Defined Benefit Supply and Demand

This should be good. This fool is writing about supply of DB plans and demand for DB plans? No, not really. But, we are going to look at a really simple way that supply and demand affect DB plans.

There are lots of DB plans out there that are frozen, be it soft or hard. Presumably, very few of them will ever be unfrozen. More likely is that plan sponsors are seeking to terminate those plans that are frozen. And, since the process for doing other than a standard termination often requires a plan sponsor to go into bankruptcy (yes, there are other ways, but that is beyond the scope of this article).

Let's look at the standard termination process in the simplest of terms. A plan has to be fully funded (including employer commitments) for the purchase of annuities, sufficient to provide all the benefits accrued and vested in the plan. Determining the level of assets to do that should be fairly simple, right?

Of course, it's simple. Presumably, you know what your funded status is on a PPA basis and you just pick up the phone and call your actuary. Actuaries have good rules of thumb for estimating everything, so your actuary will just give you a loading factor and you'll know where you stand, right?

Not so fast. Life insurance companies that are in the annuity business presumably want plan termination business. It's where they can get a large volume of business quickly. Let's consider a couple of scenarios.

Plan investments perform well, interest rates stay stable. If this is the case, then funded statuses will improve. A reasonable number of plans will be able to terminate. Insurance companies will presumably hit their goals for annuity volume.

Plan investments perform well, interest rates go up. Now, virtually everyone will think they can terminate their plans. The market will be flooded with demand for annuities. Insurers either will not be able to accommodate that much volume or will be able to create that impression.

In the second case, there is more demand, but no change in supply. I learned about this in Economics 101 (actually, it was called 14.001, and if you understand that, you'll know where I took it). Prices go up. So, your actuary's rule of thumb is going to be off by a bit ... and in the wrong direction.

We could create lots more scenarios to look at supply and demand, but this is pretty basic stuff. It's intuitive.

If you have a frozen plan and you're looking to terminate it, wouldn't you like to be able to track this loading factor or ratio of plan termination liability to PPA liability? Now you can. Contact us. Contact me.

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.