The coronavirus raises various issues in accounting for pensions under Topic 715, Compensation—Retirement Benefits. This post explores some factors reporting entities may wish to consider in accounting for pensions amidst the coronavirus. To get started, we provide some background on pension accounting.
Background on Pension Accounting
A reporting entity is required to recognize an amount on its balance sheet equal to the difference between:
- The fair value of plan assets; and
- The projected benefit obligation.
That difference is also referred to as the funded status of the plan.
Typically, a reporting entity performs a valuation of its plan assets and benefit obligation on an annual basis. For interim periods, the funded status reported on the balance sheet is the same asset or liability recorded on the prior year-end balance sheet, adjusted for:
- Accruals of net periodic pension cost (excluding the amortization of amounts previously recorded in other comprehensive income); and
- Contributions to fund the plan or benefit payments.
For interim periods, the net periodic pension cost is based on the assumptions used for the prior year-end measurement. Effectively, you perform your big valuation once a year. You use key information and assumptions from the most recent annual valuation until your next annual valuation.
Sometimes, however, a reporting entity must perform an interim remeasurement. For example, an interim remeasurement may be required due to a significant plan amendment, settlement, or curtailment. An interim remeasurement is a substantial effort. For an interim remeasurement, a reporting entity must redo the valuation of its plan assets and benefit obligation and reassess its underlying assumptions. Following an interim remeasurement:
- An entity updates its balance sheet to reflect the funded status of the plan based on that interim remeasurement; and
- Net periodic pension cost is based on the assumptions used for that interim remeasurement.
Pension Accounting and the Coronavirus
Accounting for pensions amidst the coronavirus poses various challenges. The extent that reporting entities must consider these now depend, in part, on when their last annual valuation occurred. For instance:
- Many reporting entities have a year end of December 31. These entities have completed an annual valuation somewhat recently. These entities generally will need to consider if an interim remeasurement is necessary. Even if an interim remeasurement is not required, disclosure may be appropriate to explain the effects of the coronavirus.
- Other entities have different fiscal year ends and may be working on their annual valuations now (to the extent that they have a pension). For instance, many entities in the technology sector have year ends in late spring and summer.
The following are potential effects of the coronavirus for reporting entities to consider when accounting for pensions:
Interim remeasurements: An interim remeasurement is not required for changes in interest rates or market prices. An interim remeasurement is required for certain significant events, such as substantial plan amendments, settlements, or curtailments. Topic 715 does not define what is considered “significant.” Determining if an event is significant requires a large degree of judgment. Also, Topic 715 does not prevent a reporting entity from performing an interim remeasurement if it chooses to do so. Therefore, a reporting entity may have to (or choose to) perform an interim remeasurement. If a reporting entity performs an interim remeasurement, it must remeasure its plan assets, benefit obligation, and revisit all of its supporting assumptions, regardless of the reason for performing the interim remeasurement. Let’s explore plan amendments, settlements, and curtailments further:
- Plan amendments: A plan amendment might increase, reduce, or eliminate benefits for future or prior years of service. For instance, due to financial hardship from the coronavirus, a reporting entity might freeze its plan so that participants stop accruing additional benefits for future services.
- Curtailments: A curtailment either a) substantially decreases the expected years of future service by existing employees, or b) stops the accrual of defined benefits for a significant number of employees for some or all of their future services. A curtailment might happen due to a plan amendment. A curtailment also might occur due to employee terminations. For example, the coronavirus ultimately may cause a reporting entity to permanently shutter a plant, close an office, dispose of operations, or reduce its workforce. In some cases, an employer may have furloughed employees due to a temporary government shutdown. The employer, however, may intend (and expect to be able) to rehire those same employees in the near future; if so, a curtailment may not have occurred. A reporting entity must apply judgment and consider the facts and circumstances. However, even if an employer expects a layoff to be temporary, a curtailment has happened if the layoff substantially decreases the expected years of future service of existing employees.
- Settlements: A settlement is a) irrevocable, b) relieves the employer (or plan) of primary responsibility for the pension obligation, and c) eliminates significant risk related to the obligation and assets involved in the settlement. For instance, plan participants may agree to accept a lump-sum cash payment from an employer as settlement for their pensions. A settlement can also happen if an employer sells part of its business and transfers a portion of its plan assets and pension obligation to the buyer. Due to the coronavirus, some reporting entities may sell off parts of their business to reduce risk or free up cash. Accountants must be vigilant for plan amendments, curtailments, and settlements.
Assumptions: Pension accounting requires numerous assumptions. Valuation specialists (such as actuaries) are critical in selecting appropriate assumptions. Two assumptions that are particularly important to the valuation of a pension are the discount rate and the expected long-term rate of return on plan assets:
- Discount rate: The discount rate affects not only the amount of the pension obligation recorded, but also the service cost, interest cost, and actuarial gain or loss components of net periodic pension cost recognized in the income statement. Even small changes in the discount rate can have a material impact on an entity’s financial statements. The discount rate must reflect the rate at which the benefit obligation could be settled. A couple factors to consider are:
- Interest rate levels: The discount rate must move in a manner similar to the general level of interest rates. Determining appropriate discount rates in the current environment is difficult. The Federal Reserve has issued emergency rate cuts; rate cuts lower discount rates. However, risk and uncertainty have surged due to the coronavirus; risk and uncertainty increase discount rates. Reporting entities are encouraged to engage their valuation specialists and maintain supporting documentation for the discount rate. This is always true but takes on heightened importance in light of the current economic landscape.
- High-quality investments: Reporting entities generally look to high-quality fixed income investments currently (and expected to be) available to determine the discount rate. Due to the coronavirus, the credit quality of investments is changing rapidly. Credit ratings may not yet reflect recent or ongoing deteriorations in creditworthiness. Therefore, reporting entities must be careful when identifying “high-quality” fixed income investments. If an investment is no longer high quality, it must be excluded from an entity’s determination of the discount rate.
- Expected long-term rates of return on plan assets: The expected long-term rate of return is an entity’s best estimate of the average rate of return anticipated in future years on the plan assets. Topic 715 indicates that the expected long-term rate of return must reflect long-term earnings expectations only on existing plan assets and expected contributions for the current year. In practice, if the current allocation of plan assets is not representative of how the entity expects plan assets to be invested in the future, entities sometimes base the expected long-term rate of return on their target allocation. The current allocation between types of investments (such as bonds, equities, and real estate) may be under review as a result of the coronavirus. In particular, reporting entities may be rebalancing the investments to mitigate risk uncovered or amplified by the pandemic. If so, it may be appropriate to consider the revised target allocation when determining the expected long-term rate of return. For instance, a reporting entity might consider changes to its current allocation that are probable, have been approved by management, and are expected to occur soon.
The coronavirus could also impact other assumptions used in pension accounting. For instance, if pension benefits depend on compensation, the service cost component of net periodic pension cost incorporates an assumption about rates of salary increases. Due to the coronavirus, some companies have announced salary cuts to executives or other employees. Events happening now may or may not affect certain long-term assumptions. However, it is important to consider current events to vet their potential effects on assumptions.
Also, keep in mind that plan assets are measured at fair value. Therefore, a reporting entity will encounter the same challenges in measuring plan assets that it does for other fair value measurements. Our posts on fair value measurements and the fair value hierarchy explore potential effects of the coronavirus on these areas of accounting. Also, the coronavirus may have exposed a significant concentration of risk within plan assets that a reporting entity had not previously identified. If so, a reporting entity must consider if disclosure is necessary, including in an interim period.
Required or voluntary contributions to pension plans also may be affected by the coronavirus. This is true for both employer and employee contributions. For example, a sharp drop in the fair value of plan assets may require a larger cash contribution for the employer next year to fund the benefit obligation.
Pensions may also be affected by ongoing legislation issued to address the fallout from the coronavirus. For instance, the President approved a coronavirus relief package last Friday (the CARES Act). Section 3608 delays the minimum required contribution to a single employer defined benefit pension plan that would otherwise be due during calendar year 2020 to comply with the Internal Revenue Code. The revised due date is January 1, 2021.
COVID-19 is a rapidly evolving situation. In the coming weeks and months, we may witness additional accounting effects as the full impact of this disease manifests itself. We encourage you to stay informed on accounting and financial reporting developments.
Please also check out our related posts on accounting for the coronavirus, which address revenue, fair value measurements and disclosure, and current expected credit losses (CECL) and disclosure.