Client’s challenge
Our client’s plan has been frozen for several years. Years of unfavorable discount rate changes and lower-than-expected asset returns have caused the unrecognized loss to become a large component of their balance sheet. Because the plan is frozen, the amortization period for the loss has decreased each year, causing the loss amortization to be the largest component of pension expense. Controlling pension expense is important to our client and they reached out to us to find a simple and effective strategy to reduce pension expense.
Potential solutions
Pension expense is made up of a number of items such as service cost, interest cost, expected asset return, and several amortizations of past costs. Most of these items are relatively fixed in their determination and there is little room for modifying the calculations.
The outstanding loss in the plan is amortized over the average future working lifetime of active participants. In the case of our client, the outstanding loss to be amortized (and recognized in the expense) was about $19.879 million. The average future working lifetime of active participants was expected to be 7.79 years. As a result, the loss amortization component was projected to be almost $2.6 million ($19,879,000 ÷ 7.79), over 90% of the plan’s total pension expense of about $2.8 million.
Generally, accounting rules attempt to recognize items in a logical, systematic fashion. The fact that this single component of the expense influenced the results so heavily caused us to look more deeply into the loss amortization method in order to address our client’s concerns.
Because there have been no new participants in the plan for many years, those currently still working have fewer and fewer working years left each year. Because of this, the number of years over which the outstanding loss is amortized is reduced every year. This continuously decreasing factor used to amortize losses had become, in our opinion, unreasonably small for purposes of determining the amount of the loss recognized in the current year’s expense. This forced the plan sponsor to recognize losses over shorter and shorter time periods each year, generating ever increasing loss amortizations in pension expense.
We pointed out to our client that the accounting standards that cover the determination of the pension expense state that if all, or almost all, of a plan’s participants are inactive, the employer may move to an amortization period equal to the average remaining life expectancy of the inactive participants instead of the average future service. Because the plan is frozen, participants do not earn additional defined benefits by rendering future service, so they could be considered inactive for purposes of determining the appropriate amortization period for gains and losses, even though they are still working. All the participants in the plan were fully vested and had earned sufficient service to qualify for early retirement. Therefore, any additional service earned had no impact on the benefits that would be paid from the plan.
The impact of such a change would be dramatic. Below is a comparison of what we were projecting the loss component of the pension expense to be under the “old” and “new” methods for amortizing the outstanding losses.
Old method
Loss to amortize: $19,879,000
“Old” amortization factor: 7.79
Amortization amount: $2,552,000 (19,879,000 ÷ 7.79)
New method
Loss to amortize: $19,879,000
“New” amortization factor: 24.74
New amortization amount: $804,000 (19,879,000 ÷ 24.74)
Reduction in pension expense: $1.75 million (2,552,000 – 804,000)
Outcome
We recommended to our client that we have a call with their auditor to discuss making this change to the amortization period. We felt that prior to making this change, it would be important to have discussions with the auditor to give our reasoning as to why this not only made logical sense, but also that this was indeed the correct application of the accounting rules covering this issue.
A call was quickly arranged with their auditors and we discussed the reasons why continuing to base the amortization period on expected future working lifetimes was no longer appropriate and that, for purposes of the pension expense determination, those participants continuing to work for the plan sponsor were indeed inactive participants. The auditors provided thoughtful feedback and seemed open to agreeing with our interpretation of the accounting standards. The auditors were satisfied with our reasoning and responses to their questions and let us know they would discuss the issue internally.
Auditor agreement was confirmed when a few days after the conference call, our client informed us that they were moving ahead with our recommendation for the change in amortization methodology and, in fact, declared that they would be restating their already booked 2017 pension expense to reflect the change immediately.
At the end of this process, our client enjoyed a substantial reduction in their pension expense as well as an improvement in the manner in which their pension expense is determined, making the amortization more in line with reality. Additionally, we provided the auditors with a comfort level that the methodology is solid and appropriate.