Issues in Pension Accounting

A defined benefit pension plan states how much money in retirement income an eligible employee will receive each month from his/her employer. The payment depends on pre-established criteria such as years of service and percentage of highest salary. The employer is responsible for deciding where to invest the assets so enough funds can be paid to the beneficiaries. The Employee Retirement Income Act (ERISA) was enacted in 1974 to regulate the private and public pension systems. The Financial Accounting Standards Board (FASB) also issues supplemental guidelines (FASB 87, 88, 132 & 132-R) for proper financial statement presentation. There are approximately 44 million Americans participating in defined corporate benefit pension programs and 11 million are currently retired. Presently employees in large companies and government civil servants are the main constituents. These entities are economically better suited for paying the high cost obligations. However, due to competitive forces chipping away at profits, worse than expected stock returns and the increasing expenses associated with maintaining defined benefit pensions, organizations are eliminating their retirement plans in favor of defined contribution plans like 401 K’s. A major reason is the reform initiatives for more accurate asset/liability recognition on balance sheets and income statements. Pensioners, potential investors as well as other interested parties have complained about the confusing rules applied in pension accounting. Some account items are either listed in the balance sheet, income statement, foot notes or not mentioned at all. The first issue concerning pensions is calculating the actual value. Its funding status is based on the projected benefit obligations minus the plan assets market value. Although, recorded in the notes to the financial statement, it is an off-balance sheet account according to FASB 132. Unfortunately, the projected benefit obligations primary component is based on a future improbable salary estimate that can lead to an artificial gain/loss. If wages are lower or higher than forecasted, the funded status will appear to have a surplus or deficit, respectively. When cash disbursements towards the accumulated plan contributions are greater than the accumulated plan expenses, the balance sheet may show a net prepaid asset, even if market value assets are less than projected benefit obligations. This does not honestly reflect a pension’s net worth. Another problem distorting a pension plan’s liabilities is the discount rate. The present value of plan liabilities is computed by using a discount rate that converts future benefit expenditures into today’s dollars. The interest rate is supposed to ensure that sufficient monies are generated to pay retirees. Generally Accepted Accounting Principles (GAAP) stipulates using the yield on a long term U.S. Treasury note or similar highly graded annuity. Often times, the rate is conservatively too low, which artificially inflates perceived liabilities. The investment returns are usually greater which are reported in net income. A change as much as one percent between discount rate and the real rate can produce a corresponding change of 10-20 percent modification in pension plan liabilities. Pension accounting critics believe corporations are engaging in earnings management, by manipulating interest rates on plan liabilities causing a scenario where the higher the rate, the lower the liabilities. GAAP declares total liabilities incurred in a fiscal period should not be immediately recorded but only a minimum liability amount if accumulated benefit obligations exceed plan assets fair market value. In my opinion, previous pension accounting standards have favored the employer due in large measure to their voluntary implementation of defined benefit pension systems. The regulatory agencies felt compelled to place corporation interests over that of beneficiaries so as to encourage a social agenda that provided post retirement income for elderly former workers. Initially minimum accounting rules were put in place that didn’t severely penalize companies for under funding pensions during unfavorable economic conditions which could’ve had a negative impact on stock prices, profits and long term financial viability. This is why U.S. government monitors allowed non-capitalization for pension accounts along with considerable judgment in deciding certain valuations. Even though, this approach was responsible for creating over 114,000 defined pensions prior to 1985, recent pension defaults were an impetus for additional accounting disclosure requirements. As of 2004 there are only 29,651 programs. FASB 87, 88, 132-R began to legally dictate financial statements present a more precise description regarding pension values, asset/liabilities, investment allocations, and funding status. Since firms were recording pension investment earnings in their net income but reporting minimum liabilities accrued, pension recipients weren’t sure the pension was adequately funded to meet pending obligations. I concur with FASB attempts to write down all pension related accounts in the balance sheet or income statement. There should also be a consolidated method that designates company assets and liabilities separate from core business operations. For years companies have used pension investment earnings to increase net income. A uniform standard pertaining to discount rates, salary forecasts and actual returns should be implemented. Some firms are abusing their power when selecting lower than projected wage figures for the purpose of understating future payments. Adopting comprehensive rules industry-wide will assure veracity in pension statement information. Further recommendations that may help retirees receive their promise benefits involve instituting a permanent interest rate. Tabulating a discount rate for the present value of the pension plans liabilities is crucial. Organizations base interest rate assumptions on low yields from U.S. Treasury Notes or municipal investment grade annuities resulting in an overstated projected obligation causing unwarranted fears of insolvency. Realistic market driven factors should be used in estimating discount rates. The ultimate objective underlying defined benefit pension plans is offering alternative retirement income for private sector employees. Studies have shown Social Security will not be sufficient to meet retiree’s daily expenses. However, the substantial reduction in the number of conventional defined benefit retirement models can be partly attributed to rising administrative costs and stringent legislative reforms. Many corporations have opted to cease funding these programs. U.S. government efforts to improve financial disclosures have added burdensome expenses especially for businesses in industries experiencing an economic decline. Accounting regulatory agencies must balance competing interests among shareholders, company management, pensioners and perspective investors while trying to promote accuracy in pension data. FASB and Congress should first consider potential monetary outlays for firms before proposing new accounting amendments authorizing more transparency on financial documents.