Accounting for pension buy-in

from People and Organization Accounting for pension buy-in arrangements March 29, 2016 In brief A pension buy-in arrangement is similar to a traditional non-participating annuity (a buy-out ), where a plan transfers future responsibility for some portion of promised employee retirement benefits to an insurance company. Under the buy-in arrangement, however, the benefit obligation is not transferred to the insurer. Instead, the plan remains responsible for paying the benefits, but purchases a contract from the insurer which generates returns designed to equal all future designated contractual benefits payments to covered participants. The purchase of a traditional buy-out annuity contract generally triggers settlement accounting, and often significant income statement impact. The buy-in contract, however, typically results in no settlement charges but retains some other advantages of an annuity purchase. This HRS Insight explores the advantages, disadvantages, and accounting implications of buy-in arrangements. In detail Background Buy-in contracts had become popular overseas, but until about 5 years ago had not been sold in the U.S. In May 2011, the first U.S.-based buy-in arrangement was completed. This type of arrangement offers the employer the ability to lock in the cash cost of some of its pension benefit obligation and virtually eliminate future volatility, while continuing to maintain the plan and offer benefits to employees. Several other buy-in contract transactions covering retirement benefits under US tax-qualified pension plans have occurred over the past 5 years, and more recently we re aware of a buy-in that was purchased to cover nonqualified deferred compensation benefits under a SERP (Supplemental Executive Retirement Plan). A buy-in contract is held by the pension plan, and reimburses the plan for all future benefit payments covered by the contract. That is, as benefit payments are made by the plan, the insurer will make equal payments to the plan under the buy-in contract. As a result, there is no net ongoing cash flow to the plan for the covered participants as the cost of providing benefits is funded by the buy-in contract. The contract is usually a singlepremium arrangement. An upfront payment is made by the pension plan to the insurer in exchange for the contract. The buy-in contract may be priced similarly to a buy-out annuity contract, since the economics are nearly the same. In either case, the insurer is taking on responsibility to make annual payments sufficient to cover promised retirement benefits. After acquiring the buy in contract, the employer has eliminated the risks associated with changes in the benefit obligation due to changing mortality rates fluctuating interest rates, etc. However, the employer has not eliminated all www.pwc.com

risk, because the potential inability of the insurer to make good on the contract (i.e., the insurer's credit risk) remains. To the extent the insurer is unable to make payment in full on the buy-in contract, the employer would still be responsible for all promised benefit payments. The buy-in contract may cover some or all of the plan's existing benefit obligation. For example, an employer may wish to purchase a contract covering only the benefits currently in payment status to retirees but not the active employee's future benefits. For frozen plans, employers may consider a contract that covers the entire benefit obligation. Each employer should assess its specific circumstances, and the associated benefits or drawbacks, in evaluating whether to purchase a buy-in contract. Accounting for a buy-in arrangement When a traditional non-participating buy-out annuity is purchased, an employer generally applies settlement accounting. The pension obligation is removed from the books, as are the assets used to purchase the annuity. If the price of the annuity contract exceeds the carrying value of the obligation, as is often the case, the excess is a loss. Any gains or losses deferred in accumulated other comprehensive income are also recognized in the income statement as part of the settlement gain or loss. Special rules apply if only part of the benefit obligation is settled. Since most plans today have deferred losses reflected in accumulated other comprehensive income, settlement via annuity purchase generally results in a significant income statement loss. In order to qualify as a settlement, the accounting literature 1 requires that all three criteria all be met: 1. The action is irrevocable, 2. The employer is relieved of primary responsibility for the obligation, and 3. The transaction eliminates significant risks related to the obligation and assets used to effect the settlement In the case of a buy-in contract, these three criteria usually aren t met. First, the buy-in contract is often not irrevocable, as it may include a provision under which the arrangement can be terminated. A pre-defined cash surrender value or termination formula may be negotiated up front, and while a significant termination penalty may exist, it nonetheless affords the employer the ability to unwind the transaction if desired. Based on this, the arrangement would not qualify for settlement accounting. In addition, settlement accounting is not appropriate because the employer is not relieved of primary responsibility for the obligation. Under the terms of the contract the insurer is not assuming the retirement benefit obligation, and the employer remains responsible for the plan and participants. The employer continues to be considered the plan sponsor under ERISA. Unlike an annuity contract, where participants are notified that responsibility for payment of their benefits has been transferred to the insurer and the employer is no longer involved, participants are not notified of the buy-in arrangement and cannot look to the insurer for payments directly. Furthermore, the employer/plan trustees could decide to use the money received under the buy-in contract for other purposes under the plan (i.e., to purchase other investments). The buy-in contract effectively is an investment by which the plan can receive payments from the insurer corresponding to the benefits due to the covered participants, but ultimately the primary responsibility has not been transferred. Thus, in the event the insurer was unable to make payment under the buy-in (for example, due to bankruptcy), the employer would still be obligated to provide the promised retirement benefits. Ongoing pension accounting for the buy-in asset Since settlement accounting is not applied and the contract is not considered an annuity, the buy-in contract represents an investment asset of the plan. Typically, the pension trust (and not the employer) would acquire the buy-in contract, and thus it would be accounted for as a plan asset. As noted above, we are aware of some buy-in transactions involving non-qualified retirement plans, such as SERPs. The accounting in those situations could be substantially different from the discussion in this section. We encourage you to contact us or your accounting advisor to discuss the implications of a nonqualified plan buy-in arrangement. Plan assets are recorded at fair value as of each measurement date, and are therefore generally remeasured annually (unless an interim remeasurement is required when a significant event occurs). In presentation on the balance sheet the fair value of plan assets is netted against the related pension obligation. In determining the appropriate value at which to present these buy-in 2 pwc

assets, the accounting literature is not clear. Accordingly, we believe that the following two approaches are acceptable. Under the first approach, the fair value of the buy-in contract is directly measured at each plan measurement date. Initially, this fair value would be based on the purchase price of the contract. In subsequent measurements, fair value would be estimated based on the contract's exit price 2 (the amount at which the contract could be sold to a willing third party buyer). Estimating the exit price value would likely include similar considerations as were used by the insurer when originally pricing the buy-in contract, including factors based on assumptions about the plan participants covered under the contract, such as changes in expected mortality. It would also be based on an estimate of the current discount rate. This rate would likely reflect the same rate that would be used by an insurer in determining the current price of a buy-out annuity, and generally be consistent with the PBGC published rates for single-employer pension annuities 3 (although some adjustment may be necessary to take into account any lag relative to the date(s) at which the American Council of Life Insurers gathered information from large insurance companies that was considered by the PBGC in developing the published rates). The second approach is based on the guidance in the accounting literature addressing valuation of insurance contracts that are not annuities 4. This guidance notes that such contracts should be reflected at fair value, but indicates that if the contract has a stated cash surrender value, this can be used as a proxy for fair value. For many insurance contracts held in a pension trust, the cash surrender value (if any) is considered to be reflective of fair value and thus is used for reporting purposes. In the case of buy-in arrangements, however, while a cash-out formula may exist, this value may incorporate a significant termination penalty. Based on this, while use of the surrender value would be acceptable, we believe it is not required since the surrender value may not represent a good proxy for fair value due to the penalty provision. Ongoing accounting for the pension benefit obligation When a buy-in contract is acquired, there is a question as to whether any adjustment in the measurement of the associated benefit obligation is necessary. Again, the accounting literature is not clear and therefore we believe that two approaches are acceptable. Under the first alternative, the benefit obligation covered by the buy-in contract would continue to be measured with the traditional discount rate and mortality assumptions used by the employer. The discount rate is generally based on yields of high-quality corporate bonds at each measurement date. We would expect the value of the buyin contract asset to exceed the value of the benefit obligation under this approach. While both would be based on similar participant demographics, the discount rate used in valuing the obligation would likely be higher than the rate inherent in the buy-in contract (which, as discussed above, is reflective of insurance company-based PBGC annuity rate pricing in determining the contract exit price). In addition, the value of the buy-in contract may be based on different mortality assumptions. Under the second alternative, the value of the benefit obligation associated with the participants covered by the contract would be set equal to the fair value of the buy-in contract at each measurement date. This approach is considered supportable because the guidance on establishing discount rates 5 calls for the rate at which the obligation could be 'effectively settled.' While purchase of the buy-in contract does not result in an actual settlement, it can be viewed financially as equivalent to an effective settlement, since the majority of the risks and rewards associated with the benefit obligation and related assets has been eliminated (especially if there has been no downgrading in the previously achieved ratings of the insurance company that wrote the contract). As a result, the discount rate used in pricing the buy-in contract also represents the rate at which the obligation can be effectively settled. Under this approach, it is also considered acceptable to change the mortality assumption to that reflected in the value of the buy-in contract. If this second alternative is followed, an actuarial loss will need to be recognized at the next plan measurement date, since the benefit obligation will be increased to match the (generally higher) purchase price of the buy-in contract. For example, if the benefit obligation was $100 before purchasing a buy-in contract for $105, the obligation would be reset to $105, and a $5 actuarial loss would be reflected in other comprehensive income. After this initial remeasurement, the fair value of the buy-in asset and the associated benefit obligation should be equal, other than potential breakage due to changes in credit quality of the insurer. 3 pwc

Going forward, we would generally expect the asset and obligation to continue to move in tandem. Likewise, the expected return on plan assets related to the buy-in contract and the related interest cost on the associated benefit obligation recognized as components of net periodic benefit cost should be equal and offsetting. If the buy-in contract covers only a portion of the plan obligation and participants, determination of the appropriate discount rate and expected return on assets to use may be more complex. Summary of reporting impact The following table provides a highlevel summary of the financial reporting impact of a decision to purchase a buy-in contract, a buy-out annuity, or maintaining current status quo. Balance Sheet Impact Current Income Statement Impact Future Income Statement Impact Buy-in contract Pension obligation and asset remain, but may change to reflect remeasurement values. (Buy-in contract is plan asset.) Although there could be a gain/loss, it would not be a settlement gain/loss. Continued amortization of gain/loss deferred in AOCI. Expense could increase if expected return on buy-in asset is less than previous assumed return, but expense will be less volatile. Buy-out annuity Remove/reduce pension obligation and related plan assets Recognize settlement gain/loss of amounts deferred in AOCI, including the gain/loss arising on purchase of annuity No future amortization of gain/loss deferred in AOCI. No expense volatility going forward. Status quo No change in pension obligation and plan assets No gain/loss Continued amortization of gain/loss deferred in AOCI and continued application of expected return assumption to plan assets The takeaway Employers contemplating de-risking strategies for their current pension plans may wish to consider a pension buy-in arrangement. Financial, accounting and fiduciary concerns should all be considered when deciding if a pension buy-in is appropriate. How PwC Can Help PwC has considerable expertise with respect to the accounting and disclosure for pension and OPEB plans. In addition, we can help you better understand the complex issues related to pension investment strategies, actuarial measurements, taxation and funding. Please contact one of the authors or other PwC People & Organization specialists listed below, or your local engagement partner, to further discuss how PwC can help. Footnotes 1. The US GAAP pension accounting literature addressing settlement accounting is in ASC 715-20-20. 2. As defined in ASC 820, Fair Value Measurements and Disclosures 3. The Pension Benefit Guarantee Corporation (PBGC) publishes monthly rates used in valuing single-employer annuity benefits on its website at www.pbgc.gov. Note that these rates may exclude certain administrative expenses. Also, they may be somewhat lagging relative to a current measurement date and may need to be adjusted. 4. ASC 715-30-35-60 discusses valuation of insurance contracts that are not annuities. 5. ASC 715-30-35-43 4 pwc

Let s talk For more information, please contact our authors: Ken Stoler, Los Angeles (213) 270-8933 ken.stoler@pwc.com Al Johnson, Boston (617) 530-4114 albert.e.johnson@pwc.com Grant Peterson, Los Angeles (213) 356-6804 grant.peterson@pwc.com or your regional People and Organization professional: US Practice Leader Scott Olsen, New York (646) 471-0651 scott.n.olsen@pwc.com Jack Abraham, Chicago (312) 298-2164 jack.abraham@pwc.com Ed Donovan, New York Metro (646) 471-8855 ed.donovan@pwc.com Scott Pollak, San Jose (408) 817-7446 scott.pollack@saratoga.pwc.com Charlie Yovino, Atlanta (678) 419-1330 charles.yovino@pwc.com Todd Hoffman, Houston (713) 356-8440 todd.hoffman@pwc.com Bruce Clouser, Philadelphia (267) 330-3194 bruce.e.clouser@pwc.com Nik Shah, Washington Metro (703) 918-1208 nik.shah@pwc.com Craig O'Donnell, Boston (617) 530-5400 craig.odonnell@pwc.com Carrie Duarte, Los Angeles (213) 356-6396 carrie.duarte@pwc.com Jim Dell, San Francisco (415) 498-6090 jim.dell@pwc.com Brandon Yerre, Dallas (214) 999-1406 brandon.w.yerre@pwc.com Stay current and connected. Our timely news insights, periodicals, thought leadership, and webcasts help you anticipate and adapt in today's evolving business environment. Subscribe or manage your subscriptions at: pwc.com/us/subscriptions 2016 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. SOLICITATION This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. PwC United States helps organisations and individuals create the value they re looking for. We re a member of the PwC network of firms in 157 countries with more than 195,000 people who are committed to delivering quality in assurance, tax and advisory services. Find out more and tell us what matters to you by visiting us at www.pwc.com/us. 5 pwc