Expected return on plan assets

What Is Expected Return on Plan Assets?

Expected return on plan assets is an actuarial assumption representing the long-term rate of return that a company anticipates earning on the investments held within its defined benefit pension plan. This estimate is a critical component in pension accounting, particularly for companies that offer traditional pensions to their employees. It directly influences the calculation of annual pension expense reported on an organization's financial statements.

Companies use this expectation to smooth out the volatility that actual market returns can introduce into their financial reporting. The higher the expected return on plan assets, the lower the reported net periodic pension cost, and consequently, the higher the reported net income. This estimation falls under the broader umbrella of financial reporting and impacts an entity's balance sheet and income statement.

History and Origin

The concept of expected return on plan assets as a specific component in pension accounting gained prominence with the introduction of new accounting standards in the United States. A significant development was the issuance of Statement of Financial Accounting Standards (SFAS) No. 87, "Employers' Accounting for Pensions," by the Financial Accounting Standards Board (FASB) in December 1985. This statement superseded prior standards and aimed to provide a more standardized method for measuring net periodic pension cost and improve financial position reporting.⁸ Before SFAS 87, actuarial assumptions regarding interest rates, compensation levels, and asset returns were allowed to be reasonable overall, but only the expected long-term rate of return on plan assets specifically required disclosure.⁷ The FASB sought to enhance comparability and transparency by standardizing how companies recognized the compensation cost of employee pensions over their service periods and by more directly relating that cost to the terms of the plan.⁶ This move introduced the requirement for companies to disclose various components of their pension cost, including the expected return on plan assets, aiming to provide users with a clearer understanding of the underlying economic events.

Key Takeaways

• Expected return on plan assets is a key actuarial assumption used in calculating pension expense for defined benefit plans.
• It represents the long-term average rate of return a company anticipates on its pension fund investments.
• A higher expected return generally reduces the reported pension expense, impacting a company's profitability.
• The actual return earned may differ significantly from the expected return, leading to actuarial gains or losses that are typically amortized over time.
• This estimate requires careful judgment and is subject to scrutiny by regulators and financial statement users.

Formula and Calculation

The expected return on plan assets is used to calculate the "expected return component" of the net periodic pension cost. This component is typically calculated by multiplying the expected long-term rate of return by the fair value of plan assets at the beginning of the period.

The relevant part of the formula for net periodic pension cost is:

$\text{Expected Return Component} = \text{Expected Long-Term Rate of Return} \times \text{Fair Value of Plan Assets (Beginning of Period)}$

Here:

• Expected Long-Term Rate of Return is the company's best estimate of the average rate of earnings on the investments of the pension plan, over the period that benefits are expected to be paid.
• Fair value of Plan Assets (Beginning of Period) refers to the market value of the pension plan's investments at the start of the fiscal year.

This calculation provides a stable estimate for the period's pension cost, reducing the volatility that would result from using actual, fluctuating market returns in immediate calculations.

Interpreting the Expected Return on Plan Assets

The expected return on plan assets is a forward-looking estimate that reflects management's long-term expectations for the performance of the pension plan's investment portfolio. When evaluating a company's financial statements, the expected return on plan assets provides insight into management's assumptions about future investment growth and its impact on the company's reported pension obligations.

A higher expected return on plan assets can signal management's optimism about the investment strategy and the future funding status of the plan. However, it is crucial to consider the reasonableness of this assumption, as an overly optimistic estimate can artificially lower current pension expense, potentially overstating earnings. Analysts and investors often compare a company's assumed return with those of its peers and with historical market averages to gauge its aggressiveness or conservatism.

Hypothetical Example

Consider "Tech Innovations Inc." and its defined benefit pension plan. As of January 1, 2024, the fair value of its plan assets is $100 million. The company's management, after consulting with its actuaries and considering historical market performance, its asset allocation, and future economic forecasts, sets the expected long-term rate of return on plan assets at 7% for the year.

To calculate the expected return component that will reduce the net periodic pension cost for 2024, Tech Innovations Inc. would perform the following calculation:

Expected Return Component = $7% \times $100,000,000 = $7,000,000$

This $7 million reduces the overall net periodic pension cost that Tech Innovations Inc. will report on its income statement for 2024. If, for example, other components of pension cost (like service cost and interest cost) totaled $12 million, the net pension expense would be $12 million - $7 million = $5 million.

If the actual return on plan assets for 2024 turned out to be 9% (an actual gain of $9 million), the $2 million difference ($9 million actual - $7 million expected) would represent an actuarial gain. Conversely, if the actual return was only 5% (an actual gain of $5 million), the $2 million difference ($5 million actual - $7 million expected) would be an actuarial loss. These actuarial gains and losses are typically amortized over future periods rather than being recognized immediately, reflecting the smoothing mechanism inherent in pension accounting.

Practical Applications

Expected return on plan assets is primarily relevant in the financial reporting and analysis of companies sponsoring defined benefit plans. It directly impacts the reported pension expense on a company's income statement, which, in turn, affects reported profitability. This figure is part of the broader actuarial assumptions that underpin pension accounting and requires significant judgment from management.

Regulators, such as the U.S. Securities and Exchange Commission (SEC), emphasize transparent disclosure of critical accounting estimates, including the expected return on plan assets. The SEC's interpretive guidance, specifically Release FR-72, encourages companies to provide detailed discussions in their Management's Discussion and Analysis (MD&A) about the subjectivity involved in these estimates, their potential variability, and their material impact on financial condition and operating performance.⁵ This helps investors understand how sensitive reported earnings are to changes in this key assumption.

Furthermore, the assumed rate influences the reported funding status of the plan on the balance sheet. While a higher expected return can make the plan appear healthier by reducing the reported pension obligation, analysts critically examine whether these assumptions are realistic given market conditions and the plan's asset allocation. External factors like rising interest rates can significantly impact defined benefit plans, affecting their liabilities and funding status, which in turn influences the context for assessing expected returns.⁴

Limitations and Criticisms

Despite its role in smoothing financial results, the expected return on plan assets faces several limitations and criticisms. One primary concern is its subjective nature; the rate is a management estimate, not a market-determined rate. This subjectivity can lead to accusations of "earnings management," where companies might use an overly optimistic expected return to lower reported pension expense and boost earnings. Regulators require detailed disclosure of these actuarial assumptions to provide transparency, but the inherent estimation remains.

Another significant criticism stems from the potential for a large divergence between the expected return and the actual return on plan assets. While actuarial gains and losses are generally deferred and amortized over time, significant, persistent shortfalls can accumulate and eventually impact the balance sheet through recognition of an additional minimum pension liability, or adjustments to accumulated other comprehensive income. This smoothing mechanism, while intended to reduce volatility, can also obscure the true economic status of the pension plan from immediate view.³

Public pension funds, in particular, have faced scrutiny for using optimistic expected returns to discount their liabilities, which can make their financial positions appear stronger than they truly are. This practice can lead to underfunding, where the reported projected benefit obligation is lower than it would be under more conservative assumptions, potentially leading to future funding shortfalls for taxpayers and beneficiaries.² Critics argue that this creates a mismatch where risky assets are used to back risk-free liabilities, and the high-targeted returns might not be achieved with certainty.¹

Expected Return on Plan Assets vs. Discount Rate

The expected return on plan assets and the discount rate are both critical actuarial assumptions in pension accounting, but they serve distinct purposes and are determined differently.

While both rates affect the reported net periodic pension cost, the expected return on plan assets is primarily an assumption about the earning power of the pension fund's investments, whereas the discount rate is a rate used to determine the present value of future pension obligations. The expected return component adds to the overall return on assets that reduces the company's pension cost. In contrast, the discount rate influences the "interest cost" component of pension expense and the valuation of the pension liabilities themselves. Companies are required to justify both rates with objective data and disclose the assumptions used.

FAQs

Why is the expected return on plan assets an "expected" amount and not the actual return?

The expected return on plan assets is an estimated, long-term average return rather than the actual return to smooth out the volatility of market fluctuations. If actual market returns were used directly, the reported pension expense could swing wildly from year to year, making a company's financial performance appear inconsistent. By using an expected rate, companies aim to present a more stable and predictable pension cost.

How often do companies update their expected return assumption?

Companies typically reassess their expected return on plan assets assumption annually, as part of their year-end actuarial valuation. While the rate aims to be a long-term estimate, significant changes in market conditions, the plan's asset allocation, or investment strategy can prompt a change in the assumption.

What happens if the actual return differs from the expected return?

When the actual return on plan assets differs from the expected return, the difference creates an actuarial gain or loss. These gains or losses are generally not recognized immediately in the income statement. Instead, they are typically deferred and amortized over future periods, often using a "corridor approach" or other smoothing mechanisms allowed by accounting standards, to avoid significant volatility in reported pension expense.

Does the expected return on plan assets affect a company's cash flow?

The expected return on plan assets directly affects the calculation of reported pension expense on the income statement, but it does not directly impact a company's cash contributions to the pension plan. Cash contributions are determined by funding regulations (e.g., ERISA in the U.S.), tax considerations, and the company's funding policy, which may differ from the accounting rules for expense recognition.