What’s in an Assumption?
If you aren’t an actuary, there’s a good chance you have picked up your defined benefit plan’s actuarial reports and have been confused. A number of assumptions go into the actuary’s calculations utilized for financial reporting, and they generally differ for plan sponsor financial statements (ASC 715* reports) and plan financial statements (ASC 960 reports). In past articles, we’ve touched on the fundamental differences between these actuarial reports. In this article, we highlight three key assumptions used in the development of these reports and describe why the assumptions are often different between the reports.
Discount Rate Assumptions
The discount rate is used to calculate the present value of future projected benefit payments using an expected stream of future payments.
- ASC 715 – Reflects the rates at which pension benefits could be settled. It is appropriate in estimating these rates to look to available information about rates implicit in current prices of annuity contracts that could be used to effect settlement of the obligation. Typically employers look to rates of return on high-quality fixed-income investments currently available and expected to be available during the period to maturity of the pension benefits.
- ASC 960 – One of two methods may be used:
- Expected return on assets – When used, it will match the rate of return used in the ASC 715 report.
- Settlement rate – Driven by the rate of future benefit payouts to existing plan participants and may be the same as the discount rate used in the ASC 715 report.
While ASC 960 provides for two available methods to determine the discount rate, it is important to note that the method used to determine the ASC 960 inputs must be consistent between years. When a change in approach is made, it is treated as a change in accounting principle rather than a change in estimate.
Long-Term Rate of Return
The expected long-term rate of return is used to extrapolate future income of current holdings that can be used to pay benefits to plan participants.
- ASC 715 – Based on the average rate of return on funds invested and funds expected to be re-invested to provide benefits related directly to the projected benefit obligation. This rate includes expected funds to be contributed by the plan sponsor during the plan year but excludes expected return on future years’ contributions outside of the plan year.
- ASC 960 – Based on the same factors as ASC 715.
Salary assumptions are used to project future pay levels of current participants. An increasing salary scale for existing participants has a substantial impact on the present value of future benefit payments since benefit calculations are often based on the participant’s salary level as of the date of retirement.
- ASC 715 – Based on projecting salaries into the future based on provisions within the plan. Provides the plan sponsor with future amounts to be owed to participants for specific financial statement disclosures.
- ASC 960 – Not utilized in this report.
It is critical to understand the rhyme and reason behind the varying assumptions utilized within your defined benefit plan. In reviewing their plan’s actuarial reports, plan sponsors should also be aware that the assumptions and methodologies used in the funding valuations follow different regulatory guidance rather than the guidance for financial reporting. By increasing your understanding of the assumptions, you as a plan sponsor are better able to recognize how changes in these assumptions will impact your plan.
*For insurance companies following SSAP 102, the guidance on rate development mirrors that in ASC 715.