Net pension liability

What Is Net Pension Liability?

Net pension liability represents the difference between a pension plan's total obligations to its current and former employees and the fair value of the assets set aside to meet those obligations. It is a key metric in financial accounting that reflects whether a defined benefit plan is overfunded (assets exceed liabilities) or underfunded (liabilities exceed assets). This liability is typically recognized on an organization's balance sheet and provides insight into its long-term financial health.³³

History and Origin

The accounting and reporting of pension obligations have evolved significantly over time to provide greater transparency and comparability in financial statements. In the United States, two primary standard-setting bodies govern pension accounting: the Financial Accounting Standards Board (FASB) for private sector entities and the Governmental Accounting Standards Board (GASB) for state and local governments.

Prior to modern standards, pension accounting often allowed for significant discrepancies between reported pension costs and actual funding, leading to a lack of comparability.³² For the private sector, FASB Statement No. 87, "Employers' Accounting for Pensions," issued in 1985, significantly altered how companies accounted for defined benefit plans by requiring the recognition of a liability when the accumulated benefit obligation exceeded plan assets and standardizing the measurement of net periodic pension cost.³¹

For governmental entities, GASB undertook similar efforts. GASB Statement No. 68, "Accounting and Financial Reporting for Pensions," effective for fiscal years beginning after June 15, 2014, marked a major change.³⁰,²⁹ This standard mandates that state and local governments recognize their long-term obligation for pension benefits, the net pension liability, directly on their balance sheets.²⁸ Before GASB 68, many governmental entities only disclosed this information in the notes to their financial statements or used different methods, such as the unfunded actuarial accrued liability, which relied on actuarial asset values rather than market values.²⁷ The goal of these changes was to provide a clearer picture of the financial obligations to current and former employees for past services rendered.²⁶ A comparison of the differing approaches between FASB and GASB on pension accounting has been a subject of professional discussion.²⁵

Key Takeaways

• Net pension liability is the difference between the total pension liability (present value of future benefits owed) and the fiduciary net position (fair value of plan assets).
• It signifies whether a defined benefit pension plan is underfunded or overfunded.
• For governmental entities, GASB Statement No. 68 requires the net pension liability to be reported on the balance sheet.
• This metric is crucial for assessing an entity's long-term financial obligations and stability.
• Actuarial assumptions, such as investment returns and mortality rates, heavily influence the calculation of net pension liability.

Formula and Calculation

The net pension liability is calculated as the total pension liability minus the pension plan's fiduciary net position.²⁴

Where:

• Total Pension Liability (TPL): The actuarial present value of projected benefit payments attributed to employees' past periods of service. This value is estimated based on various actuarial assumptions like projected salary changes, service credits, and post-employment benefit changes.²³
• Fiduciary Net Position (FNP): The market value of the pension plan's assets that are legally restricted for the payment of benefits to retirees and beneficiaries.²²

If the TPL exceeds the FNP, the result is a net pension liability (underfunded). If the FNP exceeds the TPL, it results in a net pension asset (overfunded).

Interpreting the Net Pension Liability

Interpreting the net pension liability involves understanding its implications for an organization's financial health and future obligations. A significant net pension liability indicates that the organization has not set aside enough assets to cover its promised pension benefits based on current actuarial estimates. This can be a concern for stakeholders, including taxpayers, investors, and employees.

For governmental entities, a growing net pension liability can indicate a need for increased employer contributions in the future, which might strain budgets and impact other public services.²¹ It's important to note that the net pension liability is a long-term liability, not necessarily an immediate cash shortfall, but it represents a future claim on resources.²⁰ Fluctuations in the discount rate used in actuarial valuations can significantly impact the reported liability, as a lower discount rate will increase the present value of future obligations, thereby increasing the net pension liability.¹⁹,¹⁸

Hypothetical Example

Consider a hypothetical public school district, "Evergreen Unified," that offers a defined benefit pension plan to its employees. At the end of the fiscal year, Evergreen Unified's actuary calculates the following:

• Total Pension Liability (TPL): $500 million (the present value of all future pension benefits earned by current and former employees)
• Fiduciary Net Position (FNP): $420 million (the fair value of the pension plan's investments and other assets)

Using the formula:

Net Pension Liability = TPL - FNP
Net Pension Liability = $500 million - $420 million
Net Pension Liability = $80 million

In this scenario, Evergreen Unified has a net pension liability of $80 million. This means that, based on actuarial assumptions, the pension plan is underfunded by $80 million. This $80 million would be reported as a liability on the district's statement of net position. The district would need to consider this obligation in its long-term financial planning, potentially adjusting future contributions or seeking other strategies to address the shortfall.

Practical Applications

Net pension liability has several practical applications across various financial domains:

• Financial Reporting and Analysis: It is a critical component of an organization's financial statements, particularly for entities with defined benefit pension plans. Analysts use this figure to assess an entity's long-term solvency and financial risk.¹⁷
• Credit Ratings: Rating agencies closely examine an entity's net pension liability when determining its creditworthiness. A large or growing unfunded liability can negatively impact credit ratings, increasing borrowing costs for governments and corporations.
• Budgeting and Financial Planning: For governmental bodies, the net pension liability directly influences future budgetary decisions. A significant liability often necessitates higher future employer contributions to the pension fund, impacting the allocation of resources for other public services. The Office of the Washington State Auditor provides guidance on how state and local governments account for and report these liabilities.¹⁶
• Investment Management: The size and trend of the net pension liability inform the investment strategy for the pension plan's assets. A large liability may prompt a review of investment performance and risk tolerance to seek better returns, although this must be balanced with the need for security and liquidity.

Limitations and Criticisms

While net pension liability provides valuable information, it comes with certain limitations and criticisms:

• Reliance on Actuarial Assumptions: The calculation of the total pension liability heavily relies on complex actuarial assumptions, such as expected rates of return on investments, mortality rates, salary increases, and retirement ages.¹⁵ Small changes in these assumptions, particularly the discount rate, can lead to significant swings in the reported net pension liability.¹⁴,¹³
• Volatility: The fair value measurement of plan assets means that the net pension liability can be volatile due to market fluctuations. A market downturn can quickly increase the reported liability, even if the long-term funding strategy remains sound.¹²,¹¹
• Not a Liquidation Value: The net pension liability does not represent the immediate cash required to terminate or settle the plan. It's a snapshot of a long-term obligation that will be paid out over many decades.¹⁰
• Differences in Standards: While both FASB and GASB aim for transparency, differences in their respective accounting standards can lead to variations in how pension liabilities are measured and presented between private and public sectors.⁹

Net Pension Liability vs. Unfunded Actuarial Accrued Liability

The terms "net pension liability" and "unfunded actuarial accrued liability" (UAAL) are closely related but have distinct meanings, particularly in governmental accounting. Both refer to the shortfall where a pension plan's obligations exceed its assets.

The key difference lies in the valuation of assets:

• Net Pension Liability (NPL): As defined by GASB Statement No. 68, the NPL is calculated using the fair market value of the pension plan's assets (Fiduciary Net Position).⁸,⁷ This provides a more immediate, market-based view of the plan's funded status.
• Unfunded Actuarial Accrued Liability (UAAL): This term was more commonly used before GASB 68. The UAAL is calculated using the actuarial value of assets, which often involves "smoothing" market fluctuations over several years. This smoothing reduces volatility but can obscure the immediate market impact on the plan's funded status.⁶

While the UAAL aimed to present a stable long-term funding measure, the NPL provides a more current reflection of the plan's financial position by using market values, making it more comparable to how other liabilities are reported.

FAQs

Q: Is net pension liability the same as a pension deficit?
A: Yes, generally. A net pension liability indicates that the total pension obligations exceed the plan's assets, meaning the plan has a deficit or is underfunded. Conversely, if assets exceed obligations, it's a net pension asset or a surplus.⁵

Q: How does a net pension liability impact a government's financial statements?
A: For state and local governments, the net pension liability is reported as a non-current liability on the government-wide balance sheet (Statement of Net Position). It also influences the reported pension expense in the Statement of Activities.⁴,³

Q: What factors can cause the net pension liability to change?
A: Several factors can cause changes, including actuarial gains or losses (differences between expected and actual experience), changes in actuarial assumptions (like discount rates or mortality rates), changes in benefit terms, and the actual investment performance of plan assets.²

Q: Does a net pension liability mean an organization can't pay its retirees?
A: Not necessarily. Net pension liability is a long-term accounting measure representing the present value of future obligations. Pension plans typically pay benefits from ongoing employer contributions and investment returns. A net pension liability suggests that current assets and expected future contributions may not be sufficient to cover all future promised benefits without additional funding or adjustments over the long term.

Q: Are defined contribution plans subject to net pension liability reporting?
A: No. Defined contribution plans do not create a net pension liability for the employer because the employer's obligation is limited to the contributions made to individual employee accounts. The employee bears the investment risk, and there is no future payout obligation from the employer's side beyond the contributions.¹