Basics of Pension Accounting
The right way for accountants, auditors and actuaries to quantify the assets and the liabilities of pension funds has been a matter of great controversy for a long time. Before 1985, companies in the United States had wide latitude in recognizing expenses and setting the assumptions that must guide accounting. That latitude was somewhat constrained by the Financial Accounting Standards Board, or FASB, when it issued its Statement 87.
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Demographic Assumptions
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Actuaries have to set assumptions, simply because pension benefits are paid in the future. Some of the assumptions are demographic, that is, they involve the expected lifespan of a 70-year old retiree, or the number of years that a 30-year-old employee will continue to work for his employer. The expected liabilities depend on the former, and the expected income depend on the latter.
Economic Assumptions
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Separately, assumptions must be made about the rate of return. Given the receipt of a dollar by the pension fund today, what will be the value of that dollar a year from now, or ten years from now, if conservatively invested?
The usual approach is "based on a fixed discount rate that is related to the assumed real rate of return on assets," according to Eduard Ponds of the University of Amsterdam in The Netherlands. A "real rate of return" is the return after an adjustment for inflation, and some rate must be assumed based on the best available view of economic reality over decades to come.
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Delayed Recognition
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One of the central principles of pension accounting according to the FASB is "delayed recognition." Neither changes in the pension obligations, such as those that might result from a new collective bargaining agreement, nor changes in the value of the assets the fund holds will be recognized immediately. Each is "recognized systematically and gradually over subsequent periods," as the FASB has said.
The 1985 changes in Generally Accepted Accounting Principles, called GAAP, meant that recognition of such changes has since taken place earlier in the life-cycle of the employees/retirees involved than it had been, but it is still gradual.
Offsetting Liabilities and Assets
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Another broad principle of pension accounting is that, where possible, the liabilities should be matched against, or shown to offset, related assets. Even though, as the FASB has said, "the liability has not been settled [and] the assets may still be largely controlled," they should be shown as netted out in order to give an accurate account of the employer's financial position.
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