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June 1993

Changes in actuarial assumptions/plan designs after FASB 106. (Accounting)

by Neuwirth, Peter

    Abstract- Statement of Financial Accounting Standard No 106, otherwise known as 'Employers' Accounting for Postretirement Benefits Other than Pensions,' states that employers must accumulate the future cost of postemployment health care benefits during the active years of service of employees. The mandate replaces the pay-as-you-go basis for accounting for health benefit costs, thus, creating substantial financial-statement changes for employers. One of these changes is the inclusion of the expected postretirement benefit obligation (EPBO) on the balance sheet. EPBO is defined as the actuarial current value of benefits to be paid upon employee retirement. After the computation of the plan benefits' actuarial present value, the yearly retiree benefits cost and the accumulated postretirement benefit obligation are measured through a specified actuarial method. A case analysis showing the impact of various actuarial assumptions and health plan designs is presented.

A true case shows the sensitivity of an employer's expense and liabilities to different actuarial assumptions and various health care plan designs. This sensitivity analysis will give preparers and users of financial statements an idea of the different consequences of SFAS No. 106.

Accounting for Nonpension


Measurement Issues. The primary measure of the obligation at each balance sheet date is called the expected postretirement benefit obligation (EPBO) which is the actuarial present value of benefits expected to be paid during the retirement period. As with the calculation of pension liabilities, in order to determine a company's EPBO, assumptions are needed regarding mortality, retirement date, employee turnover, discount rate, etc. In addition, the projection of retiree health care costs requires estimates of the medical cost trend rate, the portion of cost to be reimbursed by Medicare, and marital and dependency status during retirement.

Recognition Issues. Once the actuarial present value of plan benefits has been determined through the measurement process, each employer must use a specified actuarial method to compute the annual retiree benefits expense and the accumulated postretirement benefit obligation (APBO), the portion of the EPBO attributed to service rendered prior to the measurement date. Attribution is the process of assigning the cost of retiree benefits to periods of employee service. Therefore, the primary question is what is the appropriate attribution period. Under the FASB's Statement No. 106, the cost would generally be recognized from the date of hire to the date the employee attains eligibility for the maximum benefits earned under the plan (full eligibility date).

Employers' Reaction: Reduction

of Their Commitment

Employers' increasing financial obligation associated with their retiree benefits is understandable if statistical data is examined. In 1989, the U.S. General Accounting Office (GAO) estimated employer- sponsored retiree health plans covered about seven million retirees, at a cost to employers of approximately $9 billion. Recent estimated projections for aggregate unfunded obligations for private employers to date have ranged from approximately $227 billion to approximately $250 billion. According to the study by GAO in 1988, companies can anticipate an additional $175 billion in obligations when future service is taken into account.

Many U.S. companies are aggressively attempting to limit their own liability as they confront changes in accounting rules, growing medical costs, an aging workforce, and demanding shareholders. Several reactions have taken place. First, many companies work feverishly to hold down cash outlays in many ways. For example, they sign a contract with a larger insurer or a health-care company that has a network of hospitals and doctors. The contract provides an insurer or a health-care company with an incentive to hold down costs because it will pay all or a certain percentage of expenses that exceed a given amount. First Interstate Bancorp, Proctor & Gamble, Wang Laboratories, May Department Stores, Southwestern Bell, and Allied-signal have announced such arrangements. Second, employers shift far more of the financial risk to employees and settle for fewer benefits for employees by modifying plan design. Examples of such changes include increasing or imposing retiree contribution levels or deductibles and co-insurance levels, reducing benefits and coverage, changing coordination of benefits with Medicare, establishing a ceiling on the level of benefits, and requiring employee prefunding.

Case Analysis

Choose a relatively mature service company listed on the NYSE. Table 1 summarizes the company's demographic information, current medical benefits being provided to employees, and actuarial assumptions used in the measurement process. The firm's medical plan is quite common across firms. Using the rules in Statement No. 106 and actuarial assumptions, we find $25.8 million of accumulated postretirement benefit obligation (APBO) and $4.6 million of annual accrual expense, which includes $1.16 million of the service cost component. Under the baseline set of assumptions, the annual expense is 7.2 times higher than the annual cash payments.


Table 2 provides some sensitivity analysis showing how these numbers change after relaxing some actuarial assumptions. First, changing the average retirement age to 64.5 does not show a material difference in accrual numbers (APBO, service cost, and annual expense), but cash flow is reduced by 2.3%. Second, changing the discount rate to 9% decreases accrual numbers by 5 to 10% while cash flow remains unchanged. Third, reducing the medical cost trend rate by 1% results in even more significant reductions in the accrual numbers. As can be seen, results are extremely sensitive to both changes in discount and trend rates. Furthermore, since medical trend rate estimates are more subject to differences of opinion, it can be argued that the trend rate assumption is the one which will have the greatest impact on the determination of obligations under SFAS No. 106. Fourth, increasing employee turnover to T-8 reduces accrual numbers by 4 to 13% while cash flow remains unchanged. It is quite interesting to note that service cost component is the most sensitive to the changes in turnover.


Finally, changing all four assumptions, we find APBO and annual expense decrease by 20% while cash flow changes less than 5%. Relaxing all four assumptions from the baseline produces annual expense which is 5.9 times higher than cash payments, compared to 7.2 times before the changes.

Table 3 shows the effects of changes in plan designs from assumption six in Table 2 accrual numbers and cash payments. As discussed previously, many U.S. companies have attempted to reduce their own postretirement health care liability by modifying plan designs. Distinct from the assumption changes, plan design modifications can significantly reduce cash payments as well as accrual numbers. The first modification in the table is to confine coverage to retirees for pre-65 retirement. This modification can reduce accrual numbers by 4 to 8% while decreasing cash payments by 10%. Second, if the company limits the annual maximum benefit to $10,000, accrual numbers can decrease by 28 to 40% while 1993 cash payments remain unchanged. In this case, the ratio of annual expense over cash payments is reduced from 5.9 to 4. Third, reducing the plan's lifetime maximum from $250,000 to $100,000 can reduce accrual numbers by 18 to 25% while cash payments remain unchanged in 1993. In the event of either a reduced annual maximum or lifetime maximum, cash flow will be reduced in the long run. Fourth, the change of the Medicare integration method lessens accrual numbers by 43 to 49%, and cash flow is reduced by the same rate. Finally, by utilizing a fixed dollar credit approach, firms can shift the risk of medical cost inflation completely to employees and retirees. As a consequence, accrual numbers can be drastically reduced by 82 to 86% while cash flow is reduced by approximately 32%. The ratio of annual expense over payments under this approach is only 1.7.


The tables show that assumptions as to future medical cost increases are very critical not only for the measurement process, but for future cash flow. Also, financial statement readers, should pay special attention to the disclosure items required by SFAS No. 106, because the accrual numbers are very sensitive to employers' selection of assumptions and plan design.


As employers confront changes in accounting rules, growing medical costs, and an aging workforce, they must seriously consider the financial impact of SFAS No. 106. Firms will generally do their own sensitivity analysis to choose the most appropriate disclosure policy required. This case provides readers with a valuable insight of the consequences of the new accounting rule for retiree health care benefits by looking at an actual complete sensitivity analysis, which addresses potential changes in both actuarial assumptions and plan designs.

The study has some limitations. First, it deals with a single case which by necessity has its own unique features; second, no multi-year effect is presented. However, we can conclude that while actuarial assumption changes provide a certain limited range of effect on accrual numbers, accrual numbers are very sensitive to modifications in plan design, particularly those which reduce or eliminate the need to project future increases in medical costs. Also, the cash flow effect is much more discernible for changes in plan design rather than changes in actuarial assumptions.

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