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Accounting Rules May Put Pensions on Ice

New FASB guidelines could accelerate freezing of defined-benefit plans, but employers are warned not to act rashly.

August 28, 2006
Related Topics: Retirement/Pensions, Benefit Design and Communication, Compensation
Pension reform isn’t the only thing that companies with defined-benefit plans have to worry about these days. There is another set of rules scheduled to take effect by year’s end that will significantly affect these companies’ balance sheets.

    In November, the Financial Accounting Standards Board came out with proposed rules designed to increase transparency of employers’ post-retirement benefits, including defined-benefit plans and retiree medical costs.

    Under the first phase of the rules, which is expected to take effect by year’s end, employers will be required to include pension liabilities and retiree medical costs on their balance sheets. Currently, that information is included in footnotes.

    The rule also will require companies to measure pension liabilities on the basis of their projected benefit obligations, which includes future salary increases.

    Most employers currently measure their pension liability based on accrued benefit obligations, or those costs already assumed. By changing the model to include future pay increases, critics of the bill argue that employers will have to state liabilities that aren’t really there.

    "This could result in a massive reduction to shareholder equity," particularly for companies with big legacy costs, says Kevin Wagner, retirement practice director at Watson Wyatt World­wide.

    The accounting change would cut shareholder equity at the Fortune 1,000 by 10 percent, according to Watson Wyatt. Another consulting firm, Seattle-based Milliman, calculates that this would have translated to a decrease of $222 billion in 2005 for the 100 large firms it tracks.

    For the second phase of the rules, which isn’t in draft form yet and won’t take effect for a couple of years, FASB will re-evaluate how companies measure pension liabilities and whether the projected benefit obligation formula or the accrued benefit obligation formula should be used. These calculations would be included in companies’ income statements and be reflected in their earnings.

    Employers need to determine how the rule will affect their balance sheets, then consider ways to alter their plans to address potential issues, says Ethan Kra, chief actuary for retirement at Mercer Human Resource Consulting.

    "We are telling employers to model out alternative investment approaches," he says. One way employers can increase the predictability of their plan liabilities is by reducing the plans’ exposure to equities and increasing their bond exposure.

    Another change in plan design that employers will consider is switching from paying benefits based on final average pay to a more level payment based on employees’ pay during the course of their career, says Tonya Manning, vice president and chief actuary, U.S. retirement, at Aon Consulting. "By switching to the career-average pay model, employers can decrease their projected benefit obligations," she says.

    Overall, the rules may cause an increasing number of employers to freeze their pension plans, experts predict.

    "Some employers are going to say, ‘This puts me at a competitive disadvantage. Let’s get it off the books,’ " says Jim Verlautz, chair of the pensions committee at the American Academy of Actuaries.

    Dallas Salisbury, president of the Employee Benefit Research Institute, notes that in the United Kingdom, 70 percent of pension plans were frozen or terminated after similar accounting rules took effect.

    But experts advise employers not to have a knee-jerk reaction to the rules. "Employers are not materially impacting their costs by freezing their plans now or waiting a year," Wagner says. He notes that companies still need to manage their defined-benefit plans after they are frozen. "The volatility doesn’t go away immediately."

Workforce Management, August 28, 2006, p. 32 -- Subscribe Now!

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