Basics of accounting for pension plans

Elisabetta Russo
Marco Zecchin
University of Trieste

1. Introduction.

This report outlines some of the issues that may arise from the application of
accounting principles to pension plans. These issues are of primary interest to
experts assessing pension plans with a view to preparing financial statements and,
in particular, to actuaries. Though not strictly pertinent to actuarial mathematics,
the topic is closely connected with actuarial concepts and concerns both experts
and connoisseurs of this subject, as we will discover later in this essay.

It is probably useful to clarify that the term “pension plans” refers to that
part of the pension system that aims at providing employees with additional
pension benefits to the “basic” ones provided by the state (in particular the term
refers to those funds which are disciplined in Italy by the Legislative Decree 124,
issued on 21 April 1993 and subsequent laws).

This work focuses in particular on the schemes known as “closed pension

plans”, i.e. plans established by a company or a group of companies stemming
from an agreement between the employer(s) and the employees (thus only
applicable to the employees of that company or group of companies).

Another important aspect with regard to the accounting treatment of

employee benefits and regarding all Italian companies – and not just those
offering pension benefits to their employees - is the accounting of the Italian
T.F.R. (Trattamento di Fine Rapporto – mandatory termination indemnity).

How to account for pensions has been the subject of a thesis recently
presented at the University of Trieste ([Rus03]).

2. Company Accounts and Accounting Principles for Pension Schemes.

One of the tasks pension actuaries have to carry out is to prepare the accounting
numbers for the pension note that is disclosed as part of the financial statements of
a company. These numbers provide both a “static” description of the assets and
liabilities in connection with the company’s pension arrangement at a given date
(as summarised in the Balance-Sheet) as well as they provide a “dynamic”
description of the events that have interested the pension scheme during the
accounting period (such as benefits paid out, contributions paid in, as summarised
in the Profit and Loss account).

The aspects to be taken into account when preparing an accounting

valuation are many and diverse; they can be grouped as follows:
- Economic (or financial-economic) factors, such as inflation rates or interest
rates;
- Legal factors, which refer to a continuously and significantly evolving pension
regulation that in particular addresses the way benefits are provided for and the
possibility of early-retirement;
- Demographic factors, with great attention paid to the "longevity risk" factor.

These factors are subject to different interpretation to the extent that the
same financial situation can be presented in different ways depending on the
accounting principle adopted. For example, the fluctuation of investment returns
in the long-term impacts on the fair representation of the value of the scheme
assets and can be treated in different ways according to the accounting standard.

In the past, the adoption of different accounting principles made it

impossible to compare the pension exposure of different companies or even to
compare different accounting periods for the same company.

To avoid such consequences, accounting standards for pensions and for

other employee benefits (which in the past were not even disclosed in the
financial statements) have been introduced in many industrialised countries, with
the aim of creating a standardized method for measuring and disclosing these
liabilities and of improving their comparability and understandability.

We could state that such considerations apply – with the adequate

adjustments – to all situations that need disclosing in the company accounts.
Specially designed standards have also been developed for the accounting
reporting of life and non-life insurance companies.

Finally, it should be emphasized the importance of reflecting a “true and

fair view” of the business not just for the benefit of equity analysts, investors, loan
creditors and competitors who are the main users of financial statements, but also
for the protection of the employees’ long term welfare especially when this is
achieved by means of a retirement benefit plan.
3. Defined Benefit Pension Plans.

In general, pension plans can take different forms but they can be basically
divided into two categories: “defined benefit schemes” and “defined contribution
schemes”.

A plan is defined as a “defined benefit scheme” when the employer has the
obligation to provide the benefit to the employee upon retirement and bears the
costs of it. The benefit is estimated by means of a “formula” established by the
rules of the scheme; according to this formula, the final amount of pension
payable at retirement is linked to the salary earned by the employee throughout
his career (in the case of the career average plans) or in the last years (in the case
of final salary schemes).
A plan is a “defined contribution plan” when the rules of the plan set the
level of contributions (usually as a percentage of salary) that the employer has to
pay. Their accumulation together with the investment return gives rise to a capital
later converted into a pension annuity.

The accounting treatment of a pension scheme basically affects the first

type – the “defined benefit” schemes. In the case of “defined contribution plans”,
the only obligation for the employer is to pay the set amount of contributions and
this amount is treated as cash for the purpose of the financial statements.

4. Accounting Standards.

Accounting standards generally specify the methodology to be used in estimating

the pension expense (to be disclosed in the profit and loss account), the value of
assets and liabilities (to be disclosed in the balance sheet), and set out the items
that must be disclosed in the notes to the accounts to ensure that the accounts of
different companies adopting the same accounting principles are fully
comparable.

Before the current accounting standards were introduced, the provision of

pension benefits was accounted for as cash flow in the period in which the
payment occurred, and the company’s profit and loss account showed the
contributions paid into the pension scheme (which is usually excluded from the
company’s equity) among the company’s costs for the period.

Upon the introduction of the accounting principles, some thirty years ago,
companies were required to adopt an “accrual basis accounting” for pensions, that
is to account for the costs and the liabilities accrued in that given accounting
period.
 Usually we speak of GAAP – US GAAP and UK GAAP – and GAAP
stands for "Generally Accepted Accounting Principles". The main accounting
standards are the following:
- the US Accounting Standards, issued by the FASB (Financial Accounting
Standard Board). The Statements concerning pension schemes are the
Statements No. 87 and No. 88 (referred to as FAS 87 and FAS 88), issued in
1985;
- a first group of UK Accounting Standards, namely the Statement of Standard
Accounting Practice, whose relevant part here is the Statement No. 24 (known
as SSAP 24), issued in 1988;
- a second group of UK Accounting Standards, among which the most relevant
here is the Financial Reporting Standard No. 17, (known as FRS 17), issued in
2000, and due to come into force in Great Britain for accounting periods
beginning on or after 1 January 2005;
- The International Accounting Standards, issued in 1998 by the Accounting
Standard Committee (IASC) and concerning listed companies in the European
Union. The Statement that is relevant here is the Statement No. 19 or IAS 19.

5. Technical Assumptions and Measurement of Liabilities

The guidelines offered by the accounting principles cover a wide range of

accounting issues, some of which fall within the competence (directly or
indirectly) of actuaries. It is the case of the so-called “technical assumptions” and
of the “liability valuation methods”.

First of all, it should be clarified that the responsibility of selecting the

assumptions to adopt lies with the company under FAS 87, FRS 17 e IAS 19,
whereas it lies with the actuary under SAAP 24, provided that – under all
standards – the assumptions reflect the conditions of the market at the
measurement date. The actuary’s task is to offer a “best estimate” of those
conditions.

Set out below is a brief overview of the “technical assumptions” under

FAS 87, FRS 17 and IAS 19, i.e. when it is the company’s responsibility to set
them:

- Discount Rate: it is sufficient to say that the discount rate needs to reflect the
yield on AA or higher-rated corporate debt, allowing for some differences
depending on the standard adopted. It is worth mentioning that a rate has been
specifically created to meet the FAS criteria and this rate is the Salomon Bros,
Pension Discount Curve rate.
Similar criteria can be found in the three accounting standards, allowing for some
differences depending on the country where they are used, as far as the following
assumptions are concerned:
- Inflation rate
- Salary increases
- Pension increases
- Expected Return on Assets
- Demographic assumptions.

With regard to the calculation of the present value of scheme liabilities

(Actuarial Liability), FAS 87, FRS 17 and IAS 19 require the use of a method
called the “Project Unit Method”, which belongs to a set of methods defined
“Accrued Benefit Funding Methods” ([And85]), whose main objective is a
standard level of funding to cover benefits accrued to measurement date (as
opposed, for example, to other methods known as the “Prospective Funding
Methods”, whose target is to achieve a stable contribution rate).

Under SSAP 24, the choice of the actuarial method to adopt to calculate liabilities
lies with the actuary.

6. Overview of the Accounting Standard Guidelines

It is important to emphasise that accounting standards are valuable to companies

also because they aim at alleviating corporate costs, both in terms of time and of
the financial costs of performing a full actuarial valuation at each measurement
date.

Therefore, even though on the one hand strictness in following the

requirements of the standard is required, on the other non-standard specific
computational methods can be applied, provided the results are practically the
same. This means that actuaries are allowed to find suitable calculation
“shortcuts”.

It is worth adding that companies listed in the European Union are

required to adopt IAS for their financial statements from 1 January 2005.
However, these criteria are currently being revised and it is not known at this
stage when they will be finalised; the discussion around this standard is still open
and concerns all areas of expertise, in particular, actuaries.
7. Valuation of the Italian TFR.

A further aspect closely concerning all Italian companies is the accounting

treatment of the “Trattamento di Fine Rapporto” (TFR - Termination Indemnity).

TFR is disciplined by art.2120 of the Italian Civil Code and consists of a

benefit that is mandatorily payable by the employer upon employment termination
regardless of the reason that led to the termination (death, voluntary or forced
dismissal, retirement). In each year of service the employee accrues a part of his
1
salary (amounting to %). The accrued benefits (revaluated at the mandatory
13.5
rate of 1.5% plus 75% of the inflation rate) are then paid to the employee as a
lump sum upon leaving the company.

These benefits can currently be accounted for under Italian GAAP

according to a method than does not comply with the other accounting standards.
When IAS19 will come into effect, however, also the accounting treatment of
these benefits will have to comply with the new guidelines.

To conclude, we would like to mention that a study by M. Micocci, F.

Gismondi and V. Lovecchio ([MGL03]) has recently dealt with the accounting for
TFR, suggesting a possible approach to the problem and proposing numerical
calculations according to the “stochastic simulation” principle.

References

[And85] A. W. Anderson, Pension Mathematics for Actuaries, The Windsor Press

Inc., Wellesley, Massachusetts, U.S.A., 1985.
[Rus03] E. Russo (2003), US GAAP, UK GAAP and IAS for pension plans.
Actuarial and accounting perspectives, Thesis, University of Trieste (prepared
under the supervision of prof. M. Zecchin and prof. E. Pitacco)
[MGL03] M. Micocci, F. Gismondi, V. Lovecchio, Il principio contabile
internazionale IAS 19 e la valutazione attuariale del Fondo Trattamento di Fine
Rapporto, Abstract dei lavori presentati al XXVII Convegno Annuale AMASES,
Cagliari, 2003.
[Tom94] A. Tomassetti e altri, Tecnica attuariale per collettività (2 vol.), Edizioni
Kappa, Roma 1994.