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In addition to the demographic and actuarial/economic assumptions discussed in the previous section, pension and OPEB plans require financial assumptions to be made to value the plan obligations. These assumptions include the discount rate and estimate of future salary and benefits levels. Additionally, the expected long-term rate of return on plan assets is an important component when determining the net benefit cost each reporting period. Similar to the demographic information discussed in PEB 2.3, the financial assumptions require estimation, and using the most relevant source information available to preparers. As noted in PEB 2.3, each significant assumption should reflect the best estimate of that particular future event, and employers may not apply an approach that looks to the aggregate effect of two or more assumptions, even if their aggregate effect may be approximately the same as that of an explicit approach.

2.4.1 Discount rate used to measure the plan obligation

ASC 715-30-35-43 and ASC 715-30-35-44 describe the objective of selecting assumed discount rates, which is to measure the single amount that, if invested at the measurement date in a portfolio of high-quality debt instruments, would provide the necessary future cash flows to pay the accumulated benefits when due. Generally, government regulations specify discount rates for purposes of calculating tax-deductible contribution levels or minimum funding or benefit levels under social welfare regulations. Those discount rates are generally not based on this financial reporting measurement objective and would therefore not be acceptable for determining the assumed discount rate for US GAAP purposes.

ASC 715-30-35-43

Assumed discount rates shall reflect the rates at which the pension benefits could be effectively settled. It is appropriate in estimating those 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 (including information about available annuity rates published by the Pension Benefit Guaranty Corporation). In making those estimates, employers may also 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. Assumed discount rates are used in measurements of the projected, accumulated, and vested benefit obligations and the service and interest cost components of net periodic pension cost.

ASC 715-30-35-44

The preceding paragraph permits an employer to look to rates of return on high-quality fixed-income investments in determining assumed discount rates. The objective of selecting assumed discount rates using that method is to measure the single amount that, if invested at the measurement date in a portfolio of high-quality debt instruments, would provide the necessary future cash flows to pay the pension benefits when due. Notionally, that single amount, the projected benefit obligation, would equal the fair value of a portfolio of high-quality zero coupon bonds whose maturity dates and amounts would be the same as the timing and amount of the expected future benefit payments. Because cash inflows would equal cash outflows in timing and amount, there would be no reinvestment risk in the yields to maturity of the portfolio. However, in other than a zero coupon portfolio, such as a portfolio of long-term debt instruments that pay semiannual interest payments or whose maturities do not extend far enough into the future to meet expected benefit payments, the assumed discount rates (the yield to maturity) need to incorporate expected reinvestment rates available in the future. Those rates shall be extrapolated from the existing yield curve at the measurement date. The determination of the assumed discount rate is separate from the determination of the expected rate of return on plan assets whenever the actual portfolio differs from the hypothetical portfolio described in this paragraph. Assumed discount rates shall be reevaluated at each measurement date. If the general level of interest rates rises or declines, the assumed discount rates shall change in a similar manner.

As noted in ASC 715-30-35-44, conceptually, the PBO represents the single amount that needs to be invested in a portfolio of high quality, zero-coupon bonds whose maturities exactly match the timing and amount of the plan’s expected benefit payments. However, that exact portfolio cannot typically be constructed and, therefore, amounts must be extrapolated. Many actuarial and financial firms publish pension discount rate curves that are specifically developed to assist plan sponsors in meeting the requirements of the guidance in ASC 715-30-35-43 and ASC 715-30-35-44. These curves are generally updated monthly and include spot rate yields (zero coupon bond yield estimates) in half year increments for use in tailoring a discount rate to a particular plan’s projected benefit cash flows. There are also published pension liability indices and discount yield curves in which the discount rates are developed from these spot rate yields based on the pattern and duration of the benefit payments of pension plans of varying durations (e.g., long, intermediate, short). Other indices are available that have not been specifically designed to match the benefit payment stream of a pension plan and would only give an indication of the yields produced by high-quality bonds at a certain point in time.
The assumed discount rates should be reevaluated at each measurement date (including interim remeasurements required in connection with accounting for plan amendments, curtailments, and settlements) to determine whether they continue to reflect the best estimates of then-current rates (see ASC 715-60-35-79). Specifically, ASC 715 requires that the discount rate reflect bond yields at the measurement date. Given the volatility in the financial markets and the potential for significant movements in interest rates from period to period, the discount rate assumption should be based on current market information. Generally, developing a portfolio of bonds at an earlier date and then attempting to "roll-forward" that data to the measurement date would not be appropriate.
The SEC staff provided guidance on the selection of discount rates in ASC 715-20-S99-1.

Excerpt from ASC 715-20-S99-1

…the SEC staff expects registrants to use discount rates to measure obligations for pension benefits and postretirement benefits other than pensions that reflect the current level of interest rates. The staff suggests that fixed-income debt securities that receive one of the two highest ratings given by a recognized ratings agency be considered high quality (for example, a fixed-income security that receives a rating of Aa or higher from Moody's Investors Service, Inc.).

The FASB concluded that, conceptually, the basis for determining the assumed discount rates for measuring the expected postretirement benefit obligation (EPBO) and the service cost component for OPEB plans should be the same as the basis for determining the assumed discount rates for pension measurements. The weighted average of the assumed discount rates disclosed for OPEB may be different from the ones disclosed for pensions due to the effect of the differences in the expected timing of cash outflows of each plan.
The service cost component of net periodic benefit cost could be volatile from year to year as a result of using current discount rates because the changes in discount rates will immediately affect the PBO and EPBO, which is the basis for determining service cost. In concept, notwithstanding the long-term nature of pension and OPEB arrangements, this period-to-period volatility is an appropriate reflection of the current cost of services—i.e., the cost of services purchased in the current period should reflect current period prices. The PBO and APBO will also be immediately affected by discount rate changes. Those changes are classified as actuarial gains or losses. Changes in the discount rate also affect the interest cost component of net periodic benefit cost, although the effect of an increase (or decrease) in the rate will be offset to some degree by the effect of the corresponding decrease (or increase) in the PBO or APBO to which the interest rate is applied.
Interest rates (sometimes referred to as yields or yields to maturity) generally vary depending on the remaining maturity or duration of the obligation. Consequently, the discount rate for a plan covering only retired employees would be expected to differ from the discount rate used for a plan covering a relatively young work force. Therefore, a weighted-average or "blended" discount rate, based on individual discount rates applicable to the varying periods until the benefits are due, should be used for discounting the pension benefit obligation and related pension cost components (i.e., service cost and interest cost).

2.4.1.1 Considerations in selecting discount rates

Assumed discount rates should be reevaluated at each measurement date, including interim remeasurements required in connection with accounting for plan amendments, settlements, curtailments or other significant events. Although there is some latitude regarding the methodology that may be selected to determine the discount rate, the approach selected should be followed consistently. A change in facts and circumstances may, however, warrant a change in the approach for determining the discount rate. Changes in the approach should generally be limited to changes that produce a more refined estimate of the discount rate, such as changing from a benchmark approach (see PEB 2.4.1.2) to a specific bond matching or spot-rate yield curve approach. This would represent a change in accounting estimate that is accounted for prospectively, not a change in accounting principle, as described in ASC 250, Accounting Changes and Error Corrections.
For example, employers that determine their discount rates by matching a plan's specific cash flows to a spot-rate yield curve or individual high-quality bonds may switch from one acceptable spot-rate yield curve to another acceptable curve, or switch from an acceptable curve to an acceptable bond match. In these cases, we believe there is no change in methodology because the methodology in use continues to be based on a cash flow matching approach. Nonetheless, such a change should be accompanied by a sound rationale in support of the change. This might be the case when the employer has changed actuarial firms and the previously used spot-rate yield curve is no longer available, or the employer's actuary or an outside vendor develops a new curve that produces a discount rate that the client believes more appropriately reflects the characteristics of its benefit obligation. It is not appropriate to make a change solely for the purpose of achieving a higher discount rate or avoiding a change in the assumed discount rate.
Mergers periodically occur between certain actuarial firms that had their own proprietary methods for developing assumed discount rates. Thus, subsequent to the mergers, companies served by those actuarial firms have access to new discount rate methodologies. Having access to a new methodology would not, by itself, be considered a change in facts or circumstances that supports switching to the use of that methodology. Such a switch would have to be supported by an appropriate rationale as to why the new methodology would provide a better estimate under the circumstances.

2.4.1.2 Benchmark approach

Under a benchmark approach, entities start with a rate from a published bond index and make certain adjustments, either upward or downward, to reflect the individual facts and circumstances of their plans. The rate selected from the index or indices, as well as the adjustments made to that rate, should be supported. The following should be considered as appropriate adjustments to the indices:
  • An upward adjustment to certain published bond indices to restate them from a semi-annual coupon basis to an annual discount rate basis (some indices are already annualized)
  • An upward or downward adjustment to the yield of the index when the duration of the benefit stream is either significantly longer or shorter, respectively, than the duration of the bonds in the index. Two scenarios when these duration adjustments might be made are: (1) when the population of participants is comprised primarily of retirees, thus causing the plan’s expected benefit payment stream to have a relatively short duration, or (2) when the population of participants is comprised of very few retirees and a relatively young active workforce, thus causing the plan’s expected benefit payment stream to have a relatively long duration.
  • A downward adjustment to the yield of the index to reflect the removal of the effect of call features of callable bonds in the index, if necessary
  • Once the published yield is adjusted based on the considerations listed above, it is acceptable to round to the next 25 basis point interval, if the employer's policy is to do so. For example, if the published yield as of the measurement date of 5.66% is adjusted by eight basis points to reflect annual versus semi-annual interest payments (so 5.74%), it could then be rounded to 5.75%.

Other adjustments to the index (e.g., to replace the bonds in the index with lower quality bonds to obtain a higher yield) are not generally appropriate. If an entity sponsors more than one pension or postretirement benefit plan, it may be appropriate to choose different discount rates for different plans on the same measurement date because of differing average durations until benefit payments are made and differing patterns of cash flow requirements.
Given the availability of other yield curve and bond-matching approaches, use of a benchmark approach to develop discount rates is increasingly uncommon. For an employer using a benchmark approach, the following information should be maintained or updated/re-evaluated each period to support the discount rate:
  • Information regarding the constituent bonds in the related bond index. Obtaining this information may require the employer to acquire a subscription from the organization that produced the bond index or from a financial information service.
  • Comparing the timing and amount of cash outflows of the bonds in the index to the defined benefit plan's expected cash outflows for benefits, and quantifying/documenting the basis for any positive or negative adjustments to the bond index yield relative to the cash flow analysis
  • Considering, quantifying, and documenting any negative adjustments to the bond index yield for callable bonds included in the index. Specific expertise may be needed to compute and support an appropriate adjustment.
  • Considering, quantifying, and documenting any other adjustments to the bond index yield. The two most typical are (1) converting the rates from certain published bond indices from a reported semi-annual compound rate basis to an annual discount rate basis and (2) arithmetic rounding.

2.4.1.3 Bond matching and spot-rate yield curve approaches

A plan’s benefit cash flows are often such that the employer’s discount rate can be supported more consistently by using spot-rate yield curves or a specific bond matching approach rather than a benchmark approach. Some large actuarial firms have developed specific bond matching models and nearly all of the largest actuarial firms and other organizations have developed spot-rate yield curves to assist employers in developing their discount rate assumptions.
Although a helpful starting point, these approaches should be carefully reviewed to assess whether they incorporate appropriate bonds and bond pricing, effectively match the specific plan’s expected benefit cash flow stream, and incorporate reasonable assumptions about reinvestment of excess bond cash flows and yields for bond maturities in years in which no bonds exist (e.g., beyond 30 years). Some specific points to consider include:
  • Callable bonds should not be included in any bond matching (or included using the yield to the call date).
  • It is generally inappropriate to use the yield on a single issuer’s bond as the discount rate even if it is of equal duration and sufficient magnitude to the benefit obligation.
  • The objective in determining an appropriate discount rate using a bond-matching approach is to match cash flows of the plan to principal redemptions on zero coupon bonds. Because most publicly traded bonds included in the various models bear interest at a stated coupon, it would generally be appropriate to adjust the yields in the model (most likely upward) to reflect this difference.

2.4.1.4 Use of multiple discount rates

In recent years, some actuarial firms have proposed various approaches to change the calculation of an entity’s service cost and/or interest cost by using multiple (e.g., disaggregated) discount rates or spot rates reflective of varying employee demographics and timing of benefit payments. For companies that currently utilize a yield curve approach to calculate discount rates and the projected benefit obligation, assuming management believes it produces a better estimate of their benefit costs, a change to such an approach would be treated as a change in estimate under ASC 250, Accounting Changes and Error Corrections. To the extent that such a change produces a meaningful impact on interest cost in periods subsequent to the change, the financial statements or MD&A should include appropriate disclosure of the change and its impact on interest cost. Additionally, there are a number of potential calculation complexities to this approach to consider, including the impact on plans that allow lump-sum payouts.
For a reporting entity that currently utilizes the bond matching approach to calculate discount rates and determine its projected benefit obligation, it would likely be difficult to justify changing to a yield curve approach in order to utilize disaggregated spot rates to develop interest cost and service cost.
Regardless of the approach used – traditional bond matching or yield curve approach or a disaggregated yield curve approach – the measurement of the projected benefit obligation and the measurement of the ensuing period’s service and interest cost must be based on the same discount rate methodology. Said differently, it would not be appropriate for a reporting entity to use a bond matching approach to calculate the projected benefit obligation and a disaggregated yield curve approach to determine service and interest cost in the following period.

2.4.1.5 Negative interest rates

In some cases, particularly in certain non-US territories, observed yields on certain high-quality corporate bonds can be negative for certain bond durations. Depending on the magnitude and duration of benefit payments for a particular plan, these negative yields could meaningfully reduce the overall discount rate for a benefit plan or even lead to an overall negative discount rate, particularly for plans with primarily shorter-duration payments. While this is an unusual situation that was not specifically contemplated in the accounting guidance, we believe that the actual observed market rates should be utilized.
The objective when selecting assumed discount rates for purposes of measuring a plan’s benefit obligations is to determine the single amount that, if invested at the measurement date in a portfolio of high-quality corporate debt instruments, would provide the necessary future cash flows to pay the benefits when due. If high-quality corporate bonds available in the marketplace are trading at negative yields (i.e., their present value is greater than their nominal future cash flows), an employer would need to purchase an amount of bonds that exceeds the notional undiscounted future benefit payments to generate a stream of future cash flows to pay the benefits when due. In spite of the counterintuitive outcome, that is the economic reality of a negative interest rate environment. Therefore, we believe employers should use the actual yields, even if negative, on high-quality corporate bonds throughout the yield curve to measure their benefit obligations.

2.4.2 Expected long-term rate of return on plan assets

The expected long-term rate of return on plan assets is determined as of the measurement date and should reflect the average rate of return expected to be earned on the funds invested over the period until the benefits are expected to be paid. It is used in conjunction with the market-related value of plan assets (see PEB 2.6.5) to compute the expected return on plan assets component of periodic pension expense, discussed in PEB 3.
The expected long-term rate of return on plan assets should generally be based on the investment portfolio that existed as of the measurement date without consideration of proposed changes to the portfolio subsequent to the measurement date. We believe, however, that it may be acceptable for employers to consider probable changes in the portfolio mix (e.g., to bring it back in line with the target mix or to align with a new target mix), provided the changes will occur in a reasonable period of time and have been approved by the appropriate level of management. Judgment should be applied to determine whether a planned change is probable. The expected long-term rate of return on plan assets should also reflect the long-term earnings expectations on contributions to the plan expected to be received during the current year. Contributions expected to be made in future years should not be considered in determining the expected long-term rate of return on plan assets.
The most common approach to determining the expected long-term rate of return on plan assets is to develop a weighted average based on the mix of plan assets. Under this approach, the percentage of total plan assets of each component of the plan asset mix is multiplied by the expected asset return for that component. The sum of those asset mix weighted expected rates of return for each component are then added together to determine the total expected rate of return.
Figure PEB 2-1 illustrates the calculation of the expected long-term rate of return using a weighted average approach.
Figure PEB 2-1
Estimating the rate of return of plan assets
Component of the plan asset mix:
Percentage of total assets
Expected asset return
Expected rates of return for the component
Domestic equities
35%
9.0%
3.15%
Fixed income
32%
5.5%
1.76%
International equities
15%
9.0%
1.35%
Real estate
10%
7.0%
0.70%
Cash
3%
3.0%
0.09%
Private equity
5%
12.0%
0.60%
Impact of active management
(if applicable)
0.35%
Total adjusted rate of return
8.00%

Under this approach in Figure PEB 2-1, it is appropriate to consider the following:
  • Estimating the projection horizons for the expected returns. ASC 715 indicates that the rate of return should reflect the average rate of earnings expected on the funds invested to provide for the benefits in the PBO. Thus, the rate of return should be the rate to be earned over the period until the benefits are paid. Accordingly, it is necessary to consider the expected duration of the current PBO (i.e., without new entrants into the plan) in evaluating the time horizon for future expected earnings.
  • Assessing forward-looking capital markets returns for the individual asset classes. Using solely historical returns as an approximation of the rate of return may not produce an appropriate rate, particularly if the market has moved significantly in one direction in recent years. Accordingly, it may be more appropriate to consider forward-looking capital markets returns for the plan’s investments.
  • Projected returns should be reduced by any outflows associated with generating those returns. For example, if the benefit fund must pay taxes on its investment earnings, such taxes should be included in the projection of expected returns. Similarly, if investment management fees are charged against the actual return on assets, such outflows should be included in the expected return projection.
  • Considering the inflation component. The assumed long-term inflation assumption underlying the expected rate of return should be consistent with the inflation assumption underlying the salary increase and discount rate assumptions.
  • Determining the best estimate. The rate of return should be management’s "best estimate." Even if there is likely a range of potential returns, using either the most optimistic or most pessimistic assumptions is likely not reflective of the most likely scenario (best estimate).

2.4.3 Future salary and benefits levels

Many pension plans, and some OPEB plans, are pay related, requiring an assumption as to future salary increases. For example, an OPEB life insurance plan may define the amount of death benefit to be received based on the employee's average or final level of annual compensation. Although less common, an OPEB health care plan may define the retiree's deductible or contribution based on similar criteria. For pay-related plans, the calculation of the benefit obligation would reflect expected compensation levels, including changes attributable to inflation, seniority, promotion, and other factors. All assumptions should reflect consistent expectations of future economic conditions, such as future rates of inflation. ASC 715-30-55-20 addresses the interplay between assumed increases in salary levels and the selection of discount rates. See PEB 2.2 for additional discussion of salary and healthcare cost increase assumptions.

2.4.4 Caps or limitations in OPEB plans

An employer is required to measure its share of costs for health care services by projecting future costs. However, an employer's plan may have a limit or "cap" on the dollar amount of health care coverage it promises to pay. For these plans, the employer would measure its obligation for all years in which the cap is expected to be operative by estimating the future dollar amount of the annual cap. Only in those years in which the cap is not expected to be reached would the employer's obligation need to be calculated by making projections of future per capita health care costs. The cap may be defined in the aggregate for the retiree group. For example, an employer may agree to bear annual costs equal to a specified dollar amount multiplied by the number of plan participants in each future year. Alternatively, the cap may be defined on an individual participant basis. In these situations, if per capita claims cost estimates indicate that the cap will not be reached in certain years for at least some participants, projections of future health care coverage (rather than only the dollar-defined cap) would be required for those years.
Under these plans, the dollar-denominated cap can be fixed, increased automatically (indexed), or redetermined on an ad hoc basis. Therefore, the substantive plan approach (see PEB 2.2.2) may require an employer to anticipate increases in the dollar-denominated amount, or ignore the caps for purposes of calculating obligation and expense amounts, if:
  • The employer communicates its intent to raise the dollar-denominated amount (i.e., the cap) in the future (e.g., to keep pace with inflation), or
  • The actual increases in the dollar-denominated amount reflect a consistent past practice.

Judgment will be necessary to determine what constitutes a consistent past practice of increases.

2.4.4.1 Capped plans in collective bargaining arrangements

If the dollar-denominated caps are based on the results of collective bargaining with a labor union, there is a general presumption under ASC 715-60-35-55 that the caps should be included in the measurement (i.e., an increase in the caps included in the written plan should not be anticipated), even after a past practice of increases is established, because employers usually do not have the unilateral right to determine the magnitude of increases to a collectively bargained plan when each change in the plan must be bargained. Accordingly, if the plan is subject to union negotiation, employers should not anticipate future increases to the dollar-denominated caps. However, in some situations, an employer’s past practice in successive union negotiations may provide evidence that the substantive plan is different from the written plan, even in situations when offsetting changes were made to compensation or other benefits. All of the relevant facts and circumstances should be considered in assessing whether the substantive plan in those situations differs from the written plan. When an employer consistently waives the caps as part of multiple successive contract negotiations, this may be an indicator that the plan should be accounted for as if it were an uncapped plan, despite the fact that such waivers are negotiated and are accompanied by offsetting negotiated changes. Further, increases in caps or other plan terms that occur as a result of multiple contract negotiations may be an indicator that the substantive plan includes such increases on an ongoing basis. Even in situations when offsetting changes in other benefits or compensation have occurred or other significant costs have been incurred to maintain the cost-sharing arrangement, judgment still must be applied in determining the substantive plan and whether it differs from the written plan.
In some companies, the nonbargained employee group receives the same retiree health benefits as the collectively bargained employee group, and changes to the bargained plan have historically been made to the nonbargained plan at the same time. In that case, the facts and circumstances of each plan will need to be assessed, including past practices and cost sharing arrangements, in order to determine the substantive plan of each employee group.
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