FAS 87 is often the preferred due diligence tool in Mergers and Acquisitions. The purpose is to quantify the value of the pension plan. Even when the sales price does not vary depending on the results, such an analysis is useful to the buyer.
The problem is, FAS 87 produces a pile of numbers and, unless the parties have agreed to the use of one of them in advance (ha!), someone needs to determine which is pertinent to the transaction.
We are not going to tell which one to use in which situation. We are going to tell you what each means. Since M&A are typically "one shot" situations, we will discuss only the "liability" items; we will not address any part of the Net Periodic Pension Cost.
Accrued or Prepaid Pension Cost. This is the liability (asset) that actually shows up on the balance sheet of the sponsoring employer. Unlike most things that we actuaries call liabilities, this one is in the true, accounting sense of the word, a liability. However, it is one of the balance sheet items that gets adjusted in an M&A situation; it may not reflect the employer's true financial promise to the employees embodied in the retirement plan [footnote (1)]. It merely represents the accumulated shortfall in cash payments versus FAS 87 charges to income to the time of the transaction.
Additional Liability. This represents the difference between the Accumulated Benefit Obligation and the sum of the assets and the Accrued Pension Cost. Since it is calculated from the Accrued Pension Cost, it doesn't have much validity in M&A. Any validity it does have derives from the user's belief in the ABO, which will be coming up in a moment.
Intangible Asset. This is somewhat of an artificial offset to the Additional Liability, and is only calculated when there is an Additional Liability. It recognizes the employer's program of Net Transition Obligation and/or Past Service liability amortization. Since it is based directly on the additional liability, it can have validity only if you assign validity to the Additional Liability.
Vested Benefit Obligation. The VBO is a very artificial actuarial number based on pre-high-tech actuarial techniques. In the "old days," doing calculations for every possible reason for leaving employment at every possible year was an enormous (and thankless) job. Since the most important benefit provided by retirement plans was the normal retirement benefit and it was fairly easy to calculate, it frequently was the only value calculated. Based on the knowledge that few employees would actually stay until normal retirement, actuaries calculated a portion of the retirement liability based on the vesting provisions of the plan and called it the "vested liability." As technology improved our ability to calculate the various liabilities related to a retirement plan, ERISA was written and embodied the concept of the vested liability. It has persisted. Today, it represents a portion of a member's claim to future benefits and often shows up in plan termination calculations.
The Sum of Voluntary Severance Benefits. This number is the straight sum of the benefits that would be paid by the plan if every member voluntarily quit at the time of the calculation. Since there are no present values involved and the benefits used are pretty much the same ones as used in the VBO, it exceeds the VBO. It's typical use in Japan is the calculation of the tax deduction for plans that have some balance sheet funding ("Book Reserve" plans). It is the value that each member actually has control of under the terms of the plan - he need only quit to get his hands on the money!
Accumulated Benefit Obligation. The ABO represents the actuarial value of each member's claim to future benefits based on their service to date and assuming they never get an increase in pay. Unlike the VBO, there are two ways to calculate the ABO; accrual attribution and pro-rata attribution. Under the rules of FAS 87, the method used for the PBO must also be used for the ABO. Since the typical reason for using pro-rata attribution is in calculating the correct Net Periodic Pension Cost under FAS 87, either, or both, of the parties to an M&A may want to specifically request departure from the rules of FAS 87 and ask for an accrual calculation regardless of whether FAS 87 would require a pro-rata calculation or not. The accrual calculation more precisely represents the member's claim based on actual service and the rules of the plan.
The Sum of Involuntary Severance Benefits. This number is the straight sum of the benefits that would be paid by the plan if every member were involuntarily severed a t the time of calculation. It ignores present values and future pay increases as one might expect. In Japan, in can be quite different from the sum of voluntary termination benefits. In North America, it tends to be equal to the voluntary, since the two causes of severance are generally not differentiated in NA plans - they draw the same benefit.
Projected Benefit Obligation. This is the member's share of the present value of all future benefits at the time it is calculated. The benefit calculations include the impact of future pay increases. The member's share is calculated in one of two different ways; the accrual attribution method or the pro-rate attribution method. As with the ABO, the accrual attribution method probably better reflects the value of accrued benefits than the pro-rata method since it is based on the rules of the plan. In order to consider the PBO appropriate for pricing, the parties need to agree that future pay increases are pretty close to guaranteed in the industry and therefore should be a liability of the seller.
Each of these numbers derives from the same source; the rules of the plan and the demographic characteristics of the employees. In the background, but not discussed in this issue, is the further question of appropriate discount rates for the calculation of those values that require one. Maybe next time!
Footnote: (1) We will assume that the target organization has only one retirement plan to simplify the discussion. Remember, however, in reality, an employer may have several retirement plans, some that are not documented. Part of the job of due diligence is to identify them.
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