Tuesday, July 5, 2011

Accounting for Pension Buy-Ins

Over the last several years, so called pension buy-ins have become fairly popular in Europe. Just recently, the first one in a US qualified defined benefit plan was completed. The questions beg:

  • What is a pension buy-in?
  • How does the plan sponsor account for such a transaction? [NOTE: the author is not an accountant and does not provide accounting advice, but has drawn upon writings from and conversations with several large accounting firms.]
Briefly, here is how a pension buy-in works (from the standpoint of the plan sponsor). The plan purchases a contract from an insurer. When a benefit payment comes due for a participant covered by the buy-in, the plan pays that amount to the participant and the insurer pays an equal amount to the plan. Economically, this feels a lot like a buy-out contract where the plan purchases annuities from an insurer and the insurer pays all future benefits. The two contracts are probably priced the same as the insurer bears the same risk in each case. In the typical buy-in arrangement, the plan sponsor has the right to convert from a buy-in to a buy-out at no additional cost.

Buy-outs tend to generate what is know as settlement accounting under ASC 715 (previously FAS 88). In order for a transaction to be a settlement, it must satisfy a three-prong test:
  1. The action must be irrevocable.
  2. The action must relieve the plan sponsor of primary responsibility for the obligation being settled.
  3. With respect to the plan sponsor, the event must eliminate significant risks related to the obligations and assets used to effect the transaction.
Buy-ins, as currently structured should not generate settlement accounting, despite the visually identical economics. Here is why.
  • Typically, the action is not irrevocable as the contract often can be undone.
  • Because the insurer could become insolvent and because the plan will own the contract, neither the plan nor the plan sponsor has eliminated significant risks with respect to the obligations and assets.
So, for accounting purposes, the plan is left with the same obligations it had before and a sizable asset of a type not previously considered in the accounting literature. We then ask how should this new-fangled asset be valued. After consideration of the thoughts of accounting professionals, we conclude that there are two options. First, the contract can be valued (essentially as an obligation), but using the rate at which such asset could be sold. The accounting profession seems to me to think that the current (at the measurement date) PBGC rates for single-employer pension annuities may be an appropriate discount rate. Second, and perhaps more intuitive to me, both the asset and the associated obligation would be valued at the discount rate at which such obligation could effectively be settled.

Under the first approach, the asset will likely exceed its associated obligation. Under the second approach, they will be identical. 

"I see", said the blind man.

So, there you have it. If my reading of the tea leaves is correct, it goes like this. A buy-out generates settlement accounting. A buy-in with the same economics does not, but it does give the plan sponsor a choice of two methods of accounting one of which will produce a smaller annual pension expense than the other.


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