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Unsmoothing Defined Benefit Pension Plans

Case

ABC Company has recently reaffirmed its commitment to offering a defined benefit pension plan to its employees, but it has noticed that its very conservative, by-the-book pension policy choices made when SFAS No. 87 was adopted in 1987 are in flux among pension plan sponsors.

Some FASB allowed alternatives in pension accounting allow past stock market activity to affect current period earnings, and companies like ABC Company with large, long-standing pension plans are the most vulnerable.While the company is well-satisfied with its pension plan portfolio's overall results, the S&P total returns on a year by year basis are volatile (see Figure 1).ABC Company recognized that the volatility of pension asset returns is compounded by the volatility in pension obligations.The company currently uses the corridor method in conjunction with amortization of the net gains and losses that can be deferred into Accumulated Other Comprehensive Income, smoothing the effects of both the return volatility described above and the liability volatility from actuarial changes (see Figure 2).Audit Analytics (Coleman 2015) and the CPA Journal (Eaton 2015) both reported companies adopting a MTM (mark-to-market) approach to pension assets and liabilities, either through immediate recognition of returns on plan assets and actuarial gains and losses or through a modified MTM that retains the corridor without the additional smoothing of amortization.In fact, "by the end of 2014 51 companies had adopted MTM [mark-to-market]."(Coleman 2015 2).Thus ABC Company wanted to explore the pension alternatives that embraced the volatility, rather than smoothing it away over long periods of time.

You are part of an accounting consulting team that has been engaged to help ABC Company consider its financial accounting choices for their defined benefit pension plan.You have been given job comparing the corridor method amortization of accumulated other comprehensive income gains and losses vs. expensing all unexpected returns and actuarial changes in the period in which they occur, the two most extreme alternatives.After looking at these alternatives, the company will consider its choices further.

Pension Expense Component: Recognition of Net Gains and Losses A Corridor Method, amortization over service lives of participants B Immediate expensing20x 1 20x2 20x3 20x4 20x5 Projected Benefit Obligation, beginning of year 12343 Fair Value of Plan Assets, Beginning of yr 9451 Cash Contributions to Pension Trust Fund 945 571 473 507 479 Cash Payments to Retirees 805 822 825 1038 1015 Actual Return on Plan Assets (positive return in each of these five years) 783 925 109 1764 24 Rate of expected return on plan assets 8.50% 8.50% 8.50% 8.00% 7.75% Service Cost 183 203 213 182 187 Settlement Rate 5.75% 4.90% 4.15% 4.80% 4.00% Actuarial (Gains) and Losses 1163 1120 -849 1552 -222 Prior Service Cost Incurred 0 0 0 0 0