Senior Director | CAPTRUST Defined Benefit Practice Leader
In the previous article, my colleague Hunter Brackett outlined CAPTRUST’s process for determining capital market assumptions and set expectations for lower returns going forward for the next five to seven years. This has particular implications for defined benefit plan sponsors following U.S. Generally Accepted Accounting Principles (U.S. GAAP). Specifically, the Financial Accounting Standard Board’s (FASB) Accounting Standards Codification 715-30 outlines expense recognition for defined benefit pension plans on the income statement. One key component in this calculation is the expected long-term rate of return on plan assets (EROA), which is derived from a number of factors, including capital market assumptions.
FASB defines the EROA as “the average rate of earnings expected on the funds invested or to be invested to provide for the benefits included in the projected benefit obligation.”1 The EROA is essentially a credit to the income statement each year. If lower capital market assumptions imply a lower earnings expectation — and plan sponsors choose to reduce their EROA — it follows that their income statement must reflect a corresponding negative impact. Note that accountants amortize a combination of the difference between actual returns and the EROA with other factors on the income statement over a longer period of time. Making accurate 20 to 30 year return predictions is nearly impossible, which is presumably why the accounting standards allow for amortization of actual results relative to assumptions over a long time horizon. The key takeaway is that your EROA assumption should reflect what you actually think you can earn on invested assets over a long period of time.
While plan actuaries and financial statement auditors provide some oversight, the plan sponsor has ultimate responsibility for determining a plan’s accounting assumptions, including the EROA. Not surprisingly, many plan sponsors in turn look to CAPTRUST for information to help determine their plan’s EROA during the year-end audit process.
Given CAPTRUST’s lower forward-looking capital market assumptions for the next five to seven years, what should plan sponsors do?
• First and foremost, select an EROA that accurately reflects realistic potential earnings over the life of the projected benefit obligation. Note that this period of time may be significantly longer than our capital market assumptions’ time horizon of five to seven years.
• Consult with your actuary and auditors before the audit process begins to identify an assumption that is appropriate for your organization given:
• Capital market assumptions or forecasts from multiple research sources
• Your plan’s investment strategy and asset allocation
• Historical asset class performance
• Industry standard and peer assumptions
• When in doubt, the conservative accounting practice is to use a lower assumption. A quick Google keyword search on “ASC 715 Assumption Trends” will return countless data sources in support of this practice.
Crafting this message has me feeling a bit like a Shakespearean messenger wishing to avoid being “stew’d in brine ” 2 for delivering unsavory news. An appropriate response from the messenger in Shakespeare’s Antony and Cleopatra when delivering the news of Antony and Octavia’s marriage to a waiting Cleopatra …“I that do bring the news made not the match.” 2
In modern English (as opposed to Shakespeare’s early modern version), we are acutely aware of the fact that lowering our assumptions may create short-term budgeting challenges for plan sponsors following U.S. GAAP. However, we feel strongly that we should convey our best ideas given the global capital market opportunity set — despite the spirited discussions that may follow.
While we do not provide accounting advice, we remain committed to helping our clients navigate these and other challenging issues. If you have any questions concerning the implications of this change to your organization or would like to discuss this issue in more detail, please contact your CAPTRUST Financial Advisor.
2 Antony and Cleopatra, Act 2, Scene 5, William Shakespeare