Pension Accounting Research Series 2014: An Update for Disclosures for 2013 By Jon Waite, SEI Institutional Group seic.com/institutional
Many plan sponsors experienced a fairly positive year in pension investment management. The S&P 500 returned 21% YTD through November 30, 2013, 1 and fixed income markets have displayed quite a large change since April. After the Federal Reserve s comments on tapering in May, there was a dramatic rise in the 10-year Treasury Yield Curve, despite falling inflation rates. The average corporate pension funding status improved to 94% in November 2 the biggest boost reported since 2008. However, until we reach the New Year, we cannot be certain of year-end funded status levels. In estimating pension liabilities at year-end, plan sponsors may expect discount rates to be about 90 basis points higher (as of November 30, 2013) relative to December 31, 2012, and continue to be dependent on plan specifics and the duration of liabilities. Despite an impressive year, plan sponsors using PPA liability smoothing techniques will experience liability increases from last year, and may require additional contributions to increase the funded status. Those using unsmoothed cash valuations will likely see an improvement in funded status. Market volatility may continue to be a challenge in 2014. Now in its 12th year, SEI s Pension Accounting Research Series (updated for 2013 disclosures) is designed to educate plan sponsors and corporate officers on corporate accounting methods for the liabilities of their pensions, as well as address issues regarding FASB ASC 715. 1 MSCI EAFE Index. 2 Milliman Pension Funding Index. 2014: An Update for Disclosures for 2013
Section 1: What Discount Rate Should Plan Sponsors Use for Year-end 2013? At the end of each fiscal year, plan sponsors must select a discount rate to use in valuing the liabilities of their pension plans for corporate accounting purposes. The rate must be based on then-current market conditions and will be disclosed in the footnotes to the financial statements. In addition to determining the accounting liabilities at year-end 2013, the disclosed discount rate will also be used in determining the plan s FASB ASC 715 (formerly FAS 87) pension expense/income for the 2014 fiscal year. The setting of discount rates generally requires a closer review by plan sponsors of the specific indices or yield curve matching used to select the discount rate assumption than was required years ago. The discount rate is used to determine several accounting items, in particular the Service Cost and the Projected Benefit Obligation 3 (PBO). The Service Cost and the interest on the PBO are components of pension expense. Generally, the higher the Service Cost and the PBO, the higher the total pension expense. Additionally, the PBO is crucial in determining the adjustment to shareholder equity because the market funded status of the pension plan, whether a deficit or a surplus, will appear directly on the balance sheet. This effectively subjects the balance sheet to any volatility experienced in the funded status, such as changes in liabilities and assets that do not offset one another. This has been of particular importance over the last several years, given the high volatility in the investment markets and in the discount rate indices. When determining discount rates, the conventional benchmark used by plan sponsors and actuaries has been the range of yields between AA and AAA rated longterm corporate bonds. This has been the interpretation of the SEC s recommendation that fixed-income debt securities that receive one of the two highest ratings given by a recognized ratings agency be considered high quality. Since the AA rated bonds provide the yields on the high end of the range, they have traditionally been the benchmark rate of choice for plan sponsors. In general, the 2013 disclosure will show discount rates being set relative to the 2012 disclosure while incorporating the change in high-quality bond yields and in curve shape over the past year. Plan sponsors with calendar fiscal years will typically need to wait until year-end before they can finalize their discount rates. Plans with a fiscal year-end of November 30 have enough information now to determine the discount rates for the 2013 disclosure. Plans with a calendar fiscal year may want to look at how rates have changed from December 31, 2012, through November 30, 2013, and make assumptions about the range of yield change they can expect during December. Figure 1.1 on the following page shows the changes in long-duration yields from December 31, 2012, to November 30, 2013. Based on this analysis, and assuming no change during December 2013, plans with a December 31 measurement date should consider increasing their discount rates. 3 Note Subsection on IAS 19 for 2013: Changes for International Standard Reporters. 2014: An Update for Disclosures for 2013 1
A review of Figures 1.1 and 1.2 finds that most of the indices have increased 80 to 90 basis points (bps). As 2013 has unfolded, we have seen the yield curve rise significantly. During the year, we have seen rates move quite a bit, reinforcing the fact that accurate assumptions about the level and shape of the yield curve (and thus effective discount rates) cannot be made prior to year-end. Further, we continue to receive uncertain information from policy makers regarding potential reduction in stimulus designed to keep rates low, resulting in a wide range of possible outcomes for 2014. We continue to watch this situation closely to discern the impacts for pension plan sponsors throughout the upcoming years. Plan sponsors will select the discount rate using a method that matches plan cash flows to a yield curve. To do so, projections of each future year of the benefit payouts for a plan are used. The benefit payout in a given year is then discounted by that point on the yield curve (e.g., benefits expected to be paid out seven years from now are discounted by the sevenyear maturity point on the yield curve). This will make the selection of the discount rate specific for each plan due to the differing shapes of the benefit payouts in the future and the specific yield curve used. The change in the shape of current yield curves (see Figure 1.2) indicates the potential for quite a bit of variation and a generally large reduction in selected discount rates, although not as large an increase as during 2012. As can be seen in Figure 1.2 on the following page, the yield curve as of November 30, 2013, has increased relative to last year with large increases from year four on, as defined by the Citigroup Pension Discount Curve. The result is that all plan liabilities will be discounted at these higher rates. Further, note the change in the shape of the curve. Almost all plans will see large increases in rates due to the almost parallel shift. figure 1.1 Change In Yields, Year-End 2012 To November 30, 2013 BOND INDEX 12/2012 YIELD 11/2013 YIELD CHANGE (BPS) Barclays AA Long Credit 3.89 4.77 (88) Merrill Lynch AA 15+ Corporate 4.08 4.88 (80) 30-Year Bellwether Swap 2.77 3.74 (97) Citigroup Pension Liability Index 4.05 4.92 (87) SEI Pension Liability Index 3.76 4.63 (87) 2 2014: An Update for Disclosures for 2013
Figure 1.2 Recent AA CorPorate Bond Yield Curves 6.00% 3.00% Annual Spot Rate (%) 5.00% 4.00% 3.00% 2.00% 1.00% 2.00% 1.00% 0.00% -1.00% Spot Rate Delta 12/31/12 0.00% -2.00% 11/30/13 0.5 2.5 4.5 6.5 8.5 10.5 12.5 14.5 16.5 18.5 20.5 22.5 24.5 26.5 28.5 Maturity (Years) Table 1.3 shows that 90% of companies with defined benefit plans in the 2012 SEI Plan Sponsor Accounting Database (over 680 sponsors reporting) set their discount rates in their 2012 pension disclosure between 3.48% and 4.50% a smaller range than found in our prior analysis. The 102-basis-point range of discount rates suggests diversity among companies in fiscal year, country of origin of the pension plan, liability structure, investment philosophy, and willingness to be aggressive when setting rates. The most common range of rates (used by most of the companies in the database) from the 2012 disclosure was between 3.80% and 4.19%. figure 1.3 Distribution of 2012 Discount Rates NUMBER OF PLAN SPONSORS 688 Percentile Discount Rate 95th Percentile 4.50% 75th Percentile 4.19% 50th Percentile 4.00% 25th Percentile 3.80% 5th Percentile 3.48% 2014: An Update for Disclosures for 2013 3
Looking Back at 2012: Discount Rate Changes from 2011 Disclosure to 2012 Disclosure Last year s research as outlined in the addendum (issued in January 2013) stated plans with a December 31st measurement date should consider lowering their discount rate, many by 35 to 50 bps. The 2012 SEI Plan Sponsor Accounting Database contains 2011 and 2012 disclosure discount rates for more than 680 plan sponsors. As seen in Figure 1.4, 98% of plan sponsors decreased their rates. The rest increased the discount rate by a variety of levels or kept it the same. This shows the substantial impact that plan-specific benefit payout streams had on setting the discount rates last year. We are likely to see similar dispersion of rate changes this year. Figure 1.4 Distribution of Discount Rates, 2011 Disclosure to 2012 Disclosure Increased 1% Unchanged < 1% Decreased 1 to 24 bps 3% Decreased 25 to 49 bps 20% Decreased 50 to 75 bps 31% Decreased over 75 bps 44% Source: Standard & Poor s Institutional Market Services. Impact on 2014 Pension Expense The discount rate that is selected for the 2013 disclosure is the same rate that will be used in the calculation of 2014 pension expense. The discount rate affects three of the five components of pension expense: (1) service cost, or the present value of benefits attributed to service to be rendered in 2014; (2) interest cost, or the increase in PBO liability due to the passage of time; and (3) amortization of unrecognized gains/losses, which arise when actual experience deviates from what was assumed, including assumption changes. The other two components, expected return on assets and amortization of prior service cost (value of unamortized plan amendments), are relatively independent of the discount rate. Service Cost Component: Service cost is the portion of the present value of participants accrued benefits that is attributable to having worked during the year. With no change in the discount rate, service cost will generally increase 2% to 10% from year to year due to the methods used to value the plan (the funding method) and the aging of the population. Increases in any expense assumption added into the service cost accrual should be considered separately as that increase will generally not be the same as for benefit accrual. The impact of a change in the discount rate depends on the duration of the service cost. For plans with a service cost, most have a service cost duration that ranges between 12 and 18 years. A 25-basis-point drop in discount rates is expected to increase service cost by an additional 3% to 5%, and a 25-basis-point increase in discount rates is expected to decrease service cost by 3% to 5%, all beyond the natural increase of 2% to 10%. 4 2014: An Update for Disclosures for 2013
Interest Cost Component: Interest cost is the cost of the plan due to the passage of time. It is calculated by multiplying the PBO (adjusted for benefit payments) by the discount rate. Without changing the discount rate, interest cost will generally increase with time. Generally, before any changes in the discount rate, the interest cost component will typically increase between 5% and 12%. The impact of changing the discount rate on interest cost is not straightforward. On one hand, a change in the discount rate will change the PBO liability in the opposite direction. However, this new PBO is then multiplied by the new discount rate. The net effect of these changes is that for generalized estimation purposes, the interest cost will be unchanged for variation in the discount rate. Amortization of Unrecognized Gain/Loss: When assumptions are not met regarding liability experience and asset returns, the differences are accumulated with prior-year gains and losses and are recognized as an amortization credit or charge. The minimum recognized amount is based on the excess of the gain/loss over 10% of the greater of assets or PBO and divided by the plan s future working lifetime, which is usually eight to 15 years. Faster recognition may also be used. Amortization of gain/loss will vary dramatically from plan to plan based on several factors, including: Recognition method used (e.g., 10% corridor method) Amount of gain or loss on the balance sheet as of December 31, 2013 Relative size of gain or loss to the PBO and asset amounts Demographic changes during 2013 Assumption changes under consideration Asset smoothing method used Therefore, no generalized effect of a discount rate change on the gain/loss recognition can be made. However, a few rules of thumb can be used in an analysis: If already amortizing a loss (gain) for 2014 and the discount rate is decreased (increased), the full amount of the PBO increase (decrease) will be subject to amortization into expense. If amortizing a loss (gain) for 2014 and the discount rate is increased (decreased), the loss amortization will decrease (increase) and could be eliminated. If no gain or loss amortization is occurring for 2014, a closer examination of the specifics of the plan should be made. In summary, plan expense will typically increase from year to year due to the required funding method used and the passage of time. In addition to this natural growth, if the discount rate is decreased, plan expense can be expected to increase further and vice versa; if discount rates increase, expense will likely decrease or increase less than the natural growth. A close analysis of your plan s specific situation and the application of a few general rules should allow you to estimate the impact of changing assumptions. Accounting standards other than U.S. GAAP: Many organizations report financial results under accounting standards other than ASC 715. While discount rates for U.S. pension plans might be set in a manner similar to that for ASC 715 filers, note that the impact of a change in rates on 2014 pension expense may be very different than outlined here. 2014: An Update for Disclosures for 2013 5
SECTION 2: What Return on Assets (ROA) Assumption Should Plan Sponsors Use for 2014? In addition to the discount rate, pension plans are also required by ASC 715 to disclose an explicit assumption for the plan s expected return on assets (ROA). ASC 715 states that the expected long-term rate of return on plan assets shall reflect the average rate of earnings expected on the funds invested or to be invested to provide for the benefits.... While the discount rate is intended to adjust to current market conditions, the ROA is long-term in nature and should not be adjusted unless there are significant shifts in asset allocations, capital market expectations, or structural shifts in the economy in general. Returns in recent years have been highly volatile relative to ROA assumptions. Plan sponsors may receive some pressure from auditors to review their ROA assumptions to determine whether current assumptions are reasonable. While recent market experience is a consideration in selecting an ROA assumption, plan sponsors should consider what they expect the portfolio to return over the long-term future. They should look at long-term capital market assumptions as a guide but customize them for their portfolios asset allocations. Figure 2.1 shows the distribution of ROA assumptions used by plan sponsors in 2012. figure 2.1 Distribution of 2012 Disclosure Return On Assets (ROA) Assumption Number of Plan Sponsors 688 Percentile ROA 95th percentile 8.50% 75th percentile 8.00% Median 7.68% 25th percentile 7.15% 5th percentile 6.00% Source: Standard & Poor s Institutional Market Services. 6 2014: An Update for Disclosures for 2013
Of the 688 plan sponsors reporting ROA assumptions, most (64%) had ROAs between 7.50% and 8.50%, similar to the past several years analyses. Almost all (90%) of the plan sponsors had ROAs between 6.00% and 8.50%, a noticeable tightening of the range compared to a couple of years earlier. Considerations of other sponsors selection of ROA can be another set of data. However, when reviewing this sort of information, such as 10-K s for publicly traded companies, note that there tends to be a conservative bias with ROA averages. Very well-funded plans moving down a glidepath to termination tend to have lower returning portfolios. Also, methodology for the analysis may average U.S. and non-u.s. assumptions for ROA, which results in a downward bias for most organizations with non-u.s. pensions. As we know, the markets have been extremely volatile over the past several years and short-term average returns may be extremely time-dependent. The 25-year average of a 60/40 portfolio is 8.59% as of November 30, 2013; however, a 30-year average is 9.98%. 4 This demonstrates why it is not sufficient to look only at a given historical return period when determining the ROA assumption. It is important that plan sponsors continue to use a variety of information sources to set these assumptions. Addendum Information In January 2014, SEI will be issuing an addendum to this study that will update this research with year-end numbers relative to December 31, 2013. If you are interested in receiving a copy of the addendum, please visit www.seic.com/asc2013 to request it. 4 Benchmark is currently weighted: 38.25% S&P 500 Index, 6.75% Russell 2500 Index, 15% MSCI EAFE Index, and 40% Barclays Capital U.S. Aggregate Bond Index. 2014: An Update for Disclosures for 2013 7
About the Author Jon Waite, F.S.A., E.A., Director of Investment Management Advice and Chief Actuary for SEI s Institutional Group, is responsible for providing advice regarding defined benefit plan design, actuarial methods and assumptions, and funding policies for SEI s institutional relationships. With more than 450 institutional clients worldwide, SEI is a recognized pioneer in developing first-to-market retirement solutions that integrate investment management strategies with overall business goals. 8 2014: An Update for Disclosures for 2013
To learn more about the FASB assumptions discussed in this paper, please contact Jon at 610-676-3493 or jbwaite@seic.com 2014: An Update for Disclosures for 2013 9
1 Freedom Valley Drive P.O. Box 1100 Oaks, PA 19456 seic.com/institutional This research should be used for educational purposes only. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events, or a guarantee of future results. The information is not intended to provide actuarial or accounting advice. Please consult your financial/tax advisor for more information. Information provided by SEI Investments Management Corp., a wholly owned subsidiary of SEI Investments Company. 2013 SEI 131936 (12/13)