Case study: Exploring plan sponsor options for mark-to-market pension accounting
The challenge
Several pension plan sponsors approached Milliman with an interest in exploring the options available under current U.S. GAAP for mark-to-market accounting. In short, mark-to-market accounting reflects immediate recognition of a given year’s changes in asset and liability values, essentially reflecting the “market value” of both assets and liabilities. This differs from the current U.S. GAAP accounting adopted by most pension plan sponsors, where actuarial “gains” and “losses” are amortized over periods of roughly five to ten years, or more.
After hearing that certain prominent U.S. plan sponsors were changing their accounting methods, clients came to Milliman with two main questions:
- Why are other plan sponsors making this move?
- Would making a similar move be beneficial in our own case?
These are questions we hear often with regard to many topics. Our clients want to know what other plan sponsors—competitors included—are doing and if they should follow suit.
The solution
Addressing the first question above required an examination of the general case for all clients. We found several reasons why plan sponsors might move to mark-to-market accounting.
First, there has been momentum toward reflecting market values over the past several years. The U.S. Financial Accounting Standards Board (FASB) has expressed its intent to align U.S. GAAP with International Financial Reporting Standards (IFRS) in the near future. The relevant IFRS standard, IAS 19, already requires at least partial mark-to-market accounting, and recent revisions to IAS 19 will require full mark-to-market accounting beginning in 2013. Moving to one of the mark-to-market options available under current U.S. GAAP is thus defensible as a flavor of “early adoption”. In fact, methods that accelerate the recognition in earnings of events that have already occurred are considered preferable under U.S. GAAP. Companies at the forefront of the change have also cited multinational accounting considerations, increased transparency and better representation of underlying performance as reasons for the move.
While we can’t know which of the considerations above were included in the actual motivations of specific companies, we do know the general impact of mark-to-market accounting. The bottom line of adopting such methods now is that large losses are moved to prior accounting periods through restatements (and investors often care little about prior accounting periods). We also know that the numbers are not insignificant, since the asset losses from 2008 can be as much as 30% to 40% of plan assets. Under mark-to-market accounting, such losses would no longer bite into near-term earnings through amortizations. Another consideration is the interest rate environment. If interest rates increase from their current low levels, any resulting actuarial gains will be immediately recognized in earnings under mark-to-market accounting, rather than amortized over many years.
Addressing whether the client would benefit from mark-to-market accounting required an examination of the specific case for each client. There are options to adopt “partial” or “full” mark-to-market accounting under current U.S. GAAP, and we examined the questions that logically follow. Will asset smoothing still be allowed for expense calculations? Will annual gains and losses be recognized in their entirety? Will there be a corridor for recognition of gains and losses? How do these options align with IAS 19 as it currently applies? What about IAS 19 as it will apply in 2013? Whether the plan sponsor is part of a multinational entity is a consideration here.
We also asked questions regarding the plan sponsor’s culture. Does the client want to be on the leading edge of the transition? Does the client want to take on the additional risk associated with earnings volatility?
The upsides of making the move do come at a price. Mark-to-market accounting results in increased earnings volatility. Under full mark-to-market accounting in particular, any swings in asset and liability values are immediately recognized. Analysis of such accounting changes needs to incorporate asset allocations and asset-liability behavior in light of the plan sponsor’s ability to absorb potentially large asset and liability losses without amortization.
The outcome
For each client’s specific plans, we created an exhibit showing the prior year’s financial results, including columns showing different partial and full mark-to-market accounting options. We also illustrated 2011 results under each option. Of course, we cannot yet know the asset and liability values as of the end of 2011. However, the 2011 gains and losses can be illustrated under good, bad, and best-estimate scenarios.
The Milliman clients discussed here have not yet made the decision to change their accounting method. An exploration of potential reductions in earnings volatility should be considered as part of an asset-liability study. For other clients, especially those that eventually decide to make the change, completing such a study can uncover asset allocations that will reduce the additional volatility associated with mark-to-market accounting methods.
Making the move now to mark-to-market accounting will be right for some plan sponsors, but there are many considerations. Milliman can help provide the analysis necessary to make an informed decision.