Copyright 2010 ProQuest Information and LearningAll Rights ReservedCopyright 2010 New York State Society of Certified Public Accountants The CPA Journal
SECTION: FINANCE: EMPLOYEE BENEFIT PLANS; Pg. 56 Vol. 80 No. 3 ISSN: 0732-8435
LENGTH: 2086 words
HEADLINE: A Looming Crisis for Pensions
BYLINE: Eaton, Tim V; Easterday, Kathryn.Kothryn Easterday, PhD, CPA is an assistant professor and Tim V. Eaton, PhD, CPA, is an associate professor, both in the Department of Accountancy, Miami University’s Farmer School of Business, Oxford, Ohio.
ABSTRACTPensions are an extremely important part of the US economy, and the consequences of inadequate pension funding could be devastating to the millions of workers and retirees who are counting on their pension funds to provide for them in retirement. Managing, correctly accounting for, and determining the funding status of defined benefit pension plans can be extremely challenging. Many estimates come into play, because information about the future is unknown when an employee’s service is being rendered, financial reports are being prepared, and a plan’s funding status is being evaluated. This article reports on overall funding conditions of defined benefit plans in both the corporate and public sectors. It provides basic background on pension plans and presents evidence on defined benefit plans’ funding status based on information from various publicly available sources. FULL TEXTThe Funding of Defined Benefit Pension PlansPensions are an extremely important part of the U.S. economy, and the consequences of inadequate pension funding could be devastating to the millions of workers and retirees who are counting on their pension funds to provide for them in retirement. Managing, correctly accounting for. and detemiining the funding status of defined benefit pension plans can be extremely challenging. Accountants, who are charged with fairly presenting information about pension plans’ assets and obligations in the financial statements, often rely on actuarial experts who conduct complex analyses to estimate the magnitude of future obligations and their present values, as well as expected return of plan assets. Many estimates come into play, because information about the future is unknown when an employee’s service is being rendered, financial reports are being prepared, and a plan’s funding status is being evaluated. The following questions must be addressed when determining the proper level of pension funding: How many more years will an employee work? How will an employee’s compensation over time affect amounts promised in retirement? For how many years after retirement will an employee live and collect compensation or other post-retirement benefits? What investment returns will be earned on funds designated to meet future retirement obligations? Determining the answers to these questions is extremely difficult, particularly in light of the dramatically changing economic conditions experienced over the past two years.This article reports on overall funding conditions of defined benefit plans in both the corporate and public sectors. It provides basic background on pension plans and presents evidence on defined benefit plans’ funding status based on information from various publicly available sources.Defining the PlansThere are two types of pension plans: defined contribution (DC) plans and defined benefit (DB) plans. Examples of DC plans are the 401(k) in the corporate sector and the 403(b) in the public sector. In DC plans, an employer may provide a matching amount to an employee’s contribution, but beyond this no further promise is made regarding postretirement payments. All contributions are placed in an account that is invested and managed according to the employee’s wishes (within the constraints of that particular plan) until the employee retires and begins to withdraw whatever money is in the account. The employer is not responsible for the ending balance available to find an employee’s retirement and does not report on the status of the pension plan in its financial reports aside from reporting the effect of pension expenses when contributions are made.In contrast, DB plans represent a promise for the future. Employees participating in DB plans receive part of their compensation in the current period and part of it is deferred, to be received after they retire. In corporate plans, die present value of the total future pension liability is referred to as the pension benefit obligation (PBO). Employers set aside assets today and are responsible for managing the investment and growth of these assets to meet future pension obligations. Over the last few decades, many employers have moved to DC plans, although a significant number of employers, particularly those in unionized industries or in the public sector, still offer DB plans.Both corporate and government employers bear fiduciary responsibility to their stakeholders, including active employees and retirees, to carefully invest and manage DB plan assets. In addition to managing and reporting on pension plan assets and liabilities, an employer must annually evaluate the overall funding status of the DB plan to ensure that total plan assets are adequate to pay the ultimate total obligations to employees. Companies are required by Statement of Financial Accounting Standards (SFAS) 158 to report the funding status of DB plans, measured as the difference between the PBO and the fair value of plan assets. For public-sector plans. Governmental Accounting Standards Board (GASB) Statement 25 requires reporting of die actuarially determined values of plan assets and accrued liabilities as well as information about the relation between the two over time, and GASB Statement 50 requires disclosure of a pension plan’s funded status in the notes to the financial statements.There are three primary sources of pension plan funding problems: unexpected market performance for invested plan assets, inaccurate or unrealistic assumptions for interest rates or other actuarial factors, and decisions to procrastinate making cash payments needed to adequately fund the plan. To a degree, pension funding may fluctuate due to changing economic conditions and shortterm company performance. If diese deviations are not material, an organization can address shortfalls as market conditions and company performance improve. Sometimes pension funding deviations are material, however, and corporate performance does not recover. What happens when a company fails and the pension plan is not adequately funded? Many corporations are protected by the Pension Benefit Guaranty Corporation (PBGC). According to its website (www.pbgc.gov), almost 44 million individuals in 29.000 DB plans are under the protection of me PBGC.Status of Private-Sector DB Pension Plan FundingThe goal of legislative oversight is to ensure that companies keep promises made to employees while fairly disclosing to stakeholders the extent of their obligations. When a corporate DB pension plan is underfunded, the employer is required by law to take action. The Pension Protection Act of 2006 established new minimum funding requirements for DB plans and required corporate employers to inject additional cash into a pension plan when the funding ratio (the proportion of plan assets to PBO) falls outside predetermined parameters. Exhibit I shows that the median funding ratio for corporate DB plans increased fairly steadily from 2003 to 2007 but dropped sharply in 2008 due to the meltdown in U.S. financial markets. Extremely underfunded plans may be required to cease benefit accrual or certain payouts altogether. Congress granted companies some temporary relief from pension plan funding requirements for 2009 due to the current economic crisis. Nevertheless, the steep decline in overall corporate pension plan funding implies that unless the U.S. economy recovers quickly, allowing invested plan assets to grow significantly in a short amount of time, many of these plans will be at significant risk of being unable to meet pension obligations to their retirees.Status of Public-Sector DB Plan FundingA recent report by Public Fund Survey (www.publicfundsurvey.org) estimates that there are over 20 million active workers and retirees in federal, state, and local government DB plans. The combined reported value of U.S. state and local pension fund obligations is now over $2.6 trillion, nearly double die $1.5 trillion aggregate PBO reported for fiscal year 2008 by 875 public companies with DB plans that the authors pulled from the Compustat database. The size of state and local pension obligations dwarfed the annual budgets of most states in 2007, the most recent year for which detailed comparative data could be obtained, as shown in Exhibit 2.Depending on individual plan regulations, state constitutions, or other requirements of various government entities, some public-sector employers may be able to postpone making the cash contributions needed to maintain DB plan funding levels, effectively shifting the growing problem of underfunded pension liabilities onto future public-sector retirees and taxpayers. Ohio offers one example. According to a recent report in the Cincinnati Enquirer, the DB plan owned and operated by the city of Cincinnati for its own municipal employees is not subject to Ohio rules that set mandated contribution levels for other public employee plans (Barry M. Horstman, “Generous pensions in deep hole,” April 3, 2009). This has allowed Cincinnati to make only partial contributions to its own plan over the last several years. Deferring pension plan contributions made cash avaüable for otiier budget priorities, but the postponement – together with lower-fhan-expected market returns on invested plan assets – leaves the city’s retirement system severely underfunded. The city’s finance department reported that as of December 3 1 , 2008, the pension plan’s unfunded liability was more than $913 million (www.ci.cincinnati.oh.us/city finance/downloads/cityfinance_pdf36756. pdf). If retirees cannot be persuaded to accept reduced benefits, city taxpayers could face large increases in order to make up future shortfalls.Public-sector pension fund accountants use actuarially detenrtined values of plan assets and liabilities to establish funding status. David Evans points out that gains and losses may be averaged over several years, masking me investment performance of any one year and making reported values of plan assets potentially very different from current market values as of the date of the report (“Hidden Pension Fiasco May Foment Another $1 Trillion Bailout,” Bloomberg.com, March 3, 2009, www. bloomrjerg.oem/apps/news?pid=newsarchive &sid=alwTE0Z5.1EA). It may be challenging for administrators to determine the amounts and timing of contributions necessary to alleviate plan underfunding. Financial statement users may also find it difficult to compare funding status between plans.Where Do We Go from Hero?The recent economic downturn has led to conditions particularly ripe for the underfunding of defined benefit plans. In the 1960s corporations failed, and some retirees lost their pensions due to underfunding. In 1974, Congress passed the Employee Retirement income Security Act, which among other things created the PBGC to protect retirement benefits for workers and retirees when underfunded DB plans collapsed. PBGC funding comes primarily from insurance premiums paid by companies sponsoring DB plans and the assets of plans taken over by the PBGC, together with investment income on those assets. Unfortunately, the PBGC is reporting massive deficits of its own, as growing numbers of companies struggle with funding their DB plans. The agency reported a $33.5 billion deficit for the first half of the 2009 fiscal year, more than triple the $11 billion deficit reported for 2008 (www.pbgc.gov/media/news-archive/ news-reIeases/2009/pr09-30.html). In June 2009 alone, the PBGC announced that it had assumed responsibility for five additional pension plans unaerfunded by a total of $233 million. (See Exhibit 3.) The agency’s ability to meet its long-term financial obligations may be jeopardized as more plans come under its protection and there are fewer surviving sponsor companies to pay insurance premiums.More recently, the Pension Protection Act of 2006 required companies to provide more adequate funding for their plans. The current economic downturn and the granting of temporary relief for companies to meet the act’s requirements may, however, create a grave threat to the adequacy of corporate pension funding. In addition, the DB plans of many state and local governments are subject to similar exceptions and the possibility of underfunding.Pension accounting is extremely complex, and dealing with the looming massive underfunding of plans is an incredibly challenging task. With trillions of dollars and millions of peoples’ economic security in the balance, thoughtful reform is needed in this area of accounting.
GRAPHIC: GraphsIMAGE GRAPH, EXHIBIT 1, Median Funding Ratios for Corporate DB PlansIMAGE TABLE, EXHIBIT 2, State Pension LiabilitiesIMAGE TABLE, EXHIBIT 3, PBGC Assumed Responsibility for Five Pension Plans in June 2009
LOAD-DATE: March 30, 2010