Proxy Hysteria Coming For Companies With DB Plans

You read it here first. During the upcoming proxy season, there is going to be hysteria over the executive compensation disclosures in proxies for companies with defined benefit (DB) plans, especially those with nonqualified plans for their named executive officers (NEOs).

What's going on? As part of an NEO's compensation, filers are required to include the increase in the actuarial present value of DB plans. The actuarial present value is a discounted value of the anticipated payment stream just as it was a year earlier. While there are many assumptions that actuaries select in determining an actuarial liability, two, in particular, have changed for many companies from 12/31/2013 to 12/31/2014. One is the discount rate which will have decreased by somewhere in the neighborhood of 100 basis points and the other is the mortality assumption. Late last year, the Society of Actuaries (SOA) released its newest mortality study and many companies elected to adopt the new tables.

The effect of the change in discount rate will vary, largely on the age of the NEO in question, but it's not unreasonable to think that for most NEOs that just that discount rate change will have increased the actuarial liability attributed to them by 8%-12%. Yes, Americans are living longer. Mortality assumptions should be updated from time to time. But, for proxy purposes, the year of the update causes an additional spike in the liability attributed to the individual NEO, perhaps an additional 5% depending upon age and gender.

So consider an NEO whose 2013 compensation included $1,000,000 due to the increase in the actuarial present value of accrued pension benefits. If that person is still an NEO at the end of 2014, he or she will have had an increase in liability due to surviving one more year (interest and mortality totaling perhaps 6%), an increase due to increases in included compensation (a large bonus could have increased even 3-to-5 year average compensation by 25% (recall that in the case of a 5-year average that 2014 which was a good year for many businesses replaces 2009 which was a dismal year for many businesses)), and increases due to changes in discount rates and mortality assumptions.

So, with no changes in compensation practices, our NEO who had $1,000,000 of compensation attributable to him or her in 2013 might see that turned into an increase of $1,500,000 in 2014.

There will be outrage. Proponents of the pay ratio rule of Dodd-Frank Section 953(b) will point to these increases and say that the rank-and-file got 2%-4% increases. The media will not understand what happened. Congress, and this might be the year that it matters as the new Republican control has suggested that it will try to repeal some parts of Dodd-Frank, will not understand.

But those people who chose to read my ramblings will get it. Companies that foresee the issue can address it. It can't be solved in its entirety, but it can be managed.

I know how.

Do you?

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.

Comparability in Financials, What Comparability?

A news release from SEI said that in its study of FAS 87 (now ASC 715) discount rates for 2009 fiscal years, 90% of them fell within the 161 basis point range from 5.27% to 6.88%. I wonder, where were the other 10% and how were they justified?

In the early days of FAS 87, in my experience, most companies were fairly cavalier in their choice of discount rates. Many used the same rate as they used for funding under Code Section 412. Others used their current liability interest rate. Still others seemed to use a dart board or a Ouija board.

Then the SEC intervened. They interpreted the FAS 87 guidance that companies look to the rate on high-quality fixed income instruments to mean that the rate should approximate that found on Moody's Aa bonds. A fairly typical approach was to look at Moody's Aa's a month or two before the measurement date, round up, usually to the next higher quarter of a point (but sometimes more than that) and use that rate unless there was significant change before the measurement date.

Accounting firms gradually gave this more and more scrutiny and then came Sarbanes-Oxley. Suddenly, the Big 4 (and other accounting firms generally followed) were asking companies to justify their discount rates. Discount rates became more and more tied to bonds of similar duration to the plan's obligations. Rounding up became taboo.And, all the while, the underlying discount rates on high-quality bonds were falling. Pension cost went up at the worst possible times.

So, what happened? Consulting firms came to the rescue. Since the accountants asked that discount rates be tied to specific bonds of similar duration to the obligations, actuaries developed tools to assist defined benefit plan sponsors in selecting and perhaps optimizing discount rates. As methods became more and more sophisticated, some plan sponsors went discount rate shopping. Think about it: if you were required to book the costs for a $billion pension plan and for a fee of, say, $10,000, you could buy yourself and additional 30 basis points in discount rate, would you do it?

So, while FAS 87 was supposed to improve the comparability of accounting for pension plans (and it probably did for a while), it appears that we have returned to days of less comparability. Come up with a rule and give smart people enough time and they will find the angle and find a way to optimize results.

It'snot as bad as it could  be, but comparability, we don't have no stinkin' comparability.