Actuarial Gains or Losses
Occur when there are any changes in the present value of a defined benefit plan's projected obligation
What are Actuarial Gains or Losses?
Actuarial gains and losses occur when there are any changes in the present value of a defined benefit plan's projected obligation. These results occur from shifts in any actuarial assumptions or benefit structure.
These changes can be caused by many factors, like:
- Changes in demographic assumptions
- Changes in economic conditions
- Changes in plan design
Actuarial gains and losses are the difference between a defined benefit plan's expected and actual outcomes.
They can be positive or negative and significantly impact an organization's financial statements:
- A significant actuarial loss could decrease the net assets available for benefits, negatively affecting the pension plan's overall financial health.
- A significant actuarial gain could increase net assets available for benefits, positively affecting the pension plan's overall financial health.
These gains and losses must be recognized on an organization's financial statements under various accounting standards like the US GAAP and the IFRS.
This provides transparency to stakeholders who want to understand the organization's financial health to make investing decisions.
NOTE
Actuarial gains and losses are crucial to reporting defined benefit plans. Organizations must understand their impact to take appropriate actions and manage them effectively.
Key Takeaways
- Actuarial Gains or Losses occur when the present value of a company's defined benefits plan differs from the actual liability incurred.
- They are required to be reported on the company's financial statements according to US GAAP and IFRS.
- Actuarial Gains or Losses occur from changes in demographic factors, risk assumptions, and plan design.
- These gains or losses can be managed by planning carefully, proper due diligence, and monitoring the plan's progress.
- Actuarial Gains or Losses can be calculated using the Projected Unit Method (PUC)or the Entry Age Normal Method (EAN).
Understanding Actuarial Gains Or Losses
Actuarial gains and losses may seem like a technical concept that only professionals in the financial industry would understand. But it is relevant to everyone who plans to or is investing in a pension plan.
These gains and losses can occur due to a variety of factors, such as
- Demographic Changes
- Economic Conditions
- Plan Design
These changes can significantly impact the financial health of the pension plan and the organization behind it.
Understanding this concept is essential for individuals who want to make informed investment decisions and organizations that want to manage their pension plans effectively.
This article aims to break down the concept of actuarial gains and losses & the strategies for managing them.
We will look at the following:
- The different types of gains and losses that exist
- How to calculate them
- How they can impact the financial statements of the organizations behind them
We will also review the reporting requirements under various accounting standards, such as US GAAP and IFRS, and look at strategies for managing actuarial gains and losses, such as through changes in plan design, funding policies, or investment strategies.
Actuarial gains and losses are significant in the context of pension plans. They can impact the financial health of a plan. We will provide real-world examples of actuarial gains and losses and their impact on organizations and cover the current trends and future outlook.
Types of Actuarial Gains or Losses
Gains and losses for a defined benefits plan can occur due to various changes. Depending on the type of plan, the most common factors that influence gains and losses are:
1. Demographic Gains and Losses
This stems from changes in the demographic assumptions used in calculating a pension plan's projected obligations.
This includes:
- Changes in life expectancy
- Retirement age
- Workforce turnover
These can impact the expected cost of providing benefits to plan participants.
2. Economic Gains and Losses
This stems from changes in economic conditions.
This includes:
- Interest rates
- Inflation rates
- Market returns
All of these can impact the present value of the benefit plan obligation.
3. Plan Design Gains and Losses
This stems from changes to the design of the pension plan.
This means:
- If a plan adds benefits, the present value of the projected benefit obligation will increase, resulting in a loss.
- If a plan loses benefits, the present value of the projected benefit obligation will decrease, resulting in a gain.
4. Experience Gains and Losses
This occurs when experience differs from the assumptions used in calculating the projected benefit obligation.
This means:
- If actual mortality rates are lower than expected, the present value of the projected benefit obligation will be lower than expected, resulting in a gain.
- If actual mortality rates are higher than expected, the present value of the projected benefit obligation will be higher than expected, resulting in a loss.
5. Asset Gains and Losses
This stems from changes in the market value of the plan's assets.
This means:
- If the actual return on plan assets is higher than expected, the plan will experience an asset gain,
- If the actual return is lower than expected, the plan will experience an asset loss.
NOTE
Understanding the various types of actuarial gains and losses will help companies properly track and manage them to account for their financial impact on the organization.
Calculation of Actuarial Gains or Losses
Firms use complex models that use a combination of actuarial assumptions, demographic data, and financial data to estimate the present value of a defined benefit plan's projected benefit obligation. Then, after the real experience occurs, a plan can recognize a gain or a loss.
These calculations are typically done by an actuary with expertise in these models, as they can provide a reliable estimate of the plan's financial impact. There are two methods for calculating actuarial gains and losses:
- Projected Unit Method (PUC)
- Entry Age Normal Method (EAN)
The PUC method estimates the present value of each participant's projected benefit obligation by discounting their expected future benefits back to the present using a discount rate.
The PUC method considers various factors to estimate the present value of the projected benefit obligation, such as
- Service credits
- Salary projections
- Mortality assumptions
The projected benefit's obligations' actual value is compared to the present value of the expectation. Any difference between the actual and expected values is the actuarial gain or loss.
NOTE
The entry age normal (EAN) method is similar to the PUC method. Still, instead of individually projecting each participant's benefits, it estimates the total cost of providing benefits to all plan participants. It allocates that cost based on each participant's age and service.
In addition to these methods, some plans may use a cost method, such as the aggregate cost method or the frozen initial liability method. These methods are typically used for smaller plans or with a simpler benefit structure.
Actuaries regularly update their calculation assumptions to ensure the estimates are based on current data and the plan's financial position is accurate.
Impact Of Actuarial Gains Or Losses on Financial Statements
Gains and losses from actuarial assumptions changes can significantly impact the financial statements of a defined benefit plan's sponsors. They have different impacts on each statement:
Income Statement
Gains and losses are reflected in the income statement as a component of the other comprehensive income (OCI). However, OCI is a separate category in the income statement that captures gains or losses not included in the net income.
They are recorded in OCI in the year they are incurred. After that, they are recognized in the income statement over some time. This can result in significant fluctuations in reported net income yearly.
Balance Sheet
Gains and losses on the balance sheet are reflected in the plan's funded status.
The funded status represents the difference between the projected benefit obligation (PBO) and the fair value of plan assets. The plan is said to be underfunded if the fair value of plan assets is less than the PBO.
Conversely, the plan is said to be overfunded if the fair value of plan assets is greater than the PBO. This can impact the liability or assets reported on the balance sheet.
Statement Of Cash Flows
Actuarial gains or losses do not typically impact the organization's cash flows because they are non-cash items.
However, they can impact the cash contributions required to fund the plan. The organization may be required to make additional cash contributions if the plan becomes underfunded due to actuarial losses to return to a fully funded status.
Actuarial Gains Or Losses Reporting Requirements
Companies with defined benefit plans must report any gains or losses in their financial statements under various accounting standards, such as US GAAP and IFRS.
The reporting requirements under these accounting standards are discussed below:
Reporting Requirements Under U.S. GAAP
Under US GAAP, gains/losses are reported in the financial statements as a component of the other comprehensive income (OCI).
Specifically, they are reported as a component of the pension liability or asset in the balance sheet.
The amortization of these gains and losses from OCI to net periodic pension cost is recognized over the plan participants' expected average remaining service life or the plan participants' average remaining life expectancy if they are retirees.
Reporting Requirements Under IFRS
Under IFRS, gains/losses are also reported in the financial statements as a component of the other comprehensive income (OCI).
They are reported as a component of the total comprehensive income in the statement of comprehensive income.
The amortization of these gains and losses from OCI to net periodic pension cost is recognized over the plan participants' expected average remaining service life.
NOTE
It is important to note that there are specific measurement requirements under both US GAAP and IFRS. Assumptions related to discount rates, mortality rates, and factors used in calculating the benefit plan's liability must be listed specifically.
There are also regulatory requirements related to reporting and accounting standards. For example, organizations like the Pension Benefit Guaranty Corporation (PBGC) require companies to report any gains and losses in their annual report.
Companies should understand the accounting regulations because failure to do so may lead to negative sanctions on the company.
Managing Actuarial Gains or Losses
Managing actuarial gains or losses can be a complex and challenging task for organizations that sponsor defined-benefit pension plans, but some strategies can mitigate their impact:
Changes In Plan Design
One way to manage gains and losses is to change the plan design. For example, organizations can consider changing the benefit formula, increasing the retirement age, or modifying the vesting schedule.
These changes can help reduce the volatility of the plan liabilities and make it easier to predict future costs.
Funding Policies
Another strategy to manage gains and losses is to adjust the funding policies. For example, organizations can consider increasing their contributions to the plan when there is an actuarial loss or decreasing their contributions when there is an actuarial gain.
This can help to smooth out the impact of these gains and losses on the financial statements and reduce the likelihood of future funding shortfalls.
Investment Strategies
Organizations can also manage gains and losses by adjusting their investment strategies.
Organizations can consider hedging strategies to reduce the impact of market volatility or invest in less volatile assets, such as fixed-income securities.
Actuarial Assumptions
Adjusting the actuarial assumptions to calculate the plan liabilities is another way to manage gains and losses.
For example, organizations can adjust the discount rate or the mortality assumptions. These adjustments can help better reflect the plan's future expected cash flows and reduce the plan liabilities' volatility.
The optimal approach will depend on the specific circumstances of the organization.
Effective management of gains and losses requires companies and actuaries to
- Plan carefully
- Analyze the situation
- Monitor progress regularly
This ensures the organization is well-positioned to meet its obligations to plan participants while maintaining a stable financial position.
Why are Actuarial Gains or Losses Important for Pension Plans?
These actuarial assumptions are important for pension plans because they greatly impact their financial health.
As mentioned earlier, an actuarial gain or loss is determined by the difference between the expected and actual performance of a defined benefit plan's liability. These differences can be caused by factors like:
- Demographic assumptions
- Economic conditions
- Plan design
These actuarial assumptions can directly impact the funding status of the plan.
- If there is a loss, the plan's liabilities increase, and the funded status decreases.
- If a gain exists, the plan's liabilities decrease, and the funded status increases.
This funding status is critical because it determines the level of contributions that the plan's sponsor must make to meet its obligations to the plan participants.
An underfunded plan may require the sponsor to take on more of a financial burden that can impact its ability to invest in other areas. They are also very important to accounting regulations.
Any gains or losses from a change in actuarial assumptions must also be recorded as other comprehensive income (OCI) on its balance sheet. This can impact the financial position of the organization as well, causing fluctuations in a reported net income or loss.
Effective management of these gains and losses is critical to the long-term financial health and the ability of the plan sponsor to meet its obligations to plan participants.
It requires careful planning, analysis, and ongoing monitoring to ensure that the plan is well-positioned to navigate the complex and ever-changing landscape of pension plan management.
Future Trends of Actuarial Gains and Losses
As accounting regulation evolves, how actuarial gains and losses are reported is bound to change. However, here are some trends to look out for:
New Accounting Standards
With finances evolving, new accounting standards would be created to regulate them. This includes ASC 715 under US GAAP and IAS 19 under IFRS.
These are done to increase transparency and consistency for investors trying to understand the financial health of an organization.
Increased Focus on Risk Management
Organizations will become more aware of the risks that come with long-term obligations. As a result, they may try new investment strategies and plan designs that align better with their risk tolerance.
Low-Interest Rates
Recent years have seen lower interest rates. When interest rates are low, the present value of future benefit payments increases, creating losses. Conversely, when interest rates are high, the present value of future benefit payments decreases, creating gains.
Integration Of Technology
New software may make risk analysis easier, reducing the variability of gains or losses. Artificial intelligence may be able to highlight new factors that cause gains and losses so firms can better manage their long-term obligations.
Organizations that stay abreast of these trends and adapt their strategies accordingly will be better positioned to manage their long-term obligations and ensure their financial health over the long term.
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Summary
Actuarial gains and losses occur when there are changes in a defined benefit plan's obligation's present value.
This can occur from
- Changes in actuarial assumptions
- Changes in economic conditions
- Changes in the design of the plan
These can have significant impacts on the financial statements of an organization. The most impacted statements are:
- Income statement
- Balance sheet
- Statement of cash flows
The two methods of calculating the actuarial gain or actuarial loss that has occurred are the
- Projected Unit Credit Method
- Entry age Normal Method
These gains and losses must be reported, but how they are reported varies between accounting standards like US GAAP and IFRS.
Strategies for managing actuarial gains or losses include changes in plan design, funding policies, or investment strategies.
These are especially important for pension plans, as they can impact the financial health of a plan and its ability to pay out future benefits.
Future trends may include:
- Changes in accounting standards or regulations.
- Advances in technology and data analysis.
- An increasing focus on risk management and sustainability.
Actuarial Gains Or Losses FAQs
They are changes in the present value of a pension plan's, or another defined benefits plan, liabilities.
It can be caused by a variety of factors, including
- Changes in economic conditions
- Changes in demographic assumptions
- Changes in plan design
- Changes in investment performance
They are usually calculated by comparing the actual liability of a pension plan to the assumptions used in the plan's funding and accounting calculations.
Organizations can manage actuarial gains or losses by adjusting their plan design, funding policies, or investment strategies. They can also use accounting techniques such as smoothing or corridor methods to reduce the impact of these gains or losses on their financial statements.
Reporting requirements for actuarial gains or losses vary depending on the accounting standards, such as US GAAP or IFRS. Generally, organizations are required to disclose these in their financial statements and footnotes.
They can have a major impact on the plan's financial health. Therefore, understanding and managing these gains or losses is critical to the long-term sustainability of the pension plan.
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