By Kim Nicholl and Paul Angelo
The Governmental Accounting Standards Board (GASB), the organization responsible for establishing accounting and financial reporting for the public sector, has issued new accounting and reporting standards for pension plans provided through state and local governments and their sponsoring employers. GASB Statement 67, Financial Reporting for Pension Plans, will replace GASB Statement 25 and will apply to state and local pension plans established as trusts or similar arrangements. GASB Statement 68, Accounting and Financial Reporting for Pensions by State and Local Governmental Employers, will replace GASB Statements 27 and 50 and will apply to governments that sponsor or contribute to state or local pension plans.
The statements establish standards for measuring and recognizing liabilities, including the actuarial cost method, the discount rate and the amortization methods. In addition, the statements specify financial statement note disclosure and required supplementary information. Statement 67 will be effective for plan fiscal years beginning after June 15, 2013, and Statement 68 will be effective for employer fiscal years beginning after June 15, 2014. GASB’s new standards make significant changes to pension accounting and reporting for pension plans and for state and local governments that sponsor pension plans.
In applying governmental accounting and financial reporting standards, GASB makes distinctions between different types of pension plans and their participating employers:
- Single-employer pension plans provide pensions to the employees of only one employer.
- Agent multiple-employer pension plans provide pensions to employees of multiple employers. The plan assets are pooled for investment purposes but separate accounts are maintained for each individual employer so that each employer’s share of the pooled assets is legally available to pay the benefits of only its employees.
- Cost-sharing multiple-employer pension plans provide pensions to employees of multiple employers. The pension obligations for all employees are pooled, and plan assets can be used to pay the benefits of the em-ployees of any employer that provides pensions through the pension plan.
This article summarizes the key components of the statements.
Key Components of the New Standards
Divorce of Pension Accounting from Funding Measures
Unlike GASB’s current accounting standards, which provide a close link between pension accounting and funding measures, the new accounting standards have divorced financial reporting from any contribution requirements. Under the current standards, while the annual required contribution (ARC) is actually the accounting expense, it serves as a de facto funding standard for many plans because one of the disclosures is a historical comparison of the actual contribution made to the ARC. GASB does not and never did establish funding standards for public pension plans, and the new accounting standards make that clear by formally divorcing accounting from funding.
In some cases, the new standards do provide for a disclosure similar to the old ARC, but do not require it. For single and agent employers and for the pension plans of single and cost-sharing employers, if an actuarially determined contribution (ADC) is calculated, the required supplementary information will show comparison of the actual contributions made to the ADC. For single, agent and cost-sharing employers and for the pension plans of single and cost-sharing employers, if an ADC is not calculated and the contributions are statutorily or contractually required, the required supplementary information will show comparison of the actual contributions made to the statutory or contractually required contribution. The comparison of actual contributions to the ADC or statutory/contractual contributions is not required for cost-sharing multiple employers or their pension plans.
The ADC is defined as “A target or recommended contribution to a defined benefit pension plan for the reporting period, determined in conformity with the Actuarial Standards of Practice based on the most recent measurement available when the contribution for the reporting period was adopted.”
Single and agent employers whose pension plans do not determine an ADC should consider a review of their funding policy in order to develop an ADC.
Net Pension Liability
For single and agent employers, the balance sheet in the basic financial statements will include a measure of the unfunded (or overfunded) pension obligation, called the net pension liability (NPL). The NPL is equal to the total pension liability (TPL) minus the plan’s fiduciary net position (GASB’s term for the market value of plan assets). Single and cost-sharing pension plans will report the components of the NPL in the notes to the pension plans’ financial statements. The NPL should be measured as of a date no earlier than the end of the employer’s prior fiscal year.
The TPL is the actuarial value of projected benefit payments attributed to past periods of service, including projected salary increases, projected service, automatic cost-of-living adjustments (COLAs), and ad hoc COLAs to the extent that they are considered substantively automatic. All plans are required to use the entry age actuarial cost allocation method to determine the total liability as of the reporting period: projected benefits are discounted to their present value as of employees’ hire ages and then attributed to employees’ expected periods of employment as a level percentage of projected payroll. Many states and local pension plans use the entry age actuarial cost method for funding purposes. However, for funding purposes, the discount rate is based upon the long-term expected rate of return on plan investments. The TPL is based upon a discount rate that may in part be based upon a municipal bond rate. The derivation of the discount rate is described in detail below.
If current and expected future plan assets (related to current plan participants) are insufficient to cover future benefit payments for current employees and retirees, the basis for discounting projected benefit payments to their present value would require using a “blended” discount rate. The long-term expected rate of return can be used to discount only those projected benefits that are covered by projected assets. Any projected benefits that are not covered by projected assets would be discounted using a yield or index rate for 20-year tax-exempt municipal bonds with an average rating of AA/Aa or higher. The blended discount rate, which GASB calls the single discount rate, is determined as follows:
- Project annual future benefit payments for current employees, inactive employees and retirees.
- Project the annual value of plan assets including current assets, projected employer and employee contributions, and investment earnings. Note that projected contributions intended to finance the service cost of future employees are excluded. Projected contributions from future employees are also excluded unless those contributions are projected to exceed the service costs for those employees.
- Discount projected benefits using the long-term expected rate of return to the extent that the projected assets exceed the projected benefit payments.
- Discount all other projected benefits using the municipal bond rate.
- Determine the single discount rate that, when applied to all projected benefits, equals the sum of the two present values using the long-term expected rate of return and the municipal bond rate.
Note that if contributions are established by contract or statute or if a written funding policy related to employer contributions exists, professional judgment should be applied to project employer contributions based on those contractual, statutory or policy provisions. Professional judgment should consider the most recent five-year contribution history and should reflect all known conditions. Otherwise, the projected contributions are limited to the average of the most recent five-year period and may be modified based on consideration of subsequent events. This is another reason employers should consider establishing a funding policy if one does not currently exist.
For single and agent employers, pension expense in the current reporting period is based on changes in the NPL during the period. Most annual changes in NPL are immediatelyrecognized as pension expense when they occur. These changes include:
- Service cost (i.e., normal cost under the entry age actuarial cost method (+))
- Interest on the TPL (+)
- Projected earnings on the plan’s investments (-)
- Actual member contributions (-)
- Administrative expenses (+)
- Changes in TPL due to changes in benefit provisions (+ or -) Other changes in the NPL are included in pension expense over the current and future periods. These changes include:
- Changes in TPL due to assumption changes or gains and losses are recognized over a closed period equal to the average of the expected remaining service lives of all employees that are provided with benefits through the pension plan, including active employees, inactive employees and retirees.
- Differences between assumed and actual investment returns on pension plan assets are recognized as pension expense over a closed five-year period.
Pension plans do not recognize pension expense.
Under current GASB accounting standards, a cost-sharing employer’s pension expense is its contractually required con-tribution to the cost-sharing pension plan. The balance sheet liability is the accumulated difference (if any) between the contractually required contribution and the actual contribution. The majority of cost-sharing employers contributes to the contractually required contributions to the plan and therefore have no liability for pensions on their balance sheet.
Net Pension Liability
Under the new standards, an employer participating in a cost-sharing multiple-employer pension plan would report an NPL in its own financial statements based on its proportionate share of the collective NPL for the entire plan. The NPL for the entire plan is determined using the methods described above for single and agent employers. An individual em-ployer’s proportionate share of the collective NPL is determined using a method that is consistent with how the cost-sharing plan determines the contributions for the cost-sharing employers. A method that is based on the employer’s projected long-term contributions to the pension plan as compared to the total projected long-term contributions of all employers is encouraged. The method could be based on the individual employer’s share of the total employer contributions, payroll, or the method used by the cost-sharing plan to determine employer contribution.
Consistent with reporting NPL, a cost-sharing employer’s pension expense will be its proportionate share of the collec-tive pension expense for the entire plan. In addition, if there is a change in the employer’s proportion of the collective NPL since the prior measurement date, the net effect of that change is recognized in pension expense over the remaining service lives of all employees, inactive employees and retirees. Similarly, the annual difference between an employer’s actual contributions and its proportionate share of total contributions is recognized in pension expense over the remaining service lives of all employees, inactive employees and retirees.
Special Funding Situations
The new accounting standards address special funding situations, when an entity (called a nonemployer contributing entity) that does not employ plan participants is legally responsible for making contributions directly to the pension plan. The nonemployer contributing entity must recognize an NPL and expense determined by applying the cost-sharing measurement described just above to the collective NPL and expense. The employer then recognizes a reduc-tion in NPL and expense equal to the nonemployer contributing entity’s proportionate share of the collective NPL and expense.
Measurement Timing and Frequency
The measurement date of the NPL is as of a date no earlier than the end of the employer’s prior fiscal year. Actuarial valuations that determine the TPL must be performed at least every two years, although more frequent valuations are encouraged. The TPL as of the measurement date is determined either by:
- An actuarial valuation as of the measurement date, or
- Use of update procedures to roll forward from an actuarial valuation performed as of a date not more than 30 months plus one day prior to the current fiscal year-end.
Effective Dates and Transition
The new accounting standards are effective for pension plans (Statement 67) in fiscal years beginning after June 15, 2013. For employers (Statement 68), the standards are effective for fiscal years beginning after June 15, 2014. If practical, employers are required to restate prior financial statements. Otherwise, employers should reflect the cumulative effect of the new accounting standards in the financial statements as a restatement of beginning net position.
Current GASB standards base pension expense on the ARC, which requires amortization of the unfunded liability over a period no greater than 30 years. In addition, funded status does not appear in the financial statements, but does appear in the footnotes. GASB’s new accounting standard may have significant consequences for state and local governments:
- Reporting the NPL on the entity’s financial statements (rather than just any unfunded ARC) will change the focus of the statements from the entity’s commitment to fund its obligation to a funded status snapshot in time.
- Immediate recognition of changes in liability due to plan amendments and accelerated recognition of changes in liability due to actuarial gains and losses and changes in actuarial assumptions will result in a pension expense very different from the contribution amounts and will likely cause confusion between pension expense and pension funding.
Kim Nicholl, FSA, MAAA, EA, FCA, is senior vice president and actuary with The Segal Company in Chicago, Ill. She can be reached at email@example.com.
Paul Angelo, FSA, MAAA, EA, FCA, is senior vice president and actuary with The Segal Company in San Francisco, Calif. He can be reached at firstname.lastname@example.org.