SEC challenging long term rate of return assumptions 9% or more

[Guest Ben Sears]

There was an article in the February 3, 2003 issue of Pensions & Investments (p. 1) about the SEC intending to challenge companies with DB plans that assume long term rates of return of 9% or higher. The story said SEC associate chief accountant Todd Hardiman said in a speech to accounting professionals that the action is prompted by investor concerns about companies using articifically high return assumptions on their pension assets.

Hardiman said in his speech that the SEC arrived at the 9% figure by examining historical returns on large cap comestic stocks and corporate bonds between 1926 and the first three quarters of 2002. In that period, stocks have earned avarge returns of 10% and bonds, 6%. The article says, as SEC officials review annual corporate filings over the next few months, they will check whether the rates of return companies assume on their pension assets are consistent with the historical compound average returns on portfolios with similar asset allocations. This reference to Hardiman's speech is all I have seen on this, haven't seen anything official from the SEC. Has anyone seen any further details on the SEC position or anything official from the SEC?

[david rigby]

Nothing specific, but this should not be a surprise to anyone. It is correct that the rate should be reasonable. Any plan sponsor should be able to defend the choice of any assumption, although a range of reasonbleness almost always applies.

Suppose average equity return is 10% and bonds 6%, then a 60/40 asset mix gives about 8.4%. Thus, if the SEC is going to let 9% slide by, then they may have been generous.

[MGB]

Other SEC staffers have said that they will "question" rates of return above 9% for 2002, but absolutely will not accept it in 2003. I think this includes 9%; not that 9% gets a free pass.

For those that have other-than-12/31 fiscal years, they have already been given a surprise by the SEC when they filed last year (early in the year the form letter was quite short, but by 9/30, the form letter has gotten much longer). With the 12/31 filings happening over the next week, there will be a flood of these requests coming out from the SEC.

The SEC is asking for a HUGE explanation of the assumption setting process and what it means to future cash flow and expensing. This is in conjunction with the Management Discussion and Analysis; it is not governed by SFAS 87 in the footnotes. In this round, they are not asking for the annual report to be redone. Instead, they want companies to respond to the SEC, and then include this information in future filings. I do not know what triggers these letters. It may only go to those with something that raised a red flag; it may only go to large companies; it may only go to those whose pension assets are large in comparison to the operations; or it may go to everyone.

The following is an example of the questions they are asking be discussed in the MD&A:

Please expand in future filings your MD&A discussion to describe any known

trends and uncertainties related to your pension plan that will likely

result in a material change in your results of operations, financial condition, or

your liquidity. Your description should allow a funding obligation, and the

likelihood of materially different reported results if different assumptions

or conditions were to prevail. Consider addressing the points below to the

extent necessary for an understanding of your particular facts and circumstances.

* the source you use to determine your discount rate assumption,

including rating and maturity information;

* the method you use to determine the market-related value of plan

assets and, if you use a calculated value, the systematic and rationale method you

useto recognize changes in fair value;

* the estimated effect of any net unrealized pension asset market gain

or loss on future periods and a discussion of the extent to which it is

indicative of a potential directional change in future estimates of the expected

long-term rate of return on plan assets;

* the assumed asset allocation of your pension plan assets (common

stock, bonds, etc.); the extent to which it differs from the plan's actual asset

allocation at the reporting date and the reasons why;

* the method used to determine expected return for each asset category,

including the time period you use to analyze historical results, whether you

base your assumption on an arithmetic or geometric average of historical

returns, and the impact of using the arithmetic average rather than the

geometric average, if applicable;

* a description of the expected level of volatility in pension plan

asset returns, for example a pension plan that has significant investment in

international stocks may estimate a higher return but also expects greater

return variability year to year;

* the extent to which net pension credits/debits enhanced/reduced income

from operations;

* the extent to which changes in cash flows resulted from changes in

pension plan funding requirements;

* an explanation of the reasons for differences, if any, between the

assumed discount rate and assumed expected long-term rate of return on plan assets

used for pensions (i.e., SFAS 87) and those used for postretirement benefits

other than pensions (i.e., SFAS 106);

* a sensitivity analysis that expresses the potential change in pension

expense and funding requirement that would result from hypothetical changes

to expected long term return on plan asset assumptions, holding constant both

your discount rate and other assumptions and explains your basis for selecting

the hypothetical changes; and

* a sensitivity analysis that expresses the potential change in pension

expense and funding requirement that would result from hypothetical changes

to your discount rate, holding constant both your rate of return on plan assets

and other assumptions chosen for this year and explains your basis for selecting

the hypothetical changes.

[david rigby]

We have received a letter from auditor with the same questions described in MGB's post. I wonder how actuaries are planning to respond to these items.

[Guest Ben Sears]

Thanks for the posts, pax and MGB. Very helpful information.

[mbozek]

Pax:I thought that the auditors for the company have the responsibility for reporting the compnay's financial condition to the SEC. The auditors take the actuaries assumptions into account but are not required to adopt them.

[Mike Preston]

In the real world, the auditors do not have the ability to (nor do they want to) calculate the numbers required under the various rules of disclosure. This always falls to the actuaries. As far as the assumptions being the clients (or the auditors), the fact is that, in general, plan sponsors will look to the actuaires for guidance in these matters.

[MGB]

As of next year, the auditor is forbidden to do the calculations under the auditor independence rules. The company must do it internally or hire outside expertise, i.e., an actuary (that is not affiliated with their auditor). Most of the companies that do these in-house are insurance companies because they already have actuaries on staff. A handful of other large firms have internal actuaries, but still use outside actuaries to oversee the internal work.

The auditor has the final say in what the assumptions will be (or else can refuse to sign off on a clean audit). However, if they want something different, the client still goes back to the actuary to rerun the numbers.

[AndyH]

MGB, are you saying, for example, that one of the big 4 (or whatever number it is) auditing firms can no longer can do FAS actuarial work?

For example, we have a client that used to have their auditor do FAS#106 calcs while we did FAS#87 calcs. Now they've asked us to quote the FAS#106 work also. We're not sure why. Is this why? Can you point me to something in print? Thank you.

And p.s., does this apply only to a publicly traded company?

[MGB]

The rules are the SEC regulations under the Sarbanes-Oxley Act of 2002 concerning auditor independence.

It technically does not apply to a company that is not subject to the SEC's jurisdiction. However, whoever (e.g., lenders) is using their audited financial statements would expect such independence.

http://www.sec.gov/rules/final/33-8183.htm

Note that under the previous rules, SFAS 87 and 106 work was a specific exemption under "valuation services", not "actuarial services". Actuarial services is considered to be insurance company reserving only. Under the new rules, the exemption for SFAS 87 and 106 was dropped.

[AndyH]

My situation is a mutual insurance company. I assume that it would not fall under the SEC's jurisdiction, but insurance companies have their own funny FAS rules, so maybe they are towing this line as well. I can look at it from that angle. Thank you.