Actuarial gain or loss: Meaning, Criticisms & Real-World Uses

What Is Actuarial Gain Or Loss?

An actuarial gain or loss represents the change in a company's financial obligation or asset related to its defined benefit plan, primarily pension plans and other employee benefits. These gains or losses arise when the actual experience of a plan (e.g., employee turnover, investment returns) differs from the actuarial assumptions initially used, or when those assumptions themselves are changed. This concept is central to financial accounting for post-employment benefits.

Actuarial gains decrease the reported liability or increase the reported asset, while actuarial losses increase the liability or decrease the asset. They reflect the inherent financial risk and uncertainty in projecting future benefit payments over long periods. Companies typically recognize these amounts in their financial statements through other comprehensive income (OCI) under accounting standards like U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS)²⁴, ²⁵.

History and Origin

The accounting for employee benefits, and consequently the recognition of actuarial gain or loss, has evolved significantly over decades to provide a more transparent view of a company's obligations. Before modern accounting standards, pension obligations were often managed on a cash basis, leading to a lack of clear financial reporting regarding long-term liabilities. The complexity of these obligations, which depend on various factors like employee demographics, mortality rates, and investment performance, necessitated standardized approaches.

The International Accounting Standards Board (IASB) developed IAS 19, "Employee Benefits," which provides comprehensive guidance on accounting for post-employment benefits, including the treatment of actuarial gains and losses²², ²³. Similarly, in the United States, the Financial Accounting Standards Board (FASB) established Accounting Standards Codification (ASC) Topic 715, "Compensation–Retirement Benefits," which dictates how companies report their defined benefit pension and postretirement plans. ²¹Both standards aim to improve the reporting of the funded status of these plans on the balance sheet and the recognition of related financial activities in the profit and loss statement.
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Key Takeaways

Actuarial gain or loss arises from differences between expected and actual outcomes, or changes in the actuarial assumptions used to value pension and other post-employment benefit obligations.
These gains or losses directly impact the reported net defined benefit liability or asset on a company's balance sheet.
Under both U.S. GAAP (ASC 715) and IFRS (IAS 19), actuarial gains and losses for post-employment benefits are typically recognized in other comprehensive income.
The volatility of these amounts can be significant due to market fluctuations and changes in long-term assumptions.
Understanding actuarial gain or loss is crucial for assessing the true financial position of companies with substantial defined benefit obligations.

Formula and Calculation

An actuarial gain or loss is not calculated by a single, straightforward formula, but rather represents the net effect of changes in the present value of the defined benefit obligation (PBO) and the fair value of plan assets, which are not attributable to contributions, benefit payments, or the passage of time (interest cost). It is essentially the "remeasurement" component of the defined benefit cost.

The calculation involves comparing the actual results of the plan's experience and the impact of revised assumptions against the previously projected values. The primary components that contribute to an actuarial gain or loss include:

Experience Adjustments: Differences between the prior actuarial assumptions and what has actually occurred regarding factors such as employee turnover, salary increases, and actual investment returns on plan assets. For example, if employee turnover is higher than expected, it leads to an actuarial gain because fewer benefits will ultimately need to be paid.
Changes in Actuarial Assumptions: Revisions to the underlying assumptions used to estimate the future obligation. These can include changes to the discount rate, expected rates of return on plan assets, future salary increase rates, and mortality tables. ¹⁸, ¹⁹For instance, a decrease in the discount rate will increase the present value of the obligation, leading to an actuarial loss.

The net actuarial gain or loss for a period is the sum of these adjustments impacting the defined benefit obligation and the actual return on plan assets differing from the expected return.

Interpreting the Actuarial Gain Or Loss

Interpreting actuarial gain or loss requires understanding its origins. A significant actuarial gain often indicates that the actual experience of the pension plan was more favorable than anticipated, or that key assumptions were revised in a way that reduced the estimated future obligation. Conversely, a large actuarial loss suggests less favorable actual experience or assumption changes that increased the estimated obligation.

For example, an unexpected increase in the discount rate used to calculate the present value of the defined benefit obligation would result in an actuarial gain, as a higher discount rate reduces the present value of future liabilities. ¹⁷Similarly, if the actual return on plan assets exceeds the expected return, this would contribute to an actuarial gain. ¹⁶Investors and analysts examine these figures to gauge the volatility and underlying health of a company's pension or post-retirement benefit plans. These gains or losses are often presented in the notes to the financial statements, providing crucial context for the reported pension expense.

Hypothetical Example

Consider "Tech Innovations Inc." with a defined benefit pension plan for its employees. At the beginning of the year, its actuary calculated the present value of the defined benefit obligation to be $100 million, based on various assumptions, including a 5% discount rate and specific mortality rates. The plan also holds $90 million in assets.

During the year, two key events occur:

Change in Discount Rate: Due to rising market interest rates, the company's actuary updates the discount rate assumption from 5% to 6%. This higher rate makes future pension payments less valuable in today's terms. As a result, the present value of the defined benefit obligation decreases by $5 million. This change represents an actuarial gain of $5 million.
Actual vs. Expected Return on Assets: Tech Innovations Inc. expected its pension plan assets to earn a 7% return, which would be $6.3 million ($90 million * 0.07). However, due to a strong market, the assets actually earned 10%, or $9 million. The difference of $2.7 million ($9 million - $6.3 million) contributes an actuarial gain of $2.7 million.

In this hypothetical scenario, Tech Innovations Inc. would record a total actuarial gain of $7.7 million ($5 million from the discount rate change + $2.7 million from asset performance). This gain would typically be recognized in other comprehensive income, improving the funded status of the pension plan on the company's balance sheet.

Practical Applications

Actuarial gain or loss is a critical component in the accounting and analysis of defined benefit plans, appearing prominently in various financial contexts:

Financial Reporting and Disclosure: Companies are required by accounting standards, such as FASB ASC Topic 715 in the U.S. and IAS 19 internationally, to disclose actuarial gains and losses. These disclosures provide transparency on how changes in assumptions and actual experience affect the company's pension and post-retirement benefit obligations. ¹⁴, ¹⁵The U.S. Securities and Exchange Commission (SEC) also has specific requirements for companies to report information related to their defined benefit pension plans in proxy statements and financial filings, which includes details about actuarial gains and losses.
¹³* Valuation and Analysis: Financial analysts use the reported actuarial gains and losses to understand the true cost and risk associated with a company's pension obligations. These figures can impact a company's equity and influence investors' perception of its financial health and future earnings volatility.
Regulatory Compliance: Regulatory bodies, such as the Internal Revenue Service (IRS) in the U.S., provide guidance on the actuarial assumptions used for pension plans, including acceptable mortality tables and interest rates for calculating benefit obligations and funding requirements. ¹¹, ¹²The Social Security Administration (SSA) also publishes mortality tables that actuaries often reference for their calculations.
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Limitations and Criticisms

While necessary for valuing long-term benefit obligations, the accounting for actuarial gain or loss has faced limitations and criticisms, primarily concerning its impact on financial reporting volatility and potential for "income smoothing."

One main criticism is that the immediate recognition of large actuarial gains or losses in the profit and loss statement could introduce significant volatility that might not reflect a company's core operating performance. To mitigate this, both U.S. GAAP (ASC 715) and IFRS (IAS 19) allow for these gains and losses to be recognized in other comprehensive income, and then amortized into the pension expense over time (though IAS 19 generally requires all remeasurements, including actuarial gains and losses, to be recognized in OCI). ⁷, ⁸The "corridor approach" under previous versions of IAS 19, which allowed for delayed recognition if the accumulated actuarial gain or loss was within a certain percentage, was a form of income smoothing and has since been removed from the standard.
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Another concern revolves around the subjectivity inherent in choosing actuarial assumptions. Assumptions about discount rates, future salary increases, and mortality rates can significantly impact the calculated actuarial gain or loss. If these assumptions are not "reasonable in the aggregate," as required by the IRS for welfare benefit funds, they can lead to misstatements of obligations and potential regulatory scrutiny. ⁴The IRS has cautioned against unreasonable assumptions that could lead to disallowed deductions or penalties for actuaries. ³Changes in these assumptions, even slight ones, can create substantial swings in reported liabilities and gains or losses, making financial statement analysis more complex.

Actuarial Gain Or Loss vs. Pension Expense

Actuarial gain or loss and pension expense are related but distinct components within the financial reporting of defined benefit plans. Pension expense (often termed "net periodic pension cost" under U.S. GAAP) is the amount recognized in a company's profit and loss statement for the period, representing the cost of providing pension benefits. It comprises several components, including service cost (benefits earned by employees during the period), interest cost (the increase in the pension obligation due to the passage of time), and the expected return on plan assets.

Actuarial gain or loss, on the other hand, is the component of change in the defined benefit obligation or plan assets that arises from deviations in actual experience from what was assumed, or from changes in the actuarial assumptions themselves. While actuarial gains and losses impact the overall funded status of the plan on the balance sheet, they are generally recognized directly in other comprehensive income under current accounting standards (e.g., IAS 19, ASC 715). This means they do not directly flow through the income statement as part of the periodic pension expense, although a portion may be amortized into the pension expense over time under U.S. GAAP's "corridor" method or other systematic methods. ¹, ²The key difference lies in where and when these amounts are recognized: pension expense affects current period earnings, while actuarial gains/losses primarily affect other comprehensive income and the balance sheet's net liability/asset.

FAQs

What causes an actuarial gain or loss?

An actuarial gain or loss is caused by two main factors: experience adjustments and changes in actuarial assumptions. Experience adjustments occur when the actual events of the pension plan (e.g., how long employees live, how many leave the company, the actual investment returns) differ from the projections made by actuaries. Changes in actuarial assumptions happen when the actuary revises the estimates used for future events, such as adjusting the discount rate or updating mortality tables due to new data.

Where is actuarial gain or loss reported in financial statements?

For defined benefit plans under both U.S. GAAP and IFRS, actuarial gains and losses are typically reported in other comprehensive income (OCI), which is a component of equity on the balance sheet. While they do not usually flow directly through the profit and loss statement in the period they arise, they do impact the overall funded status of the pension plan. Under U.S. GAAP, a portion of these amounts might be amortized into the periodic pension expense over time.

Does actuarial gain or loss impact a company's net income?

Immediately, actuarial gain or loss typically does not directly impact a company's net income. Under current accounting standards, these amounts are generally recognized in other comprehensive income. However, they can indirectly affect future net income if a portion of previously recognized actuarial gains or losses is subsequently amortized into the pension expense, which is a component of net income. This amortization aims to smooth out the volatility caused by these fluctuations over time.