Audit Pitfalls: Avoid Surprises Related to Post-Retirement Benefit Plans
The assumptions used to account for defined benefit pension and other post-retirement benefit plans can have a substantial impact on your organization’s financial statements. Your actuary may suggest some assumptions but it is management’s responsibility to ensure that the assumptions represent accurate estimates and are GAAP compliant. Inappropriate assumptions used in the valuation of benefit obligations directly affect an over- or under- funded pension obligation shown on the statement of financial position. Seemingly small changes in key assumptions can cause significant discrepancies in the amount recorded.
To avoid last minute surprises during your audit there are several key assumptions to consider, including:
Both ASC 715-60, Defined Benefit Plans – Other Post-Retirement Benefits and ASC 715-30, Defined Benefit Plans – Pensions state that the discount rate for measuring pension obligations used should be the rate of return available on high quality bonds as of the plan sponsor’s fiscal year end. “High quality” means AA/Aa rated bonds. Use of an inappropriately high discount rate could result in an understatement of the projected benefit obligation and, consequently, an understatement of the pension liability (or overstatement of the pension asset if the plan is over-funded) recorded on the statement of financial position. The spread between the rates emphasizes the importance for each employer to consistently develop a tailored discount rate assumption based on individual facts and circumstances and adjust the rate on an annual basis. Most actuarial firms and employee benefits consulting firms have computer programs that will construct a hypothetical portfolio of AA/Aa rated bonds with cash flows matching a plan’s expected benefit payments optimized to maximize the yield. This is the preferred method of obtaining a discount rate; however, it is management’s responsibility to ensure that the hypothetical portfolio established is not unreasonably skewed to maximize the yield.
- Assumed long-term rate of return on plan assets
ASC 715-30 and ASC 715-60 indicate that the expected overall long-term rate of return should reflect the average rate of earnings expected on the plan’s invested funds. The long-term rate of return is not expected to change every year; however, it should be reviewed every year.
- Market-related value of plan assets
Under ASC 715-30 and ASC 715-60, the expected return on plan assets — a component of net annual benefit expense — is computed by multiplying the assumed long-term rate of return by the market-related value of plan assets. The market-related value of plan assets may be based on current fair value or on a calculated rolling average that incorporates fair value changes over no more than five years, depending on an employer’s accounting policy. Employers that are using a calculated market-related value of plan assets that is higher than the fair value and do not lower their assumed long-term rate of return on plan assets could potentially build up large losses.
- Mortality tables and other assumptions about plan participants
Management should consider key assumptions related to the plan participants, including mortality, retirement age, turnover, etc. These assumptions should represent management’s best estimate and should be re-evaluated as circumstances change.
- Health care cost trend rate assumptions
ASC 715 requires that employers develop health care cost trend rates using past and present health care cost trends. Employers generally begin developing future trend rates by analyzing the past years’ rates, taking into account any recent plan changes including those resulting from the Health Care Reform Legislation of 2010. Employers should consider estimates of health care inflation, changes in health care utilization and changes in the health status of plan participants when estimating trend rates.
- Health Care Reform Legislation of 2010
Post-retirement health care plan sponsors should consider the effects of the Health Care Reform Legislation of 2010 on their year-end assumptions. Depending on the specific terms of post-retirement health care plans and changes made to a plan as a result of the legislation, health care cost trend assumptions could change due to the following:
- Excise tax on plans that are considered “high-cost” or “Cadillac” health care plans;
- Elimination of annual and lifetime maximums; and/or
- Changes in Medicare part D coverage.
Work with your plan actuaries early to ensure a deeper understanding of the assumptions used to calculate your organization’s obligation for pension and post-retirement benefits. Share this information with your auditors as soon as it is available to avoid a potentially material audit adjustment.