The pension accounting world before 1987 was a wild place, very similar to the western town in the Mel Brooks classic, Blazing Saddles.

Before a sheriff was appointed to bring order, the peaceful town of Rock Ridge was chaotic and potentially dangerous. The pre-1987 pension world posed similar (if less comical) risks through inconsistent and potentially misleading reporting of pension accounting costs.

Statement of Financial Accounting Standards No. 87 (FAS 87) put an end to all the commotion by riding in and brandishing standard rules for pension expense accounting. As a result, the last three-and-a-half decades have been relatively peaceful. Sure, there is the occasional mortality shoot-out or bond rate border skirmish, but the law-abiding citizens of U.S. pension accounting town have mostly lived in consistent tranquility, shielded from the wild tumult of changes internationally.

Also see: "Avoiding a pension risk management apocalypse."

Unfortunately, new statements and interpretations are about to shatter that serenity like a chair flying through a saloon window. Plan sponsors may soon find themselves embroiled with their actuaries and auditors in a barroom melee of expense reporting options, including:

1) Redefining operating expense

Pension accounting cost has traditionally been reported by plan sponsors as an operating expense, similar to the cost of labor and equipment needed to run their business. This expense is not a monolithic entry, however.

Rather, it has four major components:

1) Service cost: value of benefit accruals for employees during the year (zero for frozen plans)

2) Interest cost: expected growth of the liability due to the loss of discounting over the next year

3) Amortization payment on accumulated gains and losses (due to interest rates, asset performance and demographic experience different from what was expected)

4) Expected return on plan assets (income offsetting other expenses)

Of these four items, only service cost has the compensation characteristics of an actual operating expense. The other components fall into net investment or re-measurement categories that are the result of economic factors outside of business operations.

Recognizing this, the Financial Accounting Standards Board is currently considering a proposal to categorize only the service cost component as an operating expense, moving the other three entries to a separate line item.

Rating: Good. If implemented, this change would seem to report costs more appropriately, and relieve sponsors of booking the majority of economic volatility of interest rates and markets against their operating income. 

2) Separate discount rate for service cost

Accounting liabilities are the present value of expected benefit payments discounted to the measurement date using a “discount rate,” which FAS 87 suggests can be estimated by high quality bond yields.

In the good old days (mid-1990s), actuaries often chose a Moody’s Aa rate rounded to the nearest quarter point as the discount rate, and auditors accepted this approach. But the rise of financial economics now demands it be defined as a single rate that produces the same liability as discounting cash flows along the length of a high-quality corporate bond yield curve. This single rate is then used to determine the plan’s total liability and interest cost, as well as service cost.

Since its advent, financial economics’ application to pension liabilities has spawned a cottage industry of experts pushing the boundaries of yield curve knowledge at reasonable hourly billing rates. These experts now understand benefit payments tied to service cost lie farther out on the curve, where spot rates are generally higher. So, they argue that the discount rate for the overall liability is too low to use for service cost and consequently overstates it. A separate (usually higher) discount rate strictly for service cost would be more appropriate theoretically and would also reduce operating expense for non-frozen plans.

Rating: Not necessarily bad … but maybe not material either. This approach may be technically more accurate according to yield curve logic, but the impact likely doesn’t warrant the increase of time and complexity. Service cost would generally be reduced by 3-5% (usually a quarter percent or less of total plan assets) with zero reduction for frozen plans. 

3) “Granular” interest cost

Interest cost used to be a very simple concept: multiply the liability by the discount rate to reflect the passage of time. But yield curve thinking is now challenging even this simple idea.

A large defined benefit plan sponsor recently adopted a “granular” interest cost method. Rather than multiplying the total liability by a single discount rate, this granular approach multiplies the liabilities attributable to each single future year by the corresponding spot rate on the yield curve. Each “grain” of interest cost is then added up to obtain the total.

While this may sound equivalent to the current method to a casual reader, the spot rate approach tends to produce lower interest cost in normal yield curve environments. This is because the spot rate approach implicitly assumes the effective discount rate will increase over the next year. The assumed actuarial gains from the rising rates offsets interest growth of the liabilities.

These interest cost “savings” don’t just ride off into the sunset, though. They become structural actuarial losses to the plan. The above referenced plan sponsor recognizes these losses each year, so there is no impact to their overall expense. Most plan sponsors, however, use an accounting method that defers the majority of losses, only recognizing a small fraction each year.

For them, this method would provide lower overall accounting expense. But it also risks building unnecessarily large unrecognized losses, potentially inhibiting future business transactions or plan terminations. All this at a time when unrecognized net losses are already at historically high levels.

Extra-granular granularity

As if one granular interest cost method wasn’t complex enough, there are two other varieties also being discussed:

1) Forward rates: Eliminates the upward discount rate bias of the spot rate approach…along with the accompanying reduction in interest cost. Essentially a more complicated way of replicating the current approach, which begs the question, “Why?”

2) First year spot rate: Dramatically slashes interest cost (inappropriately in my opinion) by magnifying the upward discount rate bias and sweeping large amounts into unrecognized loss.

Rating: Ugly. Unnecessarily complex and not suitable for many sponsors. Over-complication of a simple concept will increase the preparation time and fees for accounting report preparation. Well-meaning plan sponsors may grasp at expense reducing options that are poorly suited for their situations.

Also see: "Lost in translation: Annual fund notices confound readers."

So, saddle up. We’re ridin’ into a new era of pension accounting mayhem come sundown. Prepare for less standard disclosures, lengthier footnotes and harder-to-interpret pension expenses. It’s enough to make an exasperated cowboy ask, “What in the wide, wide world of sports is a-goin’ on here?” 

Clark is a consulting actuary at the Principal Financial Group, an investment management and retirement leader. He is a fellow of the Society of Actuaries and a member of the American Academy of Actuaries … Harrumph!  Harrumph! A version of this blog originally ran on The Principal blog.

The subject matter in this communication is provided with the understanding that The Principal is not rendering legal, accounting or tax advice. You should consult with appropriate counsel or other advisers on all matters pertaining to legal, tax or accounting obligations and requirements.

Insurance products and plan administrative services are provided by Principal Life Insurance Company, a member of the Principal Financial Group (The Principal), Des Moines, IA 50392.

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