Studies
Studies 

COMMENTS & RESPONSES

VALUATION OF HYBRID RETIREMENT PLANS

 

Click here for the paper. 

 

 

I have actually received three major comments to this paper - one during the Q & A portion of the presentation proper. These are as follows:

 

1.  Citing FASB clarification (since IAS has no such clarification) - there is no need to break down the hybrid program into its DC & DB components. The hybrid program is considered a defined benefit program with the stream of benefits computed as the higher of the projected vested DC account value and the minimum defined benefit. It was also cited that one multi-national accounting firm considered the hybrid plan as either a DC plan or a DB plan but then reservation was made whether all accounting firms have the same view. (For purposes of this paper, let us call this Method 2 and the method presented in the paper Method 1.)

 

2. The preferred method of valuation for hybrid plans by IAS is simply taking the present value of the defined benefit obligation and comparing it to the DC Account Balance. Additional liability exists if the present value of the defined benefit obligation is greater than the DC Account Balance. It was further stated that a long-term return on the assets can not be made as it will give rise to actuarial gains or losses which is not supposed to be done under a Defined Contribution setup.  (For purposes of this paper, let us call this Method 3.)

  

3. The other method is simply to consider the DBO as the higher of the present value of the DB component (I suppose DBO of the DB component) and the projected DC account value.  (For purposes of this paper, let us call this Method 4.)

 

I decided to have a written response to the comments for the benefit of the members of the society who are interested in the paper. There was not much time to discuss them during the presentation. Also, it would be hard to present arguments without being backed up by illustrations.

 

But first, let me thank those who commented. It affirmed the relevance of the paper. It is not, after all, simple as it may seem.

 

Let me emphasize too that, as written, Method 1 is a suggested method. I do not claim that this is the only correct method of doing the valuation knowing too well that there are always many approaches or solutions possible to every problem. I did present in the paper one method that I think is "grossly" incorrect because it is being done by some peers with the hope they adopt an acceptable method.

 

Finally, I believe that there is no preferred method as far as the IASB is concerned. Actuaries (and auditors) may have preferences and based from the comments themselves, there are differing points of view. One thing is sure though - even if there is such thing as preferred method, it does not mean actuaries can not use other methods, otherwise it should instead be called the prescribed (not preferred) method. Or if IASB really has a preferred method, then let this paper be an appeal to consider (or reconsider) the method presented as a preferred method.  Members of the PSRC may also take a closer look and evaluate if this method violates its standards.

 

Now, why don't I prefer Methods 2, 3 or 4?

 

Method 2. The major reservation that I have with this method is that it does not preserve the original nature of the DC plan which is effectively the base plan. Under Method 1, the base cost is the contribution due (which is usually a percentage of salary) plus an additional amount to cover the expected shortfalls of the DC Account Balance from the defined minimum floor of benefit. The segregation of costs under Method 1 also allows for the application of PAS 19's DC rules on the DC component.    

 

To illustrate the difference, using the example in Part III.A of the paper, the benefit allocation for the benefit of P 56,275 and the current service costs would be:

 

Benefit / Cost Allocation

Current Service Cost

Method 1

Method 2

DC

DB

Total

Method 1

Method 2

7,200

2,933

10,193

11,255

9,570

8,915

7,416

2,933

10,409

11,255

9.929

9,450

7,638

2,933

10,631

11,255

10,302

10,017

7,868

2,933

10,860

11,255

10,691

10,618

8,104

2,933

11,096

11,255

11,096

11,255

 

The difference can be highlighted using an extreme example - suppose that at a certain valuation date, the projected DC account value is greater than the minimum benefit at all future durations (it could happen depending on prevailing assumptions as of each valuation date). Method 1 treats it exactly as a DC (DB component becomes nil). Method 2 still treats it as DB and does the benefit allocation.

 

I also have some reservation in considering the vested DC account value instead of the full DC account value. How is a pure DC plan with benefits subject to a vesting schedule classified? From the PAS 19 definition, it seems it still is a DC plan (note that it still satisfies the qualification that there is  no legal or constructive obligation to pay further contributions) and probably the proper expense to be recognized is the contribution for the period less forfeitures in the same period.

 

Now, between a pure DC plan and a hybrid plan whose DC component is exactly the same as the pure DC plan, which one should have a higher liability, if ever? Definitely it should be the hybrid plan because it provides more benefits. However, Method 2 would produce a liability for a hybrid plan lower than a pure DC plan in certain circumstances because the method takes into consideration future forfeitures.

 

Nevertheless, assuming future forfeitures should be considered, Method 1 should be able to easily take care of it under the DB component in the form of negative costs.

 

Method 3. We are always guided by the actuarial equivalence principle. Applied to retirement valuation, PV Benefits = PV DBO + PV Current Service Costs at any valuation date. This means that at the valuation date, Current Service Costs are determinable and if experience exactly follows the assumption and no assumptions are changed (meaning no actuarial gains and losses), Beg PV DBO + Interest Cost + Current Service Cost - Benefit Payments = End PV DBO.


I think that if the method is made to conform to this principle, the method will give rise to "unreasonable" incidences of actuarial gains and losses.


Secondly, the Projected Unit Credit Method also has a special characteristic, as follows: (Current Service Cost)(v) / PV DBO = (1 / YOS)


It seems the proposed method does not satisfy this.


Thirdly, contributions to a DC plan are a legal liability, the very reason why if contributions due are not paid, there should be a liability to be recognized.


Finally, even with a Min DB, some DC plans will technically remain pure DC (for example those providing high contribution rates and in all likelihood will cover the Min DB). Technically, they should follow how IAS 19 recognizes the expenses for a DC Plan. The method does not seem to automatically cater to this situation.


To illustrate, let us consider the following:


Given:

a) Contribution rate = 20% of monthly salary, no contribution for services prior to establishment of the plan

b) Minimum retirement benefit = 1 month salary per year of service

c) Current salary = P 10,000

d) Age at entry = 55

e) Age plan was established: 57

f) Current age: 57

g) Current Fund Balance = 0

For simplification, let us assume that the discount rate = 0, no decrements, no salary increase. Let us also assume that actual experience exactly follows the assumptions.


In this method, at age 57, the stream of PVDBO and the Current Service Costs would be as follows if it has to satisfy the Actuarial Equivalence principle:

   

   

Assuming a contribution of P 24,000 was made at age 27, at age 28, the stream of PVDBO and the Current Service Costs would be as follows if it has to satisfy the Actuarial Equivalence principle:

   

   

The following should be noted:

a) The Expected PVDBO (DB Component) at 58 is P 20,000 + P 10,000 = 30,000

b) The Actual PVDBO (DB Component) at 58 is P 6,000: Since it is assumed that no DC contribution will be made, naturally an actuarial gain of P 24,000 occurred which equivalent to the contribution due.  The question then is - Is it sound to "disregard" future contributions? Or in other words, is it sound to assume there are no future contributions? It should be noted that contributions under a DC plan are legal obligations and it is most likely that contributions will be made. And even if not made, it becomes a liability of the sponsor.

c) CSC / PVDBO = (10,000 / 6,000) not equal to 1/3

Actual movement of the liability will be as follows:

   


Note that the expense incidence becomes frontloaded. The fact that this case is technically a pure DC scheme, application of the method distorts the stream of expense recognition.

   

In contrast, under my proposed method, the liability for the DB component of the DC/DB plan is the PV of Excess of the Future DB against the Future DC Accumulation, if any.

 

Using the above example, at Age 57, the stream of PVDBO and the Current Service Costs would be as follows if it has to satisfy the Actuarial Equivalence principle:

 

 

 

Assuming a contribution was made, of P 24,000 at age 27, at age 28, the stream of PVDBO and the Current Service Costs would be as follows if it has to satisfy the Actuarial Equivalence principle:

 

 

Dissecting:

a) The Expected PVDBO (DB Component) at 58 is P 0 + P 0 = 0

b) The Actual PVDBO (DB Component) at 58 is P 0

c) No actuarial gain or loss because as given, actual experience exactly followed the assumptions

d) Actual expense recognitions follows the DC component at P 24,000 annually

The liability moves as follows:

 

 

Application of the method automatically follows the rules the DC rules. Suppose no contribution was made for the DC, the liability movement will just be as follows:

 

 

Again, contributions to a DC plan are legal obligations and as such, recorded as liability if unpaid.

To illustrate further, using the same given above except that monthly contribution rate is 10% of salary instead of 20%.

1. Using Method 3, the stream of Current Service Costs and PVDBOs will be as follows:

At Age 57

At Age 58

Again, assuming a contribution was made. The liability will move as follows:

Like the previous example, expense recognition seems to be frontloaded and the remeasurement is a major component.

2. In contrast, Method 1 would give the following results:

At age 57,

At Age 58,

Expense would be:

Note that the incidence of expense will be P 14,800 all throughout and no remeasurements.  Of course, in actual case, there will always be remeasurements but unlike the proposed method where there will be automatic actuarial gain when a contribution is made.

Note also that CSC / PVDBO = 2,400 / 8,400 = 1 / YOS = 1 / 3


Method 4. I can not exactly imagine how the method works. It should be noted however that it may not be appropriate to consider the two as independent benefits. The defined benefit may be higher than the DC account value in some duration and vice versa.

 

My reservations on Method 3 apply also to this method.