Looking Into the FASB’s Crystal Ball: What’s on the Horizon for Phase Two of Postretirement Benefit Accounting Reform?

On September 29, 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) 158, which concluded the first phase of the FASB’s accounting reforms for pensions and other postretirement benefits. Phase One, sometimes called the “quick fix,” moved market-based measures of funded status from the footnotes of financial statements to the balance sheet. Many important issues were left for Phase Two to resolve, and its ramifications are likely to be bigger than those of Phase One.

While plan sponsors and their advisers are sorting through the mechanics and implications of Phase One, this article, the first in a planned series, is dedicated to Phase Two — opening a window into the long-term future of accounting for pensions and other postretirement benefits.

Phase Two Overview
During Phase Two, the FASB will review everything about postretirement benefit accounting. The Board is expected to firm up the timing and review process for the second phase of accounting reform within the next few months. Although the FASB will likely coordinate its efforts with those of the International Accounting Standards Board (IASB), the outcome will not necessarily look like the IASB’s current postretirement benefit accounting requirements. In fact, the future accounting requirements may not look like anything we’ve seen before.

While we can’t predict the FASB’s final decisions, we understand the broad issues the Board intends to tackle. For the next several months, the Watson Wyatt Insider will feature articles about key Phase Two issues including:

• Income statement
• Liability measurement
• Balance sheet consolidation

Income Statement Recognition
Income statement recognition is the issue keeping plan sponsors up at night. Simply put, Phase Two will decide which costs sponsors must recognize on their income statements. The current requirements allow sponsors to significantly smooth (average) and/or defer the recognition of some costs. We expect the FASB to debate both the optimal level and the appropriate mechanisms for smoothing and deferred cost recognition.

It would be a significant oversimplification to state that the FASB plans to eliminate all smoothing and to require immediate recognition of actuarial gains and losses and plan amendments through operating income, yet these appear to be plan sponsors’ biggest fears.

Appropriately recognizing true plan costs is at the heart of the income recognition issue. Too much smoothing may create a disconnect between when costs are incurred and when they are recognized. But too little smoothing may increase volatility to the point of distorting plan costs, as well as overall corporate financials. The FASB will seek an appropriate balance. Two areas under discussion — plan amendments, and actuarial gains and losses — are addressed below.

• Sponsors can amortize the cost of plan amendments over the average future participation period for active plan participants, which is often 10 or more years. This methodology reflects the theory that the benefits of such amendments span participants’ entire careers. However, some believe that because the plan incurs the liability immediately, it should be recognized on the income statement immediately. Others are concerned that immediate and full recognition of plan amendments would create lumpy earnings-per-share figures, which would make financial analysis more difficult.

  One possible compromise would amortize prior service cost bases over a shorter period of time, such as until full vesting occurs or, for collectively bargained amendments, over the period of the bargained contract.

• Actuarial gains and losses — most often from investment returns and changing discount rates — is a big issue for income statement recognition. While the FASB believes that such fluctuations are real and meaningful, it also appears to understand that these fluctuations relate to financial market exposure and so are not necessarily long-term employee compensation costs.

  The FASB plans to examine the results achieved by existing gain/loss amortization methods under FAS 87. For example, many plan sponsors are amortizing losses now that occurred in 2000-2002. While it might not be reasonable to recognize all gains and losses when they occur, not reflecting them at all or spreading them over different periods diminishes transparency.

Income Statement Classification
Cost classification may offer the biggest upside potential for plan sponsors, while also being the least well-understood issue. Under FAS 87 and FAS 106, today’s income classification system is very simple. All components of expense are considered operating costs, similar to other forms of employee compensation. Many members of the financial community believe this classification oversimplifies the cost picture. Their reasoning and possible solutions follow.

• Although some pension costs are similar to deferred salaries, others are not. In Phase Two, the FASB might assign pension costs to different buckets, such as including some costs in the P&L items that affect earnings per share and others in comprehensive income or another “below the line” item. A similar approach is used in other accounting standards for pensions and other postretirement benefits, such as International Accounting Standard (IAS) 19 and Financial Reporting Standard (FRS) 17.
• Costs could be assigned to multiple buckets, such as operating cost, financing cost and investing cost. Operating cost could include deferred salaries (service cost and possibly costs attributable to plan amendments). Financing costs could include costs similar to interest on long-term debt (interest cost). Investing cost could include costs similar to other corporate investments — primarily those attributable to asset returns.

It would be hard to overstate the importance of P&L classification. To illustrate, consider an equity analyst trying to value a publicly traded company. Analysts often look at past and projected future company earnings, review these values for other companies in the same and similar industries, and then estimate a “target” price/earnings (P/E) ratio. The analyst then compares the target P/E ratio with the stock’s current price to make an appropriate buy, hold, or sell recommendation. For example, a stock might have a target P/E ratio of 15/1 but be trading at a lower price, say 12/1. In this case, the analyst would likely make a “buy” or “strong buy” recommendation, because the stock appears to be a very good deal.

A key question is: What earnings will the analyst use in the denominator of the P/E ratio? Analysts often use only the operating earnings in the P/E multiple, as many consider that to be the best indication of future earnings potential. As a result, even if the FASB eliminated most of the smoothing in FAS 87 expense, plan sponsors could be somewhat insulated from excessive volatility as long as the costs were properly classified.

For example, if a company had a target P/E ratio of 15/1, the analyst might believe that $1 of operating earnings was worth $15 of market capitalization, but $1 of non-operating earnings was worth only $1. So while pension investment gains and losses are meaningful measures of a plan’s immediate market value, most equity analysts would not choose to magnify those gains/losses by a factor of 15. This makes good sense and would provide a significant advantage to plan sponsors, as their operating costs — the most important costs — could become smoother, while any new volatility would be channeled into less important, non-operating cost buckets.

Implications and Conclusions
While the FASB’s Phase Two reforms may make the income statement more volatile, that volatility may well be confined to a separate, more benign place on the income statement. This would clarify to financial statement users that many pension gains and losses are non-core, non-operating costs, while other elements of pension cost, such as service cost, are true operating costs. The FASB may need to integrate Phase Two with their “Project on Financial Statement Presentation,” which may restructure the income statement to more clearly differentiate between operating and non-operating earnings.

FASB chair Bob Herz recently commented on concerns about income statement recognition: “I think that [the concern] assumes a little bit the way the income statement is constructed today,” he said. “[The FASB’s project on financial statement presentation looks] at different ways of constructing the income statement — different sections — and it may change the way people look at things or think about things. It is very important.” Herz appears to be suggesting that many plan sponsors may be in for a welcome surprise when they better understand the changes being considered for Phase Two.

Adopting a more marked-to-market approach to reflecting pension expense on the income statement, along with more appropriately bucketing those costs as operating and non-operating, could have important implications for plan design. It could moderate the accounting risks posed by defined benefit plans by reducing the volatility of operating pension costs. The reforms would also have important implications for asset/liability modeling (ALM) and enterprise risk management (ERM) strategies, since the advantages of adjusting investment risk could have immediate effects on the income statement.

While the new income statement measures may look very different from the old measures, the FASB’s goal is to create transparent, meaningful measures of plan costs and risks that will be useful for financial statement users, such as equity and credit analysts.

INSIDER — February 2007 Watson Wyatt