Looking Into the FASB’s Crystal Ball: What’s Ahead for Liability Measurement?

Last year, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) 158, bringing the first phase of the FASB’s accounting reforms for pensions and other postretirement benefits to a close. Phase One moved market-based measures of funded status from the footnotes of sponsors’ financial statements to the balance sheets.

Many important issues were left for Phase Two, including the determination of expense, liability measurement and balance sheet consolidation. Phase Two will essentially rebuild the foundation of pension accounting. As plan sponsors and their advisers are completing the implementation of Phase One, this article, the second in a planned series about Phase Two, focuses on liability measurement.¹

Phase Two Overview

The FASB’s first meeting on Phase Two, which is expected in April or May, will likely set the course for this project. In a letter to the FASB, Watson Wyatt encouraged the board to (1) address Phase Two in a single, comprehensive project rather than as a series of incremental projects, and (2) address liability measurement jointly with the International Accounting Standards Board (IASB) early in the process. Watson Wyatt Insider is featuring articles about key Phase Two issues including:

• Income statement – The first article in this series (see Watson Wyatt Insider, March 2007) discussed the income statement implications. It is available online at http://www.watsonwyatt.com/us/pubs/insider/showarticle.asp?ArticleID=17098.
• Liability measurement (this issue).
• Balance sheet consolidation – planned for the May 2007 Insider.

Liability Measurement

What is the most accurate measure of a plan’s benefit obligation? It may sound like a simple question, but designing measures that convey a plan’s obligation clearly and accurately requires careful analysis. In FAS 158, the FASB decided to continue using the projected benefit obligation (PBO) as set out in FAS 87 and the accumulated postretirement benefit obligation (APBO) as set out in FAS 106, deferring liability measurement to the second phase of the project.

Watson Wyatt Observation: Because FAS 158 requires plans to use the PBO instead of the accumulated benefit obligation (ABO)² to calculate other comprehensive income for the balance sheet, many plan sponsors believe that the liability measure issue was addressed in Phase One. But the FASB intended that only as a stopgap measure — Phase Two will deliver the long-term resolution to the liability measurement issue.

To determine the appropriate measure of plan liabilities, the FASB is expected to consider a number of important questions:

• What is a plan’s true obligation? Is it the plan’s legal, contractual or substantive commitment? Are individual employee contracts subject to these rules?

Watson Wyatt Observation: Defining which commitment to measure is at the heart of many of the issues described below.

• Should the obligation reflect assumed future salary increases? When FAS 87 was written – more than two decades ago — the FASB held that the obligation for a pay-related plan included both accrued service and expected future pay. Over the last few years, however, many economists have questioned whether projected salary increases belong on the balance sheet, especially since most of the other balance sheet measures reflect realized – not projected – amounts. The FASB will review whether to reflect projected future salary increases in the liability measure on the balance sheet.

Watson Wyatt Observation: The FASB’s rationale is that in pay-related plans, projected future pay is part of the employer’s substantive commitment to plan participants. However, incorporating projected pay creates inconsistencies, because plans with similar cash flow streams are valued differently. For example, creative actuaries could construct plan designs that mimic accrual patterns in final average pay plans without actually being final average pay plans. Requiring PBO-based accounting would result in plans with virtually identical benefit accrual patterns being valued differently, which calls into question the robustness of using the PBO.

Also, some plans for collectively bargained employees routinely increase benefits during union negotiation cycles, but — unlike pay-related plans — do not include the increases in the PBO, because the increases are not known with certainty until bargaining is complete. Future increases for union plans are reasonably expected but not contractually guaranteed — similar to future pay raises for other employees — so why should projected increases for non-union plans be included in the liability measure, while those for union plans are not?

Finally, recent plan design activity has raised questions about the extent of an employer’s commitment to grant benefits based on future pay increases — is the commitment great enough to constitute a “substantive commitment” for accounting purposes?

• What is the appropriate discount rate for determining the fair value of the liability? Today, most plan sponsors base their discount rate on yields from high-quality bonds, even though benefit obligations do not necessarily parallel high-quality corporate bond obligations. For example, because qualified U.S. pension plans are backed by plan assets and partially guaranteed by the Pension Benefit Guaranty Corporation (PBGC), some economists believe their value should be based on lower-risk government bond yields. Unfunded nonqualified and retiree medical obligations, on the other hand, are higher risk, so a discount rate based on the sponsor’s borrowing rate in debt markets may more accurately reflect their value —that is, the discount rate for these obligations may be linked to the credit quality of the sponsor. Despite some differences of opinion, the general consensus in the financial community is that because most postretirement benefit obligations are debt-like, the FASB is likely to settle on some variation of debt-based discount rates — rather than expected returns on plan assets.
  
• What is the most accurate way to measure the obligation imposed by lump sum options? Many pension plans offer participants lump sums when they terminate or retire. Today’s accounting rules require actuaries to estimate the lump sum payment amount at the projected termination/retirement date (or various dates with assigned probabilities), then discount it back, with interest, to the current date. While this methodology has some merit, the resulting liability may be lower than the lump sum the participant would receive if he or she terminated immediately. Despite the fact that most participants will continue working, some economists believe that the obligation should never be less than the amount that could be taken immediately as a lump sum.

Watson Wyatt Observation: Requiring the liability to be at least as large as the amount that could be taken immediately as a lump sum could create some inconsistencies. For example, should subsidized lump sum distributions be valued differently than subsidized annuity distributions? That is, in annuity plans with subsidized early retirement options, should the value assume that all participants will take the benefit at the age that would generate the highest liability? Wouldn’t this be an unrealistic assumption about participant behavior? Why would it be appropriate to assume that a plan sponsor will incur the highest possible costs? The FASB will need to resolve these issues to ensure consistency and comparability in financial reports.

• How should rescindable benefits be treated? Unlike qualified pension benefits, retiree medical benefits and nonqualified pension benefits can often be reduced or even eliminated. For this reason, many credit and equity analysts do not consider retiree medical obligations as debt-like liabilities. The FASB will review how these obligations should be characterized for liability measurement.

• How should attribution be incorporated into liability measurement requirements? Attribution refers to the way plan sponsors allocate the projected benefit stream between past service and future service — only the obligation to past service appears on the balance sheet. While the FASB hasn’t specifically committed to address attribution, there is a need for more guidance and greater consistency.

  Currently, attribution for the ABO is very standard — all benefits accumulated to date are attributed to past service. But attribution requirements for the PBO are somewhat ambiguous. Although the PBO theoretically reflects accrued service and expected future pay, there are not always well-defined ways to achieve this, especially in some complex plan designs. The FASB will need to clarify attribution to achieve measurement consistency.

Watson Wyatt Observation: The inconsistent and ambiguous application of PBO attribution lends credence to the argument that the PBO is not the best measure of the plan’s obligation.

• How does the concept of fair value apply to pensions? The FASB wants to integrate fair values into accounting statements as it moves forward with its Fair Value Measurement Project. For postretirement benefit plans, the ultimate goal is to accurately characterize the fair value of the obligations. For example, some members of the academic community would like to see postretirement obligations measured by the buy-out or termination liability — which is higher than the current FAS 87 ABO — because that would reflect the value a plan sponsor could exchange the obligation for in the financial market. This viewpoint does not assume that the plan will terminate; it simply considers the termination liability to be the best proxy for the fair market value of the plan’s obligation. However, the termination liability may not be a meaningful or accurate measure for sponsors that have no intention of terminating their plans. The FASB will have to consider this as well as other methods of measuring fair value.

Implications and Conclusions

Because of the complexity of valuing postretirement benefit obligations, the FASB faces a challenging task. None of these issues has an obvious or simple answer, and reasonable people may disagree on the best solutions. The intellectual momentum in the pension finance community favors some measurements that would increase liabilities and others that might decrease them, so it is difficult to speculate on the overall effects on financial reports.

While the new liability measures may look very different from the old measures, the changes will not affect the intrinsic worth of plan obligations or their values. In this period of change, it is important to be mindful that the FASB’s goal is to create transparent, meaningful measures of benefit obligations that will most accurately convey their underlying economic reality.

¹ In this article, “liability” means the present value of the benefit obligation, which is similar to the vocabulary that the FASB uses when discussing this issue. The liability on the balance sheet may mean something different, such as the unfunded present value of the benefit obligation.

² The PBO is based on accrued service and projected future pay, and the ABO is based on accrued service and accrued pay.