What special accounting events occur when a pension plan is terminated?
Under the guidance of the Financial Accounting Standards Board (FASB), when a pension plan is terminated and not replaced by another defined benefit (DB) plan, the plan sponsor needs to apply special accounting rules for events that are called settlements and curtailments.
In a standard pension plan termination, pension obligations are typically settled by distributing plan assets in one of two ways: 1) the lump sum value of the benefit is paid to the participant, either as cash or in the form of a rollover to another qualified retirement plan such as a 401(k) plan, or 2) an annuity is purchased with an insurance company (referred to as an “annuity placement” or “buyout” transaction) and the benefit obligation is transferred from the plan sponsor to the insurance company. These are “settlement” events: the plan sponsor’s obligation to pay benefits has been permanently “settled.”
A ”curtailment” occurs when the plan sponsor significantly reduces or eliminates future benefit payouts for some or all active employees. This could be because of a benefit freeze, layoffs, bankruptcy, or other business event. In a plan termination situation, usually benefit accruals were frozen some time earlier, but sometimes the benefit freeze happens at the same time as the plan termination.
Overview of financial reporting for pension plans
Actuaries assist pension plan sponsors with their financial accounting and reporting by calculating the actuarial liability for future pension benefits, based on a set of actuarial assumptions. Some assumptions are “demographic” assumptions, such as mortality and retirement rates, that anticipate what’s going to happen with the plan population in future years. Other assumptions are “economic,” such as the interest rate used to discount projected future benefit payments back to a present-day value. Each year, the actuary updates the liability to reflect changes during the past year, such as removing participants who died and adding any new participants who entered the plan. The interest rate assumption is also updated to reflect current market conditions, and the plan’s asset value reflects investment performance during the year. When these actual changes over the past year differ from what was assumed at the beginning of the year, they give rise to actuarial gains or losses. For example, if the asset return was better than expected in the prior year, there is a gain. If the discount rate used to calculate the liability goes down, it causes the liability to go up more than expected and therefore there is a loss.
Actuaries also calculate the annual pension expense. This pension expense is reported on the company’s financial statements as the annual cost of the pension plan and it’s made up of several pieces:
- Service cost: The value of plan benefits that are expected to be earned in the fiscal year. This is oftentimes zero when a pension plan is completely frozen and no new benefits are being accrued.
- Interest cost: The annual interest on the pension liability, i.e., the increase due to the passage of time.
- Expected return on assets: The estimated amount the assets will grow in a year, based on a long-term rate of return assumption. This component is a negative number (subtracted), as the asset return will offset the plan sponsor’s cost of the pension plan.
- Amortization of certain items: This means recognizing certain items in expense over several years in installments, rather than all at once. Those items include:
- Unrecognized gain/loss: To the extent they’re not immediately included in the annual pension expense, gains or losses on both liabilities and assets are added to this amount.
- Unrecognized prior service cost: The cost of retroactive benefits added by plan amendments that haven’t yet been recognized in expense.
The annual pension expense is calculated for each fiscal year and additional calculations are done when special events like settlements and curtailments occur.
What are the accounting consequences of settlements and curtailments?
It is important to know that when gains and losses occur they are typically not included in pension expense right away. Rather, they are stored up as “unrecognized” gains/losses and show on the plan sponsor’s balance sheet under "Accumulated Other Comprehensive Income." They are typically gradually included (i.e., recognized) in pension expense over a number of years. However, when a pension plan terminates, the entirety of the unrecognized gains/losses must be recognized and included in pension expense right away as part of the settlement and curtailment accounting.
Settlements and curtailments can therefore cause a large accounting expense all at once, because they require immediate inclusion of those amounts that were previously amortized over several years in an employer’s annual pension expense. In the case of a partial settlement or curtailment, only a portion of these amounts need to be included; however, a complete plan termination requires full inclusion of these items. (See Figure 1.)
Many pension plans have accumulated large actuarial losses in recent years due to the significant decline in interest rates since the turn of the century. All else being equal, lower interest rates mean higher pension plan liabilities. Increases in life expectancies have also caused actuarial losses for many plans. Some plans may have experienced asset gains to offset these losses, but most plans have accumulated more losses than gains.
Note that a plan sponsor may be able to accelerate the amortization of gains or losses before plan termination by employing a method that amortizes those amounts faster than the minimum approach required under FASB accounting rules. However, if a plan sponsor wishes to change the accounting method for amortizing gains or losses it should consult with its auditor first, to understand the implications such as potentially needing to apply such a change to prior reporting periods.
The accounting treatment for plan changes follows the same basic structure as the accounting treatment for gains and losses: when a plan is amended, the resulting increase or decrease in the plan’s liabilities is not included in pension expense right away, but rather “unrecognized prior service cost” is included on the balance sheet under Accumulated Other Comprehensive Income and a portion is recognized in pension expense each year. And as with unrecognized gains/losses, any unrecognized prior service cost would need to be fully included in the pension expense at plan termination, as part of the settlement and curtailment accounting.
The combined additional accounting charge could be significant for a fiscal year, and plan sponsors should be prepared for what will need to be reported on their financial statements. Note that an amendment to the FASB rules a few years ago, which specified that settlement and curtailment costs should be reported separately outside of compensation costs, allows plan sponsors to more clearly communicate the impact of these special events in their financial reporting.
Figure 1: Ongoing amortization vs. settlement charges at termination
What if the plan termination includes a lump sum window and not just an annuity placement?
If a lump sum window is offered to participants in conjunction with a plan termination, there are technically two settlements that take place: one at the time the lump sums are paid, and another at the time the annuity placement (buyout) occurs. If the annuity placement occurs relatively soon after the lump sum payouts are made, and both events are within the same fiscal year, it may be appropriate to treat both settlements as if they happened at the same time to simplify calculations. However, if these events happen several months apart or in different fiscal years, there will need to be two separate sets of settlement accounting, each of which will include immediate recognition in pension expense of a portion of the unrecognized gains/losses and unrecognized prior service costs.
Similarly, if benefit accruals are frozen early in the plan termination process, the associated curtailment accounting would likely happen prior to the settlement accounting.
Plan sponsors should check with their auditors and actuaries to confirm an acceptable approach for their particular situations.
Is there settlement accounting in a buy-in transaction?
Some plan sponsors choose to engage in a “buy-in” agreement with an insurance company prior to plan termination, in order to reduce some of the risks associated with the termination timeline. In a buy-in transaction, a premium is paid to the insurance company, the buy-in contract is accounted for as a plan asset, and the insurance company takes over the responsibility of funding future benefit payments from the plan. However, under a buy-in, the plan sponsor has not been relieved of the responsibility for the pension benefits, so the event doesn’t meet the criteria for settlement accounting. If the buy-in is later converted to a buyout, as in a plan termination scenario, then settlement accounting is triggered at the point of the conversion to buyout.
Figure 2: Termination pathways
Regardless of the exact plan termination path taken, one of the goals should be to avoid surprises such as unexpected accounting consequences. Milliman can help you prepare for and navigate the world of settlements and curtailments during the termination process. Please contact your Milliman consultant for more information.
To see other articles in the Frozen Pension Plans: The Way Forward series, click here.