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The Corporate Pension Liability Accounting Components

While the specific calculation of the pension liability can take different forms, core principles always apply to the valuation. An individual has a unique benefit stream calculated using numerous inputs. These items include the specific plan provisions, including assumptions on mortality (e.g., how long they live), morbidity (e.g., how sick they may be), length of retirement, and employment changes (e.g., length and salary). The aggregate of all the plan participants yields the beneficiaries’ future benefits. The discounted value of these is the present value of the future benefits (PVFB). The PVAB is the liability's critical measure and is very similar to the other reporting measures (exhibit 1). Thus, when discussing the liability, the reporting regime nor the myriad of applicable names are not necessarily meaningful. The relevant insight is that the liability is roughly consistent across regimes.

Exhibit 1. Relationship to the Current Liability

There are several statutory accounting dimensions for unearned future liabilities, which financial accounting parallels. Expenses are not recognized before they occur to ensure alignment with the recognition principal of accounting. These costs contain a few elements in their calculation.

Actuarial Liability (AL) – This portion of the liability results from past service and accrues to the beneficiaries. When the plan liability contains a final average salary (FS) as a determinant, then the Actuarial Liability is equivalent to the PBO liability. When the plan does not include a final average salary, the Actuarial Liability parallels the ABO. Both measures are also called the present value of accumulated benefits (PVAB). For pension funding by the Internal Revenue Code (IRC), the liability is named the current liability (CL) and calculated using the mandated interest rates. Calculation of the liability may use mortality or morbidity tables that are either general population mortality assumptions or plan specific (i.e., if the company has enough employees and has measured them overtime). The result is that all the critical liability measures are roughly equivalent regardless of reporting regime (exhibit 1).

Future Service (FS) – This amount is the expected increase in the liability from employees remaining with the company until retirement and measured at the current salary level. This component measures employees’ accruing benefits merely from remaining at the company while excluding salary increases. When the benefit calculation includes a length of service dimension, this is a material component of the liability.

Normal Cost (NC) –This cost item reflects the current year of service and is indicative of the deferred compensation for the year. In financial accounting, this is parallel to the service cost (SC). This measure reflects a couple of crucial outcomes during the year. First, employees received salary raises, which the valuation now incorporates. Second, the employee’s length of service increased, which usually raises their benefits. The aggregate result is a higher liability.

Present Value of Future Normal Costs (PVFNC) –This is the portion of the PVFB that is attributable to the future years of service. It reflects the projected salary increases (if not already done in the Actuarial Liability), and the future Normal Cost for each year. This measure broadly reflects employees' propensity to receive annual salary increases and not leave the company (and their pension behind) the closer they are to retirement. While the company holds the option not to increase future salaries, the historical experience is that companies provide annual raises. The consequence is the liability incorporates these probable salary increases.

These components are the principal cost drivers when valuing a defined benefit pension liability. The reporting actuary determines the exact calculation method of each cost. The primary requirement is that the approach is consistent across the plan (e.g., all cost calculations use the same method). There are subtle methodological differences for each component (exhibit 2). The vital difference between the components is the calculation for service cost, which uses the current salary basis with a one-year projection. This calculation effectively excludes any future accrual of service. It provides a fair liability valuation if the sponsor were to freeze benefits at that time.

Exhibit 2. Funding and Accounting Measures

The materiality of the liability component differs depending upon the plan’s status. In most instances, PVAB is the core component, with the other measures adding incrementally to it (exhibit 3). The pension plan’s position determines the relative magnitudes of these components. A new plan would have little accrued benefits (e.g., PVAB), while a mature plan would have material accrued benefits. A closed plan would most likely not need to include future service costs or salary increases because the accrual of benefits stopped (i.e., “frozen”). Thus, the exact proportions of the measures could vary significantly between plans.

Exhibit 3. The Composition of the Actuarial Liability

The liability includes many components. Each one can materially impact the liability valuation, which will vary primarily depending upon the plan’s age, accrual method, whether the plan is open or close. The collective bargaining agreement or the strategic human resource design mostly fix these factors at plan inception. Thus, while the liability calculation method intricacies are quantitatively complex, the reality is that the liability valuation is where the risk manifests itself. This result derives from the variability of the interest rates used for valuation.

Learn more in our Accounting for Corporate Pensions Primer and follow out Corporate Pension Index.

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