Studies
Studies 

VALUATION OF HYBRID RETIREMENT PROGRAMS

Lyndon F. Fadri, FASP, ASA

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I. INTRODUCTION

 

The Philippine Accounting Standards No. 19 classifies retirement programs into two major categories - the Defined Contribution (DC) plan and the Defined Benefit (DB) plan. It states that:

 

"Post-employment benefit plans are classified as either defined contribution plans or defined benefit plans, depending on the economic substance of the plan as derived from its principal terms and conditions. Under defined contribution plans, an entity pays fixed contributions into a separate entity (a fund) and will have no legal or constructive obligation to pay further contributions if the fund does not hold sufficient assets to pay all employee benefits relating to employee service in the current and prior periods. The Standard requires an entity to recognise contributions to a defined contribution plan when an employee has rendered service in exchange for those contributions."

 

What about hybrid plans otherwise known as Defined Contribution with Minimum Defined Benefit plans?

 

Under these plans, the employee is paid with the higher of (1) the accumulated contributions including earnings commonly called the account balance; and (1) minimum defined benefit e.g. one (1) month salary per year of service. DC plans here in the Philippines are effectively hybrid plans as Republic Act 7641 mandates a minimum defined benefit for eligible retirees. The notable DC plans in the country are the Catholic Educators Association of the Philippines (CEAP) and the Philippine Employers Retirement Association (PERAA) retirement programs.

 

From the above PAS 19 provisions, it somehow seems that all plans not classified as DC plans should be considered DB plans. It may have led some (or many?) auditors and actuaries to classify hybrid plans as totally DB plans simply because they are not DC plans and actuarial valuations and disclosures disregarded the DC component of the plan. But is this the proper way of determining and presenting the expense and liability under a hybrid plan?

 

Consider this. If a company has a hybrid retirement plan and its only two employees are due for retirement now, what is the liability of the company given the following information?

 

 

Employee A

Employee B

1. Minimum Defined Benefit

100,000.00

50,000.00

2. Account Balance

95,000.00

70,000.00

3. Benefit Payable (higher of 1 and 2)

100,000.00

70,000.00

4. Excess of Benefit Payable over Account Balance (1 less 3)

5,000.00

0.00

 

Obviously, the liability of the company is P 5,000 for the additional cash it will shell out to pay the benefit of Employee A.

 

However, if the hybrid plan is considered totally as a DB plan, the computed liability (asset) would be:

Total Defined Benefit           P 150,000.00

Total Amount in the Fund     P 165,000.00

Liability (Asset)                 (P   15,000.00)

 

What should have been a liability of P 5,000.00 resulted in an asset of P 15,000.00! The major flaw in this calculation is disregarding the fact that the funds are already allocated per employee.

 

Here is an actual case encountered. Note that this is an entity with a very high turnover rate, the reason why the Defined Benefit Obligation is very small.

 

         Liability Recognized in the Balance Sheet

         a. Present Value of Obligation      P    2.2M

         b. Fair Value of Plan Asset          P   36.2M 

         c. Unfunded Obligation               P  (34.0M)

Inspection of the case revealed that the Defined Benefit Obligation was calculated based solely on the minimum retirement benefit mandated by law and the Fair Value of Plan Assets was the aggregate of the individual account balances. 

As a conclusion, treating hybrid plans as totally DB plans result in the understatement of the liability, and in many cases, even creates a "false" asset for the retirement program.

 

 

II. SUGGESTED METHOD

 

It seems the more accurate method of determining the liability then is to unbundle the program into its DC component and DB component. Unbundling does not contradict what PAS 19 provides. In fact, it breaks down the program into components that can either be classified as DC or DB without disregarding the feature of either component.

 

In the undbundled program, the DC component is accounted straightforward. Quoting PAS 19:

 

"Accounting for defined contribution plans is straightforward because the reporting entity's obligation for each period is determined by the amounts to be contributed for that period. Consequently, no actuarial assumptions are required to measure the obligation or the expense and there is no possibility of any actuarial gain or loss. Moreover, the obligations are measured on an undiscounted basis, except where they do not fall due wholly within twelve months after the end of the period in which the employees render the related service.

 

When an employee has rendered service to an entity during a period, the entity shall recognise the contribution payable to a defined contribution plan in exchange for that service:

(a) as a liability (accrued expense), after deducting any contribution already paid. If the contribution already paid exceeds the contribution due for service before the balance sheet date, an entity shall recognise that excess as an asset (prepaid expense) to the extent that the prepayment will lead to, for example, a reduction in future payments or a cash refund; and

(b) as an expense, unless another Standard requires or permits the inclusion of the contribution in the cost of an asset xxx" 

 

The DB component is the expected excesses of the minimum retirement benefits over the account balances at any duration. Thus, the Projected Unit Credit method should not be applied straightforward. Rather, a projection of the series of minimum defined benefits and individual account balances until compulsory retirement should be made for each participant. As of each period, the individual account balance is subtracted from the minimum defined benefit, and if the result is positive, the difference becomes part of the Defined Benefit Obligation (DBO) and the Current Service Cost (CSC) calculation.

 

To be able to project the account balances, the account balances as of the valuation date should be known in addition to the usual data requirements: date of hire, date of birth, gender, present salary. An additional assumption is also necessary - the estimated long-term return on plan assets. This assumption will significantly affect the progression of the individual account balances – the higher the account balance is, the less is the expected shortfall from the minimum defined benefit and conversely.

 

Extra care should be exercised in setting this assumption and should take into consideration the intended asset allocations and the investment strategy in general. It should be noted that for pure DB plans, the long-term return on plan asset does not apply in the calculation of the DBO and the CSC but only serves as a component of the expense recognition.

 

 

III. ILLUSTRATION

 

A. To illustrate, suppose a hybrid retirement program provides for a fixed contribution of 6% of salary and a retirement benefit of 100% of the account balance subject to a minimum defined benefit stated as a percentage of monthly salary per year of service in accordance with the following schedule:

Attained Age

Percentage

56

60%

57

70%

58

80%

59

90%

60

100%

 

For an employee with the following details,

  • Entry age                                        : 55
  • Starting monthly salary                      : 10,000
  •  Annual salary                                   : 120,000

let us assume the following:

  • Discount rate                                   : 6.0% p.a.
  • Expected long-term return on plan asset: 4.0% p.a.
  • Salary increase rate                          : 3.0% p.a.
  • Retirement Rates                              : Prior age 60 – None; Age 60 – 100%
  • Death and disability rates                   : None
  • Contribution payment                        : Annual at end of year

 

The year-on-year account balance and expected shortfall from the minimum defined benefit can be determined as follows:

 

Attained Age

Salary

YOS*

%

Min

Benefit

Contribution

Acct. Balance

Shortfall

56

10,000

1

60%

6,000

        7,200

7,200

         -

57

10,300

2

70%

14,420

        7,416

14,904

         -

58

10,609

3

80%

25,462

        7,638

23,139

   2,323

59

10,927

4

90%

39,338

        7,868

31,932

   7,406

60

11,255

5

100%

56,275

        8,104

41,313

  14,963

          *YOS - years of service

 

The stream of Current Service Costs and Defined Benefit Obligations would then be:

 

Attained Age

Retirement Rate

Additional Benefit Payment

tpx

Benefit Allocation to YOS

CSC

DBO

56

            -

           

   1.00

2,992.54

2,370.37

2,370.37

57

            -

            

   1.00

2,992.54

2,512.59

5,025.18

58

            -

           

  1.00

2,992.54

2,663.35

7,990.04

59

            -

           

 1.00

2,992.54

2,823.15

11,292.59

60

        1.00

14,963.68

   1.00

2,992.54

2,992.54

-

 

 

B. Using the same example but assuming separation rates of 10% per annum prior to attainment of Age 60, the stream of Current Service Costs and Defined Benefit Obligations would then be as follows:

 

Attained Age

Retirement Rate

Additional Benefit Payment

tpx

Benefit Allocation to YOS

Ben @ 58

Ben @ 59

Ben @ 60

56

0.10

          -

    1.00

774.32

1,851.59

2,992.54

57

0.10

           -

    0.90

774.32

 1,851.59

2,992.54

58

0.10

     2,323

    0.81

 774.32

 1,851.59

 2,992.54

59

0.10

     7,406

    0.73

 

 1,851.59

2,992.54

60

        1.00

   14,963

    0.66

 

 

 2,992.54

 

Attained Age

CSC

DBO

56

1,724

     1,916

57

2,031

     4,513

58

2,392

     7,715

59

2,726

11,293

60

2,993

           -

 

 

 

IV. DISCLOSURE

 

Disclosure may be made in full conformity to the disclosure requirement for DB plans by plotting the DC component as if it is a DB plan and adding the results to the DB component. Below is an illustration:

For the DC component, take note of the equivalent items:  Defined Benefit Obligation = Fair Value of Plan Asset, Interest Cost = Expected Return on Plan Asset, Current Service Cost = Contribution, and Actuarial Loss on Obligation = Actuarial Gain on Plan Asset. Also, the expense recognition is the amount contributed and the liability is nil.   

An alternative disclosure which is simpler and probably more descriptive is as follows:

 

"The company has a hybrid retirement program (a retirement program with defined contribution and defined benefit components). It contributes 5% of the employees' salary. The retirement benefit payable is the higher of the accumulated contributions including earnings and a defined benefit computed as a percentage of final salary per year of service.

 

For the Defined Contribution component, total contribution due and made for the period, recorded as expense, is P 1,000,000."

 

For the Defined Benefit component corresponding to the expected excess of the minimum defined benefit over the accumulated contributions and earnings, the expense, liability and other relevant information are presented below…

 

(The Defined Benefit Plan disclosures then follow.)

 

 

V. APPLICATION TO OTHER VALUATIONS

 

The suggested approach to the valuation of hybrid plans should also be ideal even for other purposes such as funding, or mergers and acquisitions. It should also not create any problem under any of the known retirement plan valuation methods.