The New FASB Pension Standard, SFAS 132(R)

Part I, SFAS 132 (Revised), December 2003

In December 2003, the FASB issued a revision of Statement 132, Employer Disclosures about Pensions and Other Postretirement Benefits. The existing disclosures, discussed in Chapter 12, were retained. The following additional disclosures are required by the standard:

Annual financial statements

1. Asset allocation: plan assets by asset category (equity securities, debt securities, real estate, etc.)¹ and narrative description of investment policies and strategies applicable to plan assets, including any target asset allocations, risk management practices, and the use of derivatives
   This requirement is intended to provide information about the risks associated with plan assets, including sensitivity to equity markets and interest rates.
2. Narrative description of how the return-on-assets assumption (text pages 418-421) has been estimated
   This disclosure should help financial statement users assess whether the ROA assumption is conservative or not. It should be viewed in conjunction with the first disclosure.
3. Accumulated benefit obligation for defined benefit pension plans
   The ABO (text page 405) is most useful as a measure of the liquidation value of the plan liability. It is also an indicator of whether the employer will be required to recognize a minimum liability (text page 417). However, the ABO is an aggregate for all plans while the minimum liability is determined on a plan-by-plan basis, limiting its usefulness as an indicator of the minimum liability required.
4. Expected benefit payments for each of the next five fiscal years, and (in total) for the following five fiscal years²
   These estimates should be helpful in assessing the future cash needs of the plan, indirectly indicating the employer's funding requirements. They should be consistent with the plan investment disclosures.³
5. Estimated employer contributions during the following fiscal year
   This disclosure is a prediction of the direct cash flow impact of benefit plans on the employer. The estimate is likely to change as companies react to changes in market conditions or revise funding strategies. (See requirement number 8 below.)
6. Use of tabular format to disclose the principal actuarial assumptions, with those used for the benefit obligation and benefit cost shown separately.
   This requirement should eliminate any ambiguity under current practice, as the assumptions used to determine the benefit obligation (the discount rate and rate of compensation increase) must be reported separately from those used to determine benefit cost. As a result users should be able to better assess how rate changes affect reported benefit cost.

Interim financial statements

7. Disclosure of benefit cost by component⁴
   Given the volatility of benefit cost in recent years, this requirement should help users understand the effect of benefit cost changes on interim earnings.⁵ Many companies already disclosed benefit cost on an interim basis; having the components should illuminate the factors behind cost changes and their likely future trend.
8. Any change in expected employer contributions for the current fiscal year.
   This requirement will update annual disclosures (number 5 above), improving analyst forecasts of cash from operations.

Except where noted, these requirements are effective for fiscal years ended after December 15, 2003. While disclosure requirements for private enterprises were marginally improved, they remain greatly inferior to those for public companies.

Example: MeadWestvaco

MeadWestvaco [MWV] implemented these new requirements in its 10-K report for the year ended December 31, 2003 and 10-Q for the quarter ended March 31, 2004. These two filings and other information about the company can be obtained from the company's investor relations website⁶ or from other services that provide access to SEC filings. Asset Allocation (requirements 1 - 2)

MWV reported the following asset allocation data in its 2003 financial statements:

The allocation data show that plan assets are predominantly equity securities. While the expected return is higher than for debt securities, plan assets (and therefore the funded status of the plan) fluctuate with stock prices. The overall return on plan assets was -12.5% for 2002, when stock prices fell, but 23.5% for the recovery year of 2003.

The accompanying text provides a general discussion of the investment program followed by the plan; it also reports that the plan held MWV common shares with a market value of $72 million at December 31, 2003 ($60 million at December 31, 2002).

There is no explicit discussion of how MeadWestvaco determines the assumed ROA for its pension plan. However, the company provides expected return data⁷ (shown in the table above) that we can use in conjunction with the asset allocation percentages to compute an expected portfolio ROA. That computation produces an expected ROA of 8.02% using the 2004 target allocations and 8.24% using the actual allocations on December 31, 2003. However, the ROA assumed for pension accounting purposes was 8.50% for both 2002 and 2003, and remained at that level for the first quarter of 2004 (see the following discussion of interim disclosures).

Accumulated Benefit Obligation (requirement 3)

MWV reported the accumulated benefit obligation (ABO) for its defined benefit pension plans. The following table compares the ABO with the projected benefit obligation (PBO) for 2002 and 2003. As expected for a plan based on average pay, the PBO exceeds the ABO. The lower 2003 ratio may reflect the reduced assumed rate of compensation increase (from 5.09% in 2002 to 4.5% in 2003).

Cash Flows (requirements 4 - 5)

MeadWestvaco reported that it did not anticipate any required contributions to its US qualified plans (plan assets exceeded the PBO by more than $600 million at year-end 2003). However the company did expect benefit payments for its non-qualified pension⁸ and OPEB plans to total $24 million for 2004.

The company provided the following estimates of future benefit payments for pensions and other postretirement benefits (OPEB):⁹

Pension benefits paid of $215 million for 2003 ($238 million for 2002) were inflated by termination benefits. OPEB benefits paid were $14 and $15 million for 2002 and 2003 respectively. These data suggest that the company can pursue a long-term investment strategy for its pension plan as near-term liquidity needs are low (the 2004 estimated benefits are less than 5% of 12/31/03 plan assets.

Tabular Format for Assumptions (requirement 6)

In accordance with the standard, MWV reports its actuarial assumptions separately for its benefit obligation (year-end data) and benefit cost (income statement for year) data. These tables show that the company follows the normal practice of using year-end assumptions to compute benefit cost for the following year (but some companies change the discount rate during the year). The 2003 year-end disclosures show a reduction in the discount rate (from 6.6% to 6.0%) and a reduction in the rate of compensation increase (from 4.5% to 4.0%). Both changes affect 2004 benefit cost (see discussion on text page 419).

Interim Disclosures (requirements 7 - 8)

Note 5 to MeadWestvaco's March 31, 2004 financial statements (in the March 31 10-Q) reports pension and postretirement benefit cost by component (service cost, interest cost, etc.). There is minimal change in these components from the first quarter of 2003. The expected return on plan assets, for example, was $76 million in the 2004 quarter, compared with $77 million in the 2003 quarter.

This small decline is surprising, given that pension plan assets at December 31, 2003 were 16% higher than one year earlier (reflecting the strong 2003 stock market). The explanation may be that MWV uses the market-related value of plan assets (defined in Box 12-1 on text page 402). The March 31 10-Q states that MWV's assumed ROA remained 8.5%.

Note 5 also reports that MWV paid $9 million of benefits for its non-qualified pension and OPEB plans during the first quarter of 2004 and expects to pay $22 million for 2004 as a whole. This is a small reduction from the $24 million estimate provided in the 2003 financial statements (see requirement 4 above).

Part I Conclusion

The amendments to SFAS 132 improve disclosure regarding pension and other postretirement benefit plans and should aid financial statement users in the efforts to understand the implications of these plans for a company's future earnings, cash flows, and valuation.

Part II, Accounting and Disclosure Issues related to the Medicare Prescription Drug Improvement and Modernization Act of 2003 (the Act)

Beginning in 2006, the Act will provide a 28% benefit subsidy to certain retiree health care plans that offer drug benefits that are "actuarially equivalent" to benefits available under specified Medicare plans.

The FASB staff issued an FASB Staff Position (the FSP)¹⁰ addressing accounting and disclosure by sponsors of single-employer defined benefit postretirement health care plan for which

1. the employer has determined that available prescription drug benefits qualify for the subsidy provided under the Act because they are "actuarially equivalent" and

2. the expected subsidy will offset or reduce the employer's share of the costs of drug coverage.

However the federal government has not yet published guidelines on (1) the measurement of "actuarial equivalency," and (2) the evidence required to demonstrate such equivalency.

The FSP requires that companies that have not yet determined whether the subsidy conditions are met to disclose the existence of the Act and the fact that the reported APBO and the net periodic postretirement benefit cost do not include the impact of the subsidy.

When a company can estimate the eligibility for and the amount of the subsidy, the APBO and the net periodic postretirement benefit cost must include the impact of the subsidy. The following disclosures are required when financial statements first reflect the subsidy:

1. The APBO reduction, which must be reported as an actuarial experience gain

2. The effect of the subsidy on postretirement benefit cost for the current period. That effect includes
   1. reduced service cost, because the subsidy reduces the cost of benefits earned
   2. reduced interest cost, because the APBO has been reduced
   3. amortization of the actuarial experience gain

The FSP is effective for periods beginning after June 15, 2004.

Companies must adopt the FSP at the earlier of the plan's measurement date following enactment of the Act (December 8, 2003), or the end of the company's fiscal period that includes the enactment date. Employers are permitted, but not required, to adopt the FSP retroactively as of the enactment date.

Examples:

In its December 31, 2003 financial statements, MWV elected to defer recognition of the Act and therefore the reported APBO and the net periodic postretirement benefit cost do not include the impact of the subsidy. The company stated its belief that the Act would not have a material effect on its financial position or results of operations.

Despite the absence of measurement guidance, General Motors [GM] remeasured its postretirement benefit obligations as of December 8, 2003. GM estimated¹¹ that the Act decreased its APBO by approximately $4 billion (6%), and its unrecognized actuarial losses by $4.3 billion (20%). This remeasurement reduced OPEB expense beginning January 1, 2004 but the reduction was undisclosed. The remeasurement offset a portion of the 2003 increase in unrecognized actuarial losses resulting from the lower discount rate and the higher healthcare trend rate.¹²

Part II Conclusion:

The 2003 Medicare changes impact the postretirement benefit obligation for many companies offering postretirement medical benefits. Financial statement users should read disclosures carefully to discern the timing and amounts of the resulting financial statement effects.

Update as of August, 2004

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¹ For non-U.S. plans this requirement is effective for fiscal years ended after June 15, 2004.

² Required for fiscal years ended after June 15, 2004

³ For example, plans with high expected near term payouts should not have a long-duration fixed income investment portfolio.

⁴ Texaco Table 5 on page 413 shows those components. This requirement is effective for interim periods beginning after December 15, 2003.

⁵ It would have been even better if employers were required to disclose where benefit cost is reported (e.g. in cost of goods sold), but the FASB refused to institute this requirement.

⁶ http://www.meadwestvaco.com/corporate.nsf/investor/main

⁷ Expected return data by asset class are not required by SFAS 132.

⁸ Such plans, often unfunded, are usually for executives.

⁹ Complying early, see footnote 2 above

¹⁰ FASB Staff Position No. FAS 106-2, issued May 19, 2004

¹¹ In its December 31, 2003 10-K

¹² See text page 434 for discussion of the effect of assumptions on the APBO and benefit cost.

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