earnings rate assumption X 9%
Expected return $ 270,000
(Used for expense measurement)
Actual return (Disclosed) $ 300,000
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SFAS 87 Return on Plan Assets(continued)
Plan assets must be segregated and restricted• May include employer securities, if transferable
Asset values based on beginning of year amount adjusted for contributions and benefit payments during the year
Market-related value is fair value or a consistently applied approach that smoothes asset-related gains/losses over period not to exceed five years
Various methodologies used to compute market-related value
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Market-Related Values
MRV is basis on which expected return on plan assets is calculated
MRV may be either:• fair value, or• calculated value that smoothes asset fluctuations
over period up to 5 years• method must be systematic and rational and treat
gains and losses similarly MRV generally less than current fair value due
to recent increases in stock values
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Market-Related Values(continued)
Widely used MRV approaches:• Fair Value of plan assets at each measurement date• Moving-average amortizing realized and unrealized
gains/losses over a period up to 5 years • FASB gain/loss method, used in Illustration 4 of SFAS 87
Other approaches• Faster recognition over 2- or 3-year smoothing• Different approach for different classes of assets• Fresh start for assets of an acquired company• Immediate recognition of some portion of gain/loss in MRV and
smoothing of remainder
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Market-Related ValuesUnder Alternative Approaches
MRV Approach
FASB Gain/Loss Moving-Average
MRV as of Fair Value Approach Approach beginning of year:
1991 $100.00 $100.00 $100.00 1992 119.00 118.20 113.40 1993 140.00 138.46 128.60 1994 164.00 161.17 146.20
1995 168.00 182.13 162.20 1996 222.00 210.74 186.60
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Market-Related ValuesSFAS 87 Accounting Rules
Change in MRV method is considered a change in accounting under APB 20
• Moving closer to fair value generally meets test of preferability
• Need to compute cumulative catch-up adjustment since adoption of SFAS 87
• Consider whether this catch-up adjustment is material
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SFAS 87 Aspects of Delayed Recognition
Changes in the PBO/APBO and value of assets are:
• Not recognized as they occur, but gradually over subsequent periods
• Ultimately recognized (but portion of deferred gains orlosses may be held within the corridor)
• May be offset by subsequent changes
Expense recognition achieved through amortization
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SFAS 87 Amortization of Prior Service Cost
Declining pattern of amortization• Method similar to sum-of-the-years'-digits method• May use straight-line amortization over average remaining
service period (ARSP) of employees expected to receive benefits
Amortization period - expected service period of active employees expected to receive benefits
• SFAS 87: Period to expected retirement
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SFAS 87 Amortization of Prior Service Cost
(continued)
Negative plan amendments• First offset against any positive prior service cost• Amortize remainder
History of regular amendments• Amortize over "period benefited" (e.g., union's contract
period), which may be shorter than ARSP
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SFAS 87 Substantive Commitment
Anticipate future amendments if:• History of regular increase• Other evidence• "Present commitment" to make future amendments
Disclose existence and nature of commitment
In practice, rarely used in pension accounting except in some rate-regulated situations
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SFAS 87 Unrecognized (Actuarial) Gains and Losses
Accounted for on a combined basis• Effect of assumption changes• Experience different than assumed, both asset and
obligations related• Excludes difference between MV and MRV
Corridor approach• Prescribed minimum -- 10% of greater of PBO/APBO
or market-related value of plan assets• Straight-line amortization over ARSP for excess
outside corridor
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SFAS 87 Unrecognized (Actuarial) Gains and Losses
(continued)
Alternative approaches permitted if meet certain tests:
• Amortization greater than minimum• Method applied consistently• Method applied similarly to gains and losses• Method disclosed
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Balance Sheet Considerations
Accrued (prepaid) pension liability (asset)• Based on employer's cumulative contributions/benefit
payments compared to cumulative FAS 87/106 expense
Additional SFAS 87 liability for unfunded accumulated benefits
• ABO minus fair value of assets• Offset by intangible asset up to amount of any
unrecognized prior service costs• Excess charged to stockholders' equity
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Accounting for More Than One Plan
Measure each plan separatelySeparate disclosure of overfunded and under funded
plans
SFAS 87
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SFAS 87 Measurement Date
Up to three months before year end date
May change asset values or discount rateconsiderably
Consider treatment of plan changes or and fiscal year end
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Selecting Actuarial AssumptionsDiscount Rate: Impacts obligation, but less impact on expense -- rules
require that rate selected be based on high quality bond yields at each measurement date
• Risk: Using too high a rate may be questioned by auditors and also increases risk of having actuarial losses if interest rates fall
Salary Increases: Impacts pension and retiree life obligations-- rules require underlying inflation component be consistent with other assumptions (discount rate, trend rate)
• Risk: Using too low a rate may result in actual salary increase higher than assumed causing annual losses to occur.
• Eventually may need to change assumption (timing of which is flexible) resulting in large actuarial loss
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Selecting Actuarial Assumptions(continued)
Earnings on Plan Assets: Direct impact on annual expense (applied to MRV)
• Risk: Highly visible; also, investment experience lower than expected results in potential losses; impacts future expected return component of expense (e.g., if lower assumption in future) and potential gain/loss amortization
Health Care Cost Trend: Direct impact on obligations and expense; impact depends on whether retiree health plan is capped or not
• Risk: Similar to salary scale, but may be of little impact if cost cap
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Selecting Actuarial Assumptions(continued)
Average Per Capita Costs: Direct impact on retiree health expense; costs driven by plan design and recent claims experience
• Risk: Too low a rate might generate losses in future
Demographic assumptions (turnover, retirement age, mortality): Greater impact on retiree health than on pensions
Other Retiree Health Assumptions (e.g., percent married and electing coverage): Impacts retiree health obligations and expense
• Risk: Too low might generate losses
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SFAS 132 Defined Benefit Plan Disclosures
Description of the plan Components of pension expense Reconciliation of the funded status of the plan to
the employer's balance sheet Weighted-average assumed discount, earnings
and salary progression rates Alternative amortization methods Related party transactions