Accounting standards affect how pension liabilities are reported in company accounts. FAS 158 requires that the net of pension fund assets and liabilities are reported in the main accounts. Traditional accountancy measures allow a more subjective measurement, and relegate pension information to the accounting notes.
The real issue is how a company calculates and values the projected liability—which depends on the discount rate selected, the actuarial assumptions relating to future inflation, wage increases, and, most importantly, the expected longevity of employees.
Accounting measures and buyout measures of pension liabilities differ. Finance directors need to be aware of both types of measure, their assumptions, and the interaction between them, as they can impact pension strategies and, consequently, financial reporting.
With a pension plan, companies agree to provide certain benefits to their employees, by specifying either a defined contribution (where a fixed contribution is made to the plan each year by the employer, with no promises as to the future benefits that will be delivered by the plan) or a defined benefit (where the employer undertakes to pay a certain benefit to the employee at some point in the future). Under the latter, the employer has to put sufficient money into the plan each period such that the amounts, with reinvestment, are sufficient to meet the defined benefits due as plan members retire.
With a defined contribution plan, the firm meets its obligation once it has made the prespecified contribution to the plan, and its valuation on the balance sheet is reasonably straightforward. With a defined benefit plan, the firm’s obligations are much more difficult to estimate, since they will be determined by a number of variables, including the benefits that employees are entitled to (which will change as their salary and employment status change), the prior contributions made by the employer (and the returns they have earned), the expected retirement date of employees, and the rate of return that the employer expects to make on current contributions.
As these variables change, the value of the pension fund assets can be greater than, less than, or equal to the pension fund liabilities (which include the present value of promised benefits). Recent changes to accounting regulations have increased the transparency of pension funding, and this has sparked an increased debate about the goals of defined benefit pension funds. The stakeholders of a pension fund (sponsor, trustees, and the various classes of pensioner) often have different goals, and therefore require the asset and liability information to be presented using different assumptions. These assumptions can materially affect both profit and loss (P&L) and balance sheet statements.
A pension fund whose assets exceed liabilities is an overfunded plan, whereas one in which assets are less than liabilities is underfunded, and disclosures to that effect have to be included in financial statements. When a pension fund is overfunded the firm has several options: It can withdraw the excess assets from the fund, it can discontinue contributions to the plan, or it can continue to make contributions on the assumption that the overfunding is a transitory phenomenon that could well disappear by the next period. When a fund is underfunded, the firm has a liability that must be recognized on the balance sheet.
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