New audit trends in settlement accounting
De-risking activities which continue to be popular with defined benefit (DB) pension plan sponsors include lump-sum offerings and annuity purchases, and some audit firm views on the accounting treatment of these events under US GAAP have recently evolved. Depending on market conditions, the impact on pension cost may be significant. Employers considering these types of risk transfer activity should be aware of the risk of potential significant increases to pension cost if their auditor requires them to follow a new accounting approach.
Background
Volatility of pension plan funding requirements and accounting costs, as well as steadily increasing Pension Benefit Guaranty Corporation (PBGC) premiums, has led many employers to look for ways to reduce risks and costs associated with maintaining a DB pension plan. One approach to relieving both risk and cost is a “transfer” of liabilities out of the pension plan—either a transfer to plan participants through a lump-sum offering or a transfer to an insurer through the purchase of an annuity contract. According to recent studies published in the annual reports of the PBGC Participant and Plan Sponsor Advocate1,2, risk transfer is increasing. While current historically low interest rates have increased the cost of risk transfers at the moment and some plan sponsors may have put immediate risk transfer plans on hold, the market volatility caused by COVID-19 seems sure to increase future interest in such endeavors.
Lump-sum payments (either special one-time “windows” offered as part of de-risking activities or regular payments if allowed by the plan) and annuity purchases are events which are considered “settlements” under US GAAP, and which may require special accounting treatment. Accounting for a settlement requires accelerated recognition in expense of a portion of deferred gains and losses, and a common practice has been to measure a settlement either at fiscal year-end or at the date when the amount of lump sums paid plus annuities purchased during the year exceeds a certain threshold. Because many pension plans have accumulated unrecognized accounting losses, especially after recent market conditions, the impact of settlement accounting is typically an increase to pension expense.
Accounting Standards Codification (ASC) paragraph 715-30-35-81 states that settlement accounting should take place at the date the settlement occurs. ASC 715-39-35-82 provides that the accelerated recognition of deferred gains and losses is only required “if the cost of all settlements during a year is greater than the sum of the service cost and interest cost components” of pension expense. If settlements during a year are less than this threshold for required recognition, an employer may apply settlement accounting as long as the policy is applied consistently from year to year. De-risking transfers via lump-sum offerings or annuity purchases may cause a pension plan’s total settlements during the year to come close to or exceed the threshold.
Emerging practice
Recently, auditors under US GAAP have begun to focus on ASC 715-30-55-167 and 168, which address settlement recognition before the threshold for required recognition is exceeded but when the threshold is expected to be exceeded. For example, Deloitte’s “Financial Reporting Alert 10-11” from December 2, 2010,3 states that “if an entity concludes it is probable that the threshold will be exceeded during the year, the entity should apply settlement accounting on at least a quarterly basis rather than wait for the threshold to be exceeded on a year-to-date basis.” More recently, as of December 18, 2019, PwC’s online accounting resource “Inform”4 states that “if an employer determines that it is probable that during the fiscal year the criteria for settlement accounting will be met, the employer should recognize settlements immediately when they occur, rather than wait for the threshold to be met.”
Employers and pension plan actuaries typically do assess whether liabilities settled as a part of risk transfer activities, plus any expected regular lump-sum payments allowed by the pension plan, are likely to exceed the threshold for required settlement accounting. When possible, de-risking efforts are structured in a way to keep the total settlements for the year below the threshold. But what if the threshold is actually exceeded? The question of whether this eventuality can be determined in advance may be difficult to resolve. In some recent cases, Ernst & Young has taken the position that in such a situation the accelerated recognition of deferred gains and losses should be retroactively calculated on a monthly basis for the entire year.5
There is a range of views among audit firms, and these views continue to evolve. Clearly several large firms have concluded that, if the effect is material, settlement accounting should be applied in advance of the point in time when lump sums plus annuity purchases exceed the threshold for required recognition. Specific details on the application depend on the audit firm.
Impact of earlier settlement recognition
Depending on market conditions, applying settlement accounting earlier and more frequently could result in either a significant decrease or increase to pension cost. As an example of how pension cost might increase, consider a hypothetical pension plan with a calendar year fiscal-year. This plan pays a moderate amount of regular lump sums each month, but a single unexpected large lump sum paid in March causes the threshold for required settlement recognition to be exceeded during October. Additionally, suppose that the economy during the year experiences an upswing, and by the end of the year favorable changes in interest rates and good asset performance have caused gains which eliminate a large accumulated unrecognized loss, and the plan actually ends the year with a small accumulated net gain.
A typical approach to applying settlement accounting might be to first recognize a settlement when the threshold is exceeded during October, and then again at the end of the year. But what if the employer’s auditor determines that the appropriate approach is to apply settlement accounting at the end of each month throughout the entire year? Under the conditions described above, there could be a significant increase to expense.
The reason for the potential increase is that the settlement charge would tend to be larger when calculated earlier in the year because accelerated recognition would then be applied to the plan’s beginning of year large accumulated unrecognized loss before that loss is gradually reduced through favorable experience. There will be changes in other expense items due to more frequent measurement throughout the year, but in this example, the overall increase in expense would be driven by the settlement charge.
Final thoughts
It may be unnecessary for a pension plan’s actuary to calculate expense based on monthly application of settlement accounting. The fees associated with the effort would not be justified if the employer’s auditor is not realistically expected to insist on such an approach. Auditors typically prefer consistency in applying accounting policy, and employers that do often exceed the threshold for required settlement accounting may have an established policy which can be followed. However, new or unusual circumstances may give rise to a change in auditor views—in such circumstances, it may be prudent for the actuary to estimate whether a different approach to settlement accounting would result in a significantly different expense.
Risk transfer efforts are a good way to manage pension plan volatility and costs, but care should be taken in cases where settlement accounting may be required to be applied—especially for pension plans which regularly pay lump sums. If there is a possibility of a material settlement expense, employers may wish to contact their auditors in order to learn their views on settlement accounting.
1PBGC (December 29, 2017). 2017 Annual Report of the Participant and Plan Sponsor Advocate. Retrieved on October 2, 2020 from https://www.pbgc.gov/sites/default/files/pbgc_advocate_report_2017.pdf.
2PBGC (December 31, 2018). 2018 Annual Report of the Participant and Plan Sponsor Advocate. Retrieved on October 2, 2020 from https://www.pbgc.gov/sites/default/files/pbgc_advocate_report_2018.pdf.
3Deloitte (December 2, 2010). Financial Reporting Considerations Related to Pension and Other Postretirement Benefits. Financial Reporting Alert 10-11. Retrieved on October 2, 2020 from https://dart.deloitte.com/USDART/ov-resource/7d1d931b-3f81-11e6-95db-0f40239d9acd.html.
4PwC (December 18, 2019). Chapter 4: Amendments, curtailments, and settlements. 4.3 Settlement accounting - 4.3.3 Exceptions to settlement accounting. Retrieved on October 2, 2020 from https://inform.pwc.com/show?action=applyInformContentTerritory&id=2050035601172318&tid=225.
5Thornley, N. (October 24, 2018). Session 602 Accounting for Pension and Defined Contribution Plans – Current Topics and Challenges. 2018 CCA Annual Meeting.