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Accounting for pensions: very much under construction

Jun 12, 2009

The purpose of this article is to bring together in one place – and try to make sense of – the various ongoing Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) projects on pension accounting. IASB deliberations are relevant to US companies because FASB and IASB are coordinating a broad review/revision of pension accounting with a view to "convergence" –unifying, where possible, FASB and IASB accounting.

As a preliminary matter, let's distinguish between two different "domains" of accounting regulation. The first, and by far the most important for most sponsors, is the set of rules (such as FASB Statement No. 87, or FAS 87) for disclosure on the books of the employer-plan sponsor of the effect on company financials of any defined benefit (DB) plan it sponsors. The second is the set of rules for disclosure on the books of the plan of the financial condition of the plan (i.e., FAS 35). This article focuses exclusively on the first set of rules – disclosure on the books of the employer-plan sponsor.

Effect on employer financials of a DB plan, in the abstract

Before discussing particular FASB and IASB projects, let's consider a first order question: to whom does this information (i.e., information about the effect on an employer's financial condition of a DB plan) matter and in what way? The answers to these questions are not simple and depend on what kind of entity and what kind of investor we're talking about.

What kind of entity?

Understanding that no reporting entity can be viewed as having a static financial condition – stable or unstable – let's consider, nevertheless, the issue of DB plan obligations from these two different points of view.

An "on-going" financially stable entity. For this sort of company (subject to the disclaimer above) the plan represents a claim on revenues, to fund benefits, but not a threat to creditors. So the impact of the plan is primarily an issue for equity investors. And their concern is, generally and in a very real and non-regulatory sense, "how much will this plan cost over time?" One not so obvious element of this question is, however, regulatory: under ERISA funding rules, the ability of an employer to recover overfunding from a plan is very limited. Thus, a challenge for equity analysts is how to evaluate the impact on financials of excess DB funding ("stranded surplus") given regulatory constraints.

A financially unstable entity. For this sort of company, the plan again represents a threat to equity investors. It also represents a threat to creditors. But the question changes. It's no longer a matter of "how much this plan will cost over time." Instead, it's a question of what demands on company cash are imposed by the regulatory scheme and how, in bankruptcy, the relative priority of the claims of creditors, plan participants and the Pension Benefit Guaranty Corporation (PBGC) (an FDIC-like federal corporation that insures, up to certain limits, unfunded DB benefits) are sorted out. That regulatory scheme defines the obligations of the entity and different entity stakeholders.

And, since where you sit often affects where you stand on these issues, let's try to sort out some of the different interests of "users of financial statements" – defining that term somewhat more broadly than FASB does.

What kind of investor?

FASB generally views its constituency – the persons to whom it is responsible – to be "users of financial statements." Generally this group is understood by FASB to include securities analysts and investors (understood broadly and to include lenders generally). Let's take a slightly broader, more detailed look, at who as a practical matter uses financial statements and how they use them.

Equity investors. Per the discussion above, equity investors would seem to be interested in what is the "real cost" of plan benefits. While complicated, and with the exception of the difficulty in analyzing the stranded surplus issue, this is not a fundamentally different question than the evaluation challenge presented by any compensation program – stock options, vacation pay, medical package.

Unsecured lenders. Again, per the discussion above, general creditors would seem to be primarily interested in (1) the plan's cash flow demands (under the regulatory scheme, which, in the United States, for corporate plans, is ERISA) and (2) the status in bankruptcy of the plan and the company's unsecured creditors.

PBGC. Under current rules, and with a lot of exceptions, the PBGC can be thought of as another (in some cases subordinated) unsecured lender, with the same concerns noted above.

The US Treasury. Implicit in Congressional debates as to what to do about DB funding and the financial condition of the PBGC is the prospect that – a la the current credit crisis – if the PBGC is overwhelmed with insured unfunded liabilities, the federal government may be called on to bail it out. Thus, possible DB meltdown liability can be viewed as an unaccounted for off-US balance sheet liability. And the Treasury has an interest in the size of that liability.

Employees. Under certain circumstances, employees can lose benefits – generally if the benefits exceed PBGC guarantees. To that extent, employees also occupy a position similar to that of unsecured lenders.

Company executives. Curiously, for a couple of reasons, company executives are users of financial statements. First, and most importantly, executive pay/bonus pools are often driven off numbers pulled from financial statements such as Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). This can have an enormous – in some cases, determinative – effect on executive decision-making. Thus, how a particular decision is accounted for may have much more significance than more fundamental, "true" economic factors. Second, there is continuing pressure for legislation (some actually implemented in the 2006 Pension Protection Act) to limit funding for executive benefits where DB plan funding is inadequate.

The ideal

We've begun this discussion of the current state of DB accounting with an abstract analysis because we believe it's useful to start with the question, what do users need from financial statements? And based on the foregoing, the conclusion we come to is that, ideally, financial statements should provide two things. First, an adequate picture of the real cost of the plan. And, second, the threat the plan presents to a company's liquidity – ongoing cash costs and the charges it may represent against the company's bankruptcy estate.

The practical

That first ideal objective, the "true" cost of the plan, is in some senses simply unattainable. Why? Because DB plans represent a promise to pay money in the future, often for an indeterminate period (the life of the participant). There is no "real" answer to the question: what is that benefit worth today? There are a lot of arguments about it, which we will rehearse in a moment, but essentially it's an argument over competing valuation models, not the "real" vs. the "unreal."

The second ideal objective is, it seems to us, very attainable. It is simply a description of the demands of the current regulatory regime against this company for this plan.

To date, FASB, in a very imperfect way, has tackled the first objective and not the second.

The "true" economic cost of a plan

There is an ongoing controversy over this issue – the "true" economic cost of a plan – within the actuarial community. On the one side (the newer, "emerging" side) are those who, under the banner of "financial economics," argue that a company's liability with respect to a plan should be discounted the way any other company obligation is discounted. In one version, advocates of this point of view would propose that, if a liability could be settled in the market, at, say, an annuity purchase rate, that rate should be the rate at which liabilities should be valued. At its most robust, advocates of this point of view believe that plan liabilities should be valued at something close to a risk free rate of return. If it's not obvious, financial economics partisans believe that plan valuation discount rates should be pretty low. Lower discount rates = higher valuations = bigger charges = lower company earnings (for instance, lower EBITDA).

On the other side are those (“traditionalists”) who view a pension plan as a “closed” entity and believe that discount rates should somehow reflect projected returns on plan assets and thus should be higher than a company's regular liability discount rate.

Financial economics advocates usually analyze the issue of DB funding in the abstract. But there are two elements of corporate DB finance that pose problems for this abstract analysis. First, PBGC insurance, which turns a company's pension promise from an obligation contingent on company financial viability to an obligation insured by the government, or at least a government corporation. And, second, the problem that plan surplus – resulting, for instance, from use of a low discount rate combined with an aggressive (and successful) investment policy – cannot generally be recovered.

Moreover, where you stand on what is the right liability discount rate probably depends in part on where you sit. Equity investors need, as a practical matter, to know how the plan will affect net revenues. Unsecured lenders need to know plan cash demands and the threat the plan presents in bankruptcy. You would think that these users of financial statements might want to use different valuation methodologies given their different concerns.

Expected return, presentation, executive compensation and decision making

There are some who would say that the most problematic aspect of current accounting treatment – really, dwarfing all the others – is the use, for income statement purposes, of an "expected return" on plan assets. And the biggest problem with this feature of accounting is that riskier portfolios generate a bigger number (bigger here being better), which gets booked to income, while recognition of adverse experience (resulting from, for instance, all that increased risk) is either ignored (because it is within the non-recognition corridor) or deferred (through amortization; income statement treatment is discussed in detail below). Connecting the dots: merely by adopting an aggressive (and more risky) investment strategy, and without regard to actual results, a company may get credit on its income statement for a higher rate of return on plan assets.

Under current rules, that bigger income number is booked to operating income. Thus, an aggressive portfolio strategy may, for an overfunded plan for instance, generate more (operating) income than a more conservative strategy or than, critically, a strategy that hedges-out plan risk. Conservative and hedging strategies usually result in a lower expected return. And since there may be limited (or no) credit on the financials for reduced period-to-period volatility, there is no compensation for lower expected returns, in the plan financials. In real life, of course, the compensation is that, after the equity market "corrects" down 20 or 30%, conservative and hedging investment strategies leave the plan in much better financial condition.

Not infrequently, executive compensation keys off income statement performance. Thus, given the incentives rehearsed above, executives have an incentive to pursue an aggressive plan investment strategy and a disincentive to hedge.

In this regard, one element of the current review of DB accounting treatment is how performance of the plan is presented, an issue that both FASB and IASB say they have under active consideration.

Clearly it is not the job of the accounting regulatory community to set executive compensation practices or to frame policy in terms of its consequences for executive behavior. But many believe that this issue should be addressed at some level by someone (board compensation committees? executive compensation practitioners?).

*     *     *

Enough of the abstract. Let's consider what FASB and IASB are actually doing about pension accounting.

FASB's current plan

FASB's process is not as inflexible (or predictable) as, for example, a Treasury/IRS regulation project, so the process we're about to describe should be understood as provisional. That said, here, as we understand it, is a summary of FASB's current plan with respect to the revision of DB accounting rules.

1. Phase 1, revision of balance sheet treatment – completed. See discussion below of FAS 158.

2. Phase 2, a comprehensive revision of financial statement treatment, addressing, critically, issues of income statement treatment and smoothing – leverage the work by the IASB (discussed below) and proceed as follows:

a. Once the IASB completes its work on accounting for "obligations that are contribution-based promises" (including cash balance plans), FASB would consider adopting similar requirements that would improve reporting in the United States. In turn, the IASB may also consider adopting requirements put forth by the FASB in additional areas not addressed by the IASB.

b. Address the possible elimination of smoothing devices and associated recycling of costs from other comprehensive income into earnings. This would include disaggregating the components of postretirement benefit expense and determining how each would be reported in comprehensive income within the reporting framework being developed by the financial statement presentation project. The Board may also consider implementing interim improvements for postretirement benefit reporting prior to completion of the financial statement presentation project. [We are essentially quoting Board minutes here. We explain this in less technical terms below.]

c. Implement disclosure requirements about an employer's participation in a multiemployer plan. (We will not be covering this element of the project.)

d. Improve disclosures about risks in plan assets (i.e., FSP FAS 132(R)-1, discussed further below).

This description of the FASB DB accounting project was as of the FASB's August 29, 2007 Board meeting. While all items on this list are significant, perhaps the most significant is item b. – elimination of smoothing and disaggregating the components of postretirement benefit expense. As more than one board member noted at the August 29, 2007 meeting, users of financial statements have consistently said that smoothing was the big issue. Also mentioned (again, more than once) is current "aggregation" of component expenses. We believe the concern is that users would like to eliminate all of those accounting rules which fail to recognize, or defer the recognition of, the period-to-period mark-to-market effect of changes in plan assets and liabilities. Those rules are discussed in detail below (at FAS 87 and the income statement). In the rest of this article we're simply going to call this the "buffering" issue.

So – just to be clear – as we understand it, item b. puts buffering, in some sense, on FASB's agenda.

IASB's current plan

IASB is considering changes in DB accounting in four areas:

a. Elimination of deferred recognition of changes in DB assets and liabilities. These rules are more or less the same as the FASB rules (which fail to recognize, or defer the recognition of, the mark-to-market effect of changes in plan assets and liabilities). So, it would seem that buffering is also on IASB's agenda.

b. Revision of the rules for the presentation of those recognized changes – either in regular profit and loss or in other comprehensive income.  It appears that IASB remains committed to requiring that entities "recognise all changes in the value of plan assets and in the post-employment benefit obligation in the financial statements in the period in which they occur … and recognise unvested past service cost in the period of a plan amendment." Such an approach would effectively eliminate buffering allowed under current rules.

c. Rules for plans that make a contribution-based promise (which generally would include cash balance plans).

d. Rules for "greater of" arrangements (e.g. floor-offset, multiple formulas).

As part of its project, IASB issued a Discussion Paper in March 2008 making specific proposals for treatment of each of these items (a -d). We'll be discussing some of those proposals in detail below. An exposure draft is scheduled for later this year, with finalization planned for 2011 and implementation in 2013. But before we launch into what in some areas will become a very detailed discussion (and more than many readers will want to know) about the current state of pension accounting, let's review the main points.

The big picture

Just to try to keep a handle on all of this, let's summarize really briefly:

Pension accounting is viewed both by FASB and IASB as part of a "convergence" project. The ultimate goal is to have identical FASB and IASB rules for DB accounting.

With that goal in view, FASB has released guidance on disclosure of information about plan assets (FSP FAS 132(R)-1)) and is working on multiemployer plan reporting. IASB is working on issues of cash balance accounting and "greater of" arrangements. Those who anticipate international convergence expect that leveraging this division of labor, IASB will adopt FASB's asset disclosure and multiemployer plan rules, and FASB will adopt IASB's cash balance and floor-offset rules.

The elephant in the room is the buffering issue. Addressing that issue is on both FASB's and IASB's agenda. Indeed, IASB's March 2008 Discussion Paper proposes, in strong and unambiguous language, moving quickly to a mark-to-market regime. Moreover, based on comment letters and IASB reaction over the past several months, it appears likely that IASB will focus on income statement buffering now, with the goal of a 2013 effective date, and defer consideration of measurement issues for “contribution-based” and “greater of” arrangements for the time being.

FASB is paying close attention to IASB activity on the buffering issue. According to the FASB website: “FASB is currently monitoring the work of the IASB to determine the next steps on” phase II of its own project on postretirement benefits (phase I being the release of FAS 158).

So, it appears FASB is ceding the initiative to IASB on the buffering issues. In light of the agreed-upon goal of convergence, those interested in the trend of US GAAP pension accounting on this key issue are well advised to keep a close eye out for the IASB exposure draft slated for release later this year.

The devilish details

That's the big picture version and probably provides most of the takeaways. For those who want to understand what's going on under the hood, however, we are going to provide, in what follows, more detail on most of the accounting issues discussed above. The exceptions: we will not discuss multiemployer or "greater of" accounting proposals.

The remainder of this article is intended as a resource. For instance, if you want to become more familiar with current income statement treatment or cash balance proposals, you could just read those sections.

We address projects in the following order (moving from the more particular to the more general): (1) FASB FSP FAS 132(R)-1 – Disclosure of information with respect to plan assets; (2) IASB – Accounting for contribution-based promises; (3) FAS 158 – the balance sheet; and (4) FAS 87 and the income statement.

FASB FSP FAS 132(R)-1 –Disclosure of information with respect to plan assets

We have provided a detailed update on this guidance in our article FAS 132 update. Summarizing: FASB is requiring (in the form of a FASB Staff Position designated FSP FAS 132(R)-1), for fiscal years ending after December 15, 2009, detailed disclosures on corporate financials about the assets held in any employer sponsored DB plan. There are, basically, two broad areas of disclosure under the FSP:

1. Information about valuation inputs, similar to information required with respect to corporate fair value disclosures under FAS 157, identifying assets as either:

Level 1 inputs – generally quoted prices from a reliable, liquid market

Level 2 inputs – generally quoted prices that don't qualify for Level 1 treatment

Level 3 inputs – unobservable inputs

Additional, detailed disclosure applies, particularly with respect to Level 3 assets.

2. Detailed information about asset categories (cash, equities, debt, asset-backed securities, private equity funds, etc.) and concentrations of risk.

IASB –Accounting for contribution-based promises

We're going to assume some background on cash balance plans in this discussion – for a fuller treatment see our (somewhat dated but still useful for the basics) article Cash Balance Plans – A Primer.

Many believe that current (FAS 87 and IAS 19) accounting doesn't do an adequate job reflecting the costs of cash balance plans. Quoting the IASB Discussion Paper: "IAS 19 does not result in a faithful representation of the liability for some benefit promises that are based on contributions and a promised return on assets." Perhaps the crux of the problem is how to reflect the value of the "promised return," the return (expected or actual) on plan assets and the plan's discount rate.

In 2004, FASB interrupted its comprehensive pension accounting project to tackle cash balance plan accounting. A major issue that FASB focused on was appropriate treatment of "arbitrage" (generally, the difference between the plan's stated interest crediting rate and the amount earned on trust assets) vs. "walk away" liability. If the participant quits and takes his or her money ("walks away"), the plan doesn't get anticipated arbitrage. After considerable criticism, FASB dropped this project.

As noted above, IASB has taken on accounting for "contribution-based promises" (a concept that is broader than, but includes, cash balance plans). FASB's hope is to leverage this work. The IASB Discussion Paper proposes, with respect to contribution based promises:

An entity should measure its liability for a contribution-based promise at fair value assuming the terms of the benefit promise do not change.

There should be no requirement to recognise an additional amount determined by the benefit that an employer would have to pay when an employee leaves employment immediately after the reporting date. [This proposal, in effect, rejects FASB's concern with "walk away" liability.]

Descending to the super-technical, another issue presented by cash balance plan accounting is whether to account for the pay credit and the interest credit (and any implicit "arbitrage") separately, or as one item. As the Discussion Paper explains, accounting for them separately would, for example, produce the result that, while the following promises are economically identical, they would be accounted for differently:

• a promised lump sum of $1,340 paid in five years (i.e., a contribution of $1,340 plus a fixed return of 0%); and
• a promised lump sum of $1,000 plus a fixed return of 6% per year paid in five years.

For that reason, IASB is proposing "a single measurement basis for the contribution amount and the promised return." In other words, arbitrage is booked immediately against the "contribution" obligation. Combined with IASB's no "walk away" liability rule, we believe it can be fairly said that this represents pro-arbitrage, pro-sponsor accounting treatment for cash balance plans and a lot better deal (for sponsors) than FASB was considering in  2004-2005.

IASB's primary rule for valuation of cash balance plan obligations is general – simply that it be measured at fair value. In this regard, it describes fair value as including an estimate of the future cash flows, the effect of the time value of money, and the effect of risk.

IASB appears to be committed to an approach of providing general rather than detailed and prescriptive rules for cash balance plan accounting. Quoting (from its discussion of the estimate of cash flows): "the Board intends to give high level guidance on the estimation of such cash flows, but not detailed guidance, such as might be found in an actuarial textbook."

We're not going to go into further detail on IASB's proposals. They are preliminary, and the extent to which they will be adopted by FASB is uncertain. It is also important to note that the proposal as detailed in the discussion paper has been highly criticized in the comments provided to the IASB so much so that Board has decided to set it aside until the project on recognition and presentation is complete.  However, it represents a current public position of the accounting profession on the valuation of cash balance plan liabilities. And they do appear to address directly – implementing a fair value-based rather than an "actuarial convention"-based approach – the issue of how to value the critical relationship between the "promised return" on the participant's account, the return (expected or actual) on plan assets, and the plan's discount rate.

*     *     *

Now let's turn to the bigger issues of balance sheet and, most importantly, income statement treatment.

FAS 158 – the balance sheet

In September 2006, FASB adopted FAS 158, generally revising rules for balance sheet disclosure of DB liabilities. The critical, and most significant, element of FAS 158 was a requirement that a company's balance sheet reflect the difference between DB plan liabilities and assets (at fair market value). Since only balance sheet treatment was affected, FAS 158 provided for income statement reconciliation with this change to the balance sheet via an "other comprehensive income" item.

There was a lot of controversy over FAS 158, primarily centered on FASB's decision to use as the value of DB plan liabilities the "projected benefit obligation" (PBO – discussed further below), which includes in liabilities (to some extent) future pay increases.

The numbers which FAS 158 moved on to the balance sheet had, under FAS 87, already been in balance sheet footnotes. If we set aside the impact (which did not appear to be great) of this change in balance sheet recognition on loan covenants and bank capital requirements, it's hard to see why FAS 158 mattered at all. No new information was being disclosed, it was just being moved from the footnotes directly onto the balance sheet.

FAS 87 and the income statement

Ignoring transition rules applicable to liabilities for periods prior to 1987 (when the current DB accounting regime became effective), under current rules (FAS 87) a company's pension expense for a DB plan it sponsors generally has four components:

Service cost

An interest charge on the plan's projected benefit obligation ("PBO")

A charge for amortization of unrecognized prior service cost

A credit/charge for experience gains and losses

Expected earnings on plan assets are credited against these charges.

A little translation:

"Service cost" is the cost for the current year's benefit.

You get "prior service cost" when, for instance, you amend a plan to increase benefits based on total service, including pre-amendment service.

PBO is discussed further below; generally, it's current plan liabilities taking into account the effect of projected salary increases.

You sustain an "experience gain" when an assumption you made about the future turns out to be wrong in good way (i.e., in a way that results in a smaller liability number than you expected). For instance, you assume that salaries are going to increase at a rate of 5% per year, and they only increase at a rate of 4% per year. You sustain an experience loss when your assumption turns out to be wrong in a bad way (i.e., in a way that results in a larger liability number than you expected) – say, salary increases at a rate of 6% per year instead of the 5% assumed.

Changes in the present value of a plan's liabilities resulting from changes in the discount rate used to measure them are a critical element of FAS 87 experience gain/loss treatment. If the interest rate you use to present-value liabilities goes down, the value of your liabilities will go up. That change – that increase in liabilities – is treated in the same way as other experience gains/losses. We cannot emphasize enough the importance of this issue. Remember, the (2000-2002) perfect storm was about a decline in asset returns and, in many cases more significantly, a decline in interest rates. (In fact, while assets declined during 2000-2002, interest rates dropped every year between 2000 and 2005). Interest rates go down, liabilities go up. How that decrease/increase is reflected on a company's books is one of the most significant elements of any DB accounting regime.

Expense buffering under current rules

So, where's the buffering? Generalizing, three elements of current accounting treatment buffer the impact on the income statement of changes in plan expenses and liabilities: smoothing of, and credit for an expected rate of return on, asset values; limited recognition of gains and losses; and delayed recognition of gains and losses and prior service cost.

Smoothing of asset values and the expected rate of return

Under FAS 87, the value of plan assets may be smoothed for a period of up to five years. An expected rate of return, based on the makeup of the plan's asset portfolio, is then credited on this amount. This treatment introduces two "iterations away from reality."

First, returns are based on smoothed, not current fair value, of assets. So if you're using an 8% expected return, your smoothed assets are $100 and your actual assets are $80, your expect return is $8, not $6.40.

Second, "expected" returns are booked – so that if, in the prior example, the expected return is 8% and the actual return is 7%, the 8% return is booked.

Any losses – differences between real asset value and real returns on the one hand and smoothed value and expected returns on the other – are only recognized (if at all) in future accounting periods pursuant to the rules for limited recognition of gains and losses.

Limited recognition of gains and losses

Unrecognized asset gains and losses that are not yet reflected in the smoothed value of assets are not subject to recognition under FAS 87. In the example above, the $20 difference between smoothed and market assets is an unrecognized loss, but none of it is subject to recognition in the current year. Only over time, as the loss becomes reflected in the smoothed value of assets, does it even become subject to recognition under FAS.

After carving out the difference between smoothed and market value, gains and losses are netted, and net gains/losses are only recognized to the extent they exceed 10% of the higher of the plan's (smoothed) value of plan assets or its PBO. If gains/losses do exceed the 10% "non-recognition corridor," then that excess is not charged to the current year but is amortized in future years over the "average remaining service of active plan participants."

Gains and losses include: changes in the present value of liabilities resulting from an increase/decline in interest rates; differences between the expected return on plan assets and actual return; and other "actuarial" gains and losses (e.g., differences in expected and actual turnover, salary increases, mortality, etc.).

Let's consider an example of how limited recognition works, focusing on interest rate assumptions. Let's assume a plan has liabilities (PBO) of $1,000 using a 6% interest assumption. Assume interest rates go down to 5%, the liabilities increase to $1,100, and no other sources of gain or loss. First, the $100 increase in liabilities does not affect current year earnings, which ignores current year gains and losses. Even in the following year, none of the $100 loss is recognized, because it does not exceed 10% of the plan's PBO. If the interest rate change resulted in a liability increase of $200 (to $1,200), then only $80 of the change would be subject to recognition the following year.

Delay in recognition of gains and losses

As described above, net gain or loss is only recognized if it exceeds the 10% liability/asset non-recognition corridor. The recognition of that excess is also delayed. It is not recognized in total but is amortized thereafter generally over the average remaining service of active plan participants (generally 10 to15 years). In the example above, based on a $200 liability loss, the amount recognized on the following year’s income statement might be $6 to $8.

As mentioned above, the delay is even more pronounced for asset returns, since asset gains and losses are only eligible for recognition to the extent they have been smoothed into the asset value (e.g., over five years).

The upshot is that the gap between the occurrence of a gain or loss and its full reflection in the income statement is often several years, sometimes longer.

The recognition of prior service cost is also delayed under current rules. When a sponsor amends a plan to increase benefits it is common to apply the benefit increase to prior periods of service. The liability for that prior service benefit is, under current rules, charged against future income over time – generally over the average remaining service of active plan participants.

Note that both of these delays in recognition might be considered deviations from standard accounting practice. Gains and losses relate to the current or prior periods, not the future period over which they are actually charged off under FAS 87. And participants can walk away now with any "past service" benefits.

Buffering, IASB proposals and FASB

These elements of current accounting – smoothing of asset values and use of an expected (rather than actual) rate of return, limited recognition of gains and losses, and delayed recognition of gains and losses and prior service cost – are what we mean when we refer to "buffering." As noted above, IASB has proposed, in its March 2008 Discussion Paper, that these elements of current accounting be eliminated and that instead (excerpting from the Discussion Paper):

Entities should recognise all changes in the value of plan assets and in the post-employment benefit obligation in the financial statements in the period in which they occur.

Entities should not divide the return on assets into an expected return and an actuarial gain or loss.

Entities should recognise unvested past service cost in the period of a plan amendment (i.e., no deferred recognition of past service liability).

That's the most aggressive "elimination of buffering" proposal on the table right now and from the tentative decisions the board has made since the publication of the paper it is apparent that it is committed to remove any buffering from the income statement. FASB's approach to the issue is and has been much more tentative. For example, the language in the latest FASB Phase II Project Update describes the agenda as:

Presentation of postretirement benefit assets, benefit liabilities, and the cost of providing postretirement benefits (whether to disaggregate the components of postretirement benefit expense, considering how each component would be reported in comprehensive income).

Arguably, issues of "presentation" do not even touch on issues of whether and when gains and losses are recognized.

As we said, it is hard to see, in the meta-context of convergence, how on such a big issue – really, the critical issue in the revision of pension accounting – IASB would be able to set policy without real input from (really, joint consideration with) FASB.

Comments on the IASB Discussion Paper were due September 26, 2008. IASB intends to publish an Exposure Draft later this year, and currently anticipates the exposure draft will be released in July.

Conclusion

With the exception of companies that are primarily driven by cash flow considerations, accounting treatment is the most important DB plan finance issue. Both FASB and IASB seem committed to transparency and rationality, with a view to serving their constituency: users of financial statements. History tells us, however, that the road to DB accounting reform is long and winding. We would expect more iterations of both FASB's and IASB's agenda, as they move forward with their projects. We will continue to follow, and update you on, these issues.