Actuarial gains and losses

What Are Actuarial Gains and Losses?

Actuarial gains and losses represent the changes in the present value of a defined benefit plan's obligations or its plan assets due to either differences between actual outcomes and original actuarial assumptions, or changes in those assumptions themselves. These fluctuations are a critical component of financial accounting for entities sponsoring pension plans, falling under the broader category of employee benefits accounting. Actuarial gains and losses directly impact how a company's pension liabilities or assets are reported on its balance sheet and affect the overall financial position.

History and Origin

The concept of actuarial gains and losses gained prominence with the evolution of global accounting standards for employee benefits, particularly post-employment benefits like pensions. Prior to standardized rules, companies had more discretion in how they accounted for pension obligations, often smoothing out volatility. The introduction of comprehensive international and national accounting standards aimed to provide greater transparency.

A significant development in this area was the adoption of International Accounting Standard 19 (IAS 19), "Employee Benefits," by the International Accounting Standards Board (IASB). IAS 19, revised over the years, specifically addresses how entities should account for actuarial gains and losses. For example, amendments to IAS 19 in December 2004 aimed to clarify how these changes should be reported.⁷ The standard mandates specific recognition criteria, ensuring that these unpredictable fluctuations are properly reflected in an entity's financial statements. In the United States, the Employee Retirement Income Security Act of 1974 (ERISA) established minimum standards for most voluntarily established retirement and health plans in private industry, providing a framework within which actuarial valuations are performed and reported.⁶

Key Takeaways

• Actuarial gains and losses arise from discrepancies between actual financial outcomes and initial actuarial assumptions regarding pension obligations and assets.
• They can result from changes in demographic assumptions (e.g., mortality rates) or financial assumptions (e.g., discount rates, expected returns).
• For defined benefit plans, these gains or losses are typically recognized in Other Comprehensive Income (OCI) under IAS 19, impacting equity but not immediate profit or loss.
• Large actuarial gains or losses can significantly alter a company's reported pension surplus or deficit.
• Effective risk management and careful setting of actuarial assumptions are crucial to managing their impact.

Formula and Calculation

Actuarial gains and losses are not calculated using a single, direct formula, but rather emerge from the re-measurement of the defined benefit obligation (DBO) and the fair value of plan assets. The primary components are:

1. Experience Adjustments: The effect of differences between previous actuarial assumptions and what has actually occurred.
2. Effects of Changes in Actuarial Assumptions: The impact of revising assumptions for future events.

The net actuarial gain or loss for a period is essentially the change in the net defined benefit liability (or asset) that is not attributable to current service cost, past service cost, net interest on the net defined benefit liability, or payments of benefits.

Under IAS 19, these re-measurements are recognized in Other Comprehensive Income (OCI). The net defined benefit liability (or asset) is calculated as:

Actuarial gains or losses arise from changes in either of these components due to the aforementioned factors. For example, if the discount rate used to calculate the present value of the DBO changes, it will lead to an actuarial gain or loss.

Interpreting Actuarial Gains and Losses

Interpreting actuarial gains and losses requires understanding their impact on a company's financial health, especially for those with significant defined benefit plans. A gain implies that the pension obligation is lower, or the plan assets are higher, than previously projected, improving the pension funding status. Conversely, a loss indicates an increase in the obligation or a decrease in asset value, worsening the funding position and potentially signaling future contribution requirements.

These fluctuations are often volatile and can be substantial, particularly in periods of significant market changes or shifts in demographic trends. For example, a sudden drop in prevailing interest rates can increase the present value of a company's pension obligations, leading to an actuarial loss, as future liabilities are discounted at a lower rate. Similarly, unexpected strong investment returns on plan assets would generate an actuarial gain. Financial analysts pay close attention to the recognition of actuarial gains and losses in Other Comprehensive Income as they reflect inherent risks within a company's pension plan and can provide insights into the long-term sustainability of its employee benefits commitments.

Hypothetical Example

Consider "Tech Solutions Inc.," a company with a defined benefit plan. At the start of 2024, its actuaries estimated the present value of its Defined Benefit Obligation (DBO) at $500 million, based on assumptions about future salary increases, employee turnover, and a discount rate of 4.0%. The fair value of its plan assets was $450 million.

During 2024, actual events deviate from expectations:

1. Market Performance: The actual return on plan assets was 12%, significantly higher than the expected return. This unexpected positive performance leads to an actuarial gain on assets.
2. Mortality Rates: Data collected during the year indicates that employees are living longer than previously assumed, which increases the expected future benefit payments. This revision in demographic assumption leads to an actuarial loss on the DBO.

After re-measurement at the end of 2024:

• The fair value of plan assets increased to $504 million due to strong investment performance.
• The re-calculated present value of the DBO, adjusted for the longer life expectancies and other factors, is now $515 million.

The actuarial gain on assets ($504M actual - $450M initial) is not simply $54M. It's the difference between the actual return and the expected return applied to the beginning balance of assets. The change in DBO due to the revised mortality assumption also creates an actuarial loss. These specific components contribute to the overall actuarial gains and losses recognized in the company's financial statements.

Practical Applications

Actuarial gains and losses are crucial in several practical financial contexts, primarily within pension accounting and corporate finance.

• Financial Reporting: Companies with defined benefit plans must report these gains and losses in their [financial statements](https://diversification.com/term/financial statements). Under IAS 19, they are typically recognized in Other Comprehensive Income (OCI), providing transparency without immediately affecting the income statement. This prevents volatility from distorting a company's reported profit.
• Funding Decisions: Significant actuarial losses can indicate a growing pension deficit, potentially necessitating increased employer contributions to maintain the plan's solvency. Conversely, consistent actuarial gains might reduce future funding requirements. For instance, a rise in corporate bond yields, which are used to discount pension liabilities, has been observed to reduce pension scheme liabilities significantly, potentially turning deficits into surpluses for some companies.⁵
• Mergers and Acquisitions (M&A): During M&A activities, the pension obligations of target companies are meticulously assessed. Unrecognized actuarial gains and losses can represent hidden liabilities or assets that impact the acquisition price and future financial obligations of the combined entity.
• Asset-Liability Management (ALM): Actuaries and financial managers use these insights for ALM strategies, aiming to align the characteristics of plan assets with the nature of pension liabilities. This helps mitigate the impact of adverse actuarial movements. The Pension Benefit Guaranty Corporation (PBGC), established by ERISA, protects participants in defined benefit plans from plan terminations that lack sufficient assets, highlighting the importance of robust ALM.⁴
• Regulatory Compliance: Regulatory bodies, like the U.S. Department of Labor, oversee pension plans under ERISA. They monitor funding levels and actuarial soundness to protect plan participants.³

Limitations and Criticisms

While necessary for accurate financial reporting, the treatment of actuarial gains and losses has faced certain criticisms. One common critique revolves around the use of actuarial assumptions, which inherently involve estimates and judgments about future economic and demographic conditions. If these actuarial assumptions are overly optimistic or pessimistic, they can obscure the true financial health of a pension plan. For example, a historical trend of declining interest rates has put pressure on public pension plans, making it challenging to meet overly optimistic assumed rates of investment return and requiring a re-evaluation of assumptions.²

Another point of contention has been the option, historically available under some accounting standards (like the "corridor approach" in earlier versions of IAS 19), to defer the recognition of these gains and losses, which was seen by some as a form of "income smoothing."¹ While IAS 19 (revised in 2011) largely eliminated this deferral option by requiring immediate recognition in Other Comprehensive Income (OCI), the volatility they introduce into OCI can still be challenging for some stakeholders to interpret. This volatility can make period-to-period comparisons of equity more difficult, even though it provides a more faithful representation of the actual fluctuations in the defined benefit plan's financial position. The complexity of these calculations also necessitates specialized expertise, which can be costly for companies.

Actuarial Gains and Losses vs. Pension Deficit

Actuarial gains and losses are components that contribute to, or reduce, a pension deficit, but they are not the same thing.

In essence, actuarial gains and losses explain why the pension deficit might have changed from one period to the next, specifically due to factors outside of normal operations like contributions or benefit payments. A pension deficit, on the other hand, is the bottom-line measure of the funding gap itself.

FAQs

What causes actuarial gains and losses?

Actuarial gains and losses arise from two main sources: "experience adjustments," which are the effects of differences between actual outcomes (e.g., actual investment returns, actual mortality) and previous actuarial assumptions, and "changes in actuarial assumptions," which occur when the assumptions themselves are revised to reflect new information or future expectations. For example, if the discount rate used to value pension liabilities changes, it creates an actuarial gain or loss.

How do actuarial gains and losses affect a company's financial statements?

For defined benefit plans under international accounting standards (like IAS 19), actuarial gains and losses are recognized in Other Comprehensive Income (OCI). This means they bypass the main income statement but are reflected in the company's total equity on the balance sheet. This treatment aims to reduce volatility in reported profits while still showing the full impact of pension plan fluctuations on the company's net worth.

Are actuarial gains and losses predictable?

No, by their nature, actuarial gains and losses are largely unpredictable. They result from unexpected deviations from assumptions (experience adjustments) or from changes in assumptions due to unforeseen future events (e.g., shifts in market interest rates or longevity trends). While risk management strategies can mitigate their impact, they cannot be perfectly forecast.

What is the difference between an actuarial gain and an actuarial loss?

An actuarial gain occurs when the actual outcomes are more favorable than expected, or when actuarial assumptions are revised in a way that reduces the present value of the defined benefit plan's liabilities or increases the value of its plan assets. An actuarial loss is the opposite, arising when outcomes are less favorable or assumptions are revised in a way that increases liabilities or decreases asset values.