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HRS Insight
Human Resource Services
June 27, 2011
HRS Insight 11/11
Accounting for Pension Buy
Arrangements
Authored by: Ken Stoler, Partner
The first pension "buy-purchased
-in" contract was recently
purchased by a U.S. pension plan. This buy-buy
in
arrangement is similar to a traditional non
non-participating
participating annuity (a "buy
buy-out"), where a
plan transfers future responsibility for
promised employee retirement benefits to an
insurance company. Under the buy
buy-in
arrangement, however, the benefit obligation is
not transferred rred to the insurer. Instead, the plan
remains responsible for paying the benefits, but
purchases a contract from the insurer which
generates returns designed to equal all future
benefits payments to covered participants.
participants
When accounting for a traditional
buy-out
annuity, the purchase of the annuity generally
triggers settlement accounting, with often a
significant income statement effect. The buy
buy-in
contract, however, typically generates no
settlement but retains certain other advantages
of an annuity purchase. rchase. This HRS Insight
Buy-In
explores the advantages and disadvantages, and
the accounting implications, of buy
buy-in
arrangements.
Background
Purchases of buy-in contracts have been
gaining popularity overseas, but until recently
had not been sold in the U.S.
In May 2011, the
first U.S.-based buy
buy-in arrangement was
completed. This contract offers the employer
the ability to "lock in" the
cash cost of some of
its pension benefit obligation and virtually
eliminate future volatility, while continuing to
maintain the plan and offer benefits to
employees.
The buy-in contract is held by the pension plan,
and essentially reimburses the plan for all
future benefit payments covered by the
contract. That is, as benefit payments are made
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by the plan, the insurer will make mak
equal
payments to the plan under the buy
buy-in contract.
As a result, the net ongoing cash flow to the
plan for the covered participants is nil, and the
cost of providing benefits is entirely funded by
the buy-in contract.
The contract is generally a single-singl
premium
arrangement, where an upfront payment is
made by the pension plan to the insurer in
exchange for the contract. The buy-buy
in is often
priced similar to a buy-buy
out annuity, since the
economics are nearly the same (insurer taking
on responsibility to make annual payments
sufficient to cover promised retirement
benefits). Generally, the buy
buy-in contract also
allows the holder to covert the arrangement to a
buy-out annuity upon request and for no
additional cost.
After acquiring the buy
buy-in contract, the
employer has eliminated the risks associated
with changes in the benefit obligation due to
changing mortality rates, fluctuating interest
rates, etc. However, the employer has not
eliminated all risk, because the ability of the
insurer to make good on the
contract (i.e., the
insurer's credit risk) remains. To the extent the
insurer is unable to make payment in full on the
buy-in contract; the employer would still be
responsible for all promised benefit payments.
Observation: The buy-buy
in contract may cover
some or all of the plan's existing benefit
obligation, depending on the specific situation.
For example, an employer may wish to
purchase a contract covering only the benefits
currently in payment status to retirees but not
cover active employee's future
benefits. For
frozen plans, some employers may consider a
contract that covers the entire benefit
obligation. Each employer should assess its
specific circumstances, circumstances
and the associated
benefits or drawbacks,
in evaluating whether
to purchase a buy-
-in contract.
Accounting for a Buy-Buy
In
Arrangement
When a traditional non
non-participating buy-out
annuity is purchased, an employer generally
applies settlement accounting. The pension
obligation is removed from the books, as are
the assets used to purchase the an
annuity. If the
price of the annuity contract exceeds the
carrying value of the obligation, as is often the
case, the excess is a loss. Any gains or losses
deferred in accumulated other comprehensive
income are also recognized in the income
statement as part rt of the settlement gain or loss.
Special rules apply if only part of the benefit
obligation is settled.
Observation: Since most plans today have
deferred losses reflected in accumulated other
comprehensive income, settlement via annuity
purchase generally ally results in a significant
income statement loss.
In order to qualify for a settlement, the
accounting literature
literature1 requires that three
criteria all be met:
1) The action is irrevocable,
2) The employer is relieved of primary
responsibility for the obligation, and
1 The US GAAP pension accounting literature
addressing settlement accounting is in ASC
20-20. International financial reporting
standards (IFRS) related to settlement
accounting are generally consistent with US
GAAP.
715-
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3) The transaction eliminates significant
risks related to the obligation and
assets used to effect the settlement
In the case of a buy-in contract, these three
criteria are typically y not met. First, the buy-buy
in
contract is often not irrevocable, as it may
include a provision under which the
arrangement can be terminated. A pre-pre
defined
cash surrender value or termination formula
may be negotiated up front, and while a
significant termination mination penalty may exist, it
nonetheless affords the employer the ability to
unwind the transaction if desired. Based on
this, the arrangement would not qualify for
settlement accounting.
In addition, settlement accounting is not
appropriate because the
employer is not
relieved of primary responsibility for the
obligation. Under the terms of the contract the
insurer is not assuming the retirement benefit
obligation, and the employer remains
responsible for the plan and making benefit
payments to the plan an participants. The
employer continues to be considered the plan
sponsor under ERISA. Unlike an annuity
contract, where participants are notified that
responsibility for payment of their benefits has
been transferred to the insurer and the
employer is no longer involved, participants are
not notified of the buy-cannot
-in arrangement and
look to the insurer for payments
cannot directly. Furthermore, the employer/plan
trustees could decide to use the money received
under the buy-in contract for other purposes
under er the plan (i.e. to purchase other
investments).
The buy-in contract effectively is an investment
by which the plan can receive payments from
the insurer corresponding to the benefits due to
the covered participants, but ultimately the
primary responsibil
Thus, in the event the insurer was unable to
make payment under the buy
due to bankruptcy), the employer would still be
obligated for the promised retirement benefits.
Ongoing Pension Accounting
for the Buy-
Since settlement accounting is not applied and
the contract is not considered an annuity, the
buy-in contract represents an investment asset
of the plan. Typically, the pension trust (and
not the employer) would acquire the buy
contract, and thus it would be accounted for as
a plan asset. Plan assets are recorded at fair
value as of each measurement date, and are
therefore generally remeasured annually
(unless an interim remeasurement is required if
a significant event occurs). In presentation
the balance sheet the fair value of plan assets is
netted against the related pension obligation.
In determining the appropriate value at which
to present these buy
literature is not clear. Accordingly, we believe
that the following two approaches are
acceptable.
Under the first approach, the fair value of the
buy-in contract is directly measured at each
plan measurement date. Initially, this fair
value would be based on the purchase price of
the contract. In subsequent
value would be estimated based on the
contract's 'exit price'
the contract could be sold to a willing third
responsibility has not been transferred.
buy-in (for example,
-In Asset
2 As defined in ASC 820,
Measurements and Disclosures
buy-in
us on
buy-in assets, the accounting
llowing measurements, fair
2, or the amount at which
third-
Fair Value
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party buyer. Estimating this value would likely
include similar considerations as were used by
the insurer rer when originally pricing the buy
buy-in
contract, including factors based on
assumptions about the plan participants
covered under the contract, such as changes in
expected mortality. It would also be based on
the current discount rate inherent in the
contract. ract. This rate would likely be the same
rate used by an insurer in the current price of a
buy-out annuity, often using the PBGC
published rate for single
single-employer pension
annuities3.
The second approach is based on the guidance
in the accounting literatu
literature addressing
valuation of insurance contracts that are not
annuities4. . This guidance notes that such
contracts should be reflected at fair value, but
indicates that if the contract has a stated cash
surrender value, this can be used as a proxy for
fair value. For many insurance contracts held
in a pension trust, the cash surrender value (if
any) is considered to be reflective of fair value
and thus is used for reporting purposes. In the
case of buy-in arrangements, however, while a
cash-out formula may
exist, this value generally
incorporates a fairly sizeable termination
penalty. Based on this, while use of the
surrender value would be acceptable, we believe
it is not required since the surrender value
generally would not represent a good proxy for
fair ir value due to the penalty provision.
3 The Pension Benefit Guarantee Corporation
(PBGC) publishes hes monthly rates used in valuing
single-employer annuity benefits on its website
at www.pbgc.gov.
4 ASC 715-30-35-60 discusses valuation of
insurance contracts that are not annuities
Ongoing Accounting for the
Pension Benefit Obligation
When a buy-in contract is acquired, there is a
question as to whether any adjustment in the
measurement of the associated benefit
obligation is necessary. Again,
literature is not clear and therefore we believe
that two approaches are acceptable.
Under the first alternative, the benefit
obligation covered by the buy
continue to be measured with the traditional
discount rate and mort
by the employer. The discount rate is generally
based on yields of high
at each measurement date. We would expect
the value of the buy
the value of the benefit obligation
approach; while both would be based on similar
participant demographics, the discount rate
used in valuing the obligation would likely be
higher than the rate inherent in the buy
contract (which, as discussed above, is likely
based on lower PBGC annui
addition, the value of the buy
be based on different mortality assumptions.
Under the second alternative, the value of the
benefit obligation associated with the
participants covered by the contract would be
set equal to the fair value of the buy
at each measurement date. This approach is
considered supportable because the guidance
on establishing discount rates
at which the obligation could be 'effectively
settled.' While purchase of the buy
does not result in an actual settlement, it can be
viewed to result in an effective settlement since
5 ASC 715-30-35-43
the accounting
buy-in contract would
mortality assumptions used
high-quality corporate bonds
buy-in contract asset to exceed
under this
; buy-in
annuity rates). In
buy-in contract may
buy-in contract
rates5 calls for the rate
buy-in contract
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the majority of the risks and rewards associated
with the benefit obligation and related assets
has been eliminated. As a result, the discount
rate used in pricing the buy-buy
in contract also
represents the rate at which the obligation can
be effectively settled. Under this approach, it is
also considered acceptable to change the
mortality assumption to that reflected in the
value of the buy-in contract.
ntract.
If this second alternative is followed, an
actuarial loss will need to be recognized at the
next plan measurement date, since the benefit
obligation will be increased to match the
(generally higher) purchase price of the buy-buy
in
contract. For example, le, if the benefit obligation
was $100 before purchasing a buy
buy-in contract
for $105, the obligation would be reset to $105,
and a $5 actuarial loss would be reflected in
other comprehensive income. After this initial
Summary of Reporting Impact
The following table provides a high
purchase a buy-in contract, a buy
remeasurement, the fair value of the
asset and the associated benefit obligation
should be equal, other than potential breakage
due to changes in credit quality of the insurer.
Going forward, we would generally expect the
asset and obligation to continue to move in
tandem. Likewise,
assets related to the buy
related interest cost on the associated benefit
obligation recognized as components of net
periodic benefit cost should be equal and
offsetting.
Observation: If the buy
only a portion of the plan obligation and
participants, determination of the appropriate
discount rate and expected return on assets to
use may be more complex.
lowing high-level summary of the financial reporting impact of a
buy-out annuity, or maintaining current status quo.
buy-in
the expected return on plan
buy-in contract and the
buy-in contract covers
ay decision to
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Balance Sheet
Impact
Buy-in
contract
No change.
Pension
obligation
remains. Buy
contract is plan
asset.
Buy-out
annuity
Buy-in
Remove pension
obligation and
related plan
assets
Status
quo
No change in
pension
obligation and
plan assets
Current Income
Statement Impact
Future Income Statement
Impact
No settlement gain/loss Continued amortization of
gain/loss deferred in AOCI.
Expense could increase if expected
return on buy
previous
expense will be less volatile.
Recognize settlement
gain/loss on recognition of
amounts deferred in AOCI,
including the gain/loss
arising on purchase of
annuity
buy-in asset is less than
assumed return, but
No future futur
amortization of
gain/loss deferred in AOCI. No
expense volatility going forward
No settlement gain/loss Continued amortization of
gain/loss deferred in AOCI and
continued application of
return assumption to plan assets
expected
How PwC Can Help
PwC has considerable expertise with respect to the accounting and disclosure for pension and OPEB
plans. In addition, we can help you better understand the complex issues related to pension
investment stment strategies,
actuarial measurements, taxation and funding. Please contact one of the
individuals listed below, or your local engagement partner, to further discuss how PwC can help.
