CAS/PPA Harmonization Rules
Below an analysis of the recently published changes to the Cost Accounting Standards (CAS) required by the Pension Protection Act (PPA) provisions concerning "harmonization" of CAS and PPA. The analysis, prepared jointly by Crowell & Moring and John McQuade and Jim Buss at Pine Cliff Consulting, two of the leading actuarial experts on Government contracting rules for pensions costs, summarizes the significant changes in the CAS rules about accounting for defined-benefit pension costs, identifies the issues created by the new rules, and suggests practical strategies for addressing those issues.
In 2006, Congress enacted the Pension Protection Act ("PPA"). The primary thrust of PPA was to address underfunding of defined benefit pension plans by increasing minimum funding requirements. PPA took effect in 2008 for most plan sponsors but was delayed until 2011 for a handful of the largest defense contractors.
Recovery of pension costs under Government contracts is governed by Cost Accounting Standards ("CAS") 412 and 413. When PPA was enacted, it was anticipated that the revised minimum funding requirements would typically exceed contractors' recovery of CAS pension costs, which in turn would result in negative cash flows at defense contractors. To address this cash flow problem, Section 106 of PPA required the CAS Board to "harmonize" CAS 412 and 413 with PPA minimum funding requirements by January 1, 2010. The CAS Board followed the statutory 4-step promulgation process and issued final revisions to CAS 412 and 413 on December 27, 2011, nearly two years later than the statute required. We refer to the revised version of CAS 412 and 413 as "Harmonized CAS."
Summary of Changes
The Harmonized CAS contains two fundamental changes:
- Addition of "settlement" liabilities. The Harmonized CAS requires actuarial valuations to be completed on two alternative actuarial bases:
- "Going concern" basis. Consistent with the original CAS requirements that date to the 1970s, contractors must continue to measure the actuarial accrued liability ("AAL") and normal cost ("NC") of their defined-benefit pension plans on a "going concern" basis in accordance with their established cost accounting practices. The "going concern" approach assumes that participants will continue to earn pension benefits as part of an on-going business, so it incorporates investment returns based on a long-term expected rate of return and future compensation increases. The Harmonized CAS amends the "going concern" approach to permit the projection of future increases in flat dollar benefits under collectively bargained plans based on the average increase over the last six years, but otherwise the new regulation does not change the calculation of the AAL and NC.
- "Settlement" basis. In addition to the "going concern" basis, the Harmonized CAS require the calculation of a minimum actuarial liability ("MAL") and a minimum normal cost ("MNC"). Consistent with the approach generally used for PPA calculations the MAL and the MNC are calculated on a "settlement" basis. A "settlement" approach means that only benefits earned up to the valuation date (in the case of the MAL) and benefits expected to be earned in the current year (in the case of the MNC) are considered; thus, compensation increases and projected increases in flat dollar collectively bargained benefits beyond the current year are ignored. In addition, the MAL and the MNC are not determined using the long-range expected return on plan assets, but rather utilize discount rates consistent with recent bond yields on A to AAA corporate bonds. The MAL and the MNC are conceptually similar to the Funding Target and the Funding Target Normal Cost, respectively, under PPA.
The Harmonized CAS provide that the sum of the AAL and NC "going concern" amounts are compared with the sum of the MAL and MNC "settlement" amounts; whichever measure is larger forms the actuarial basis to be used to compute CAS pension costs.
- Actuarial gains and losses. Harmonized CAS provides that actuarial gains and losses must be amortized over 10 years. This change will result in more rapid recognition that under the prior regulation, which required 15-year amortization. However, the 10 year period selected by the CAS Board exceeds the 7 year PPA period. The CAS Board justified that compromise between traditional CAS rules and PPA requirements on the ground that using 10 years instead of 7 would ease pressure on Government spending and would tend to reduce pension cost volatility.
The Harmonized CAS are effective February 27, 2012. This date is important because only contracts entered into before that date are eligible to receive an "equitable adjustment" under contractual CAS clauses as a result of the adoption of the revised regulations. Therefore, if forward pricing rates incorporating the Harmonized CAS are not used in negotiating the prices of fixed price contracts awarded on and after February 27, 2012, any increased costs would not be included in the contract price and the Government is likely to argue that increased costs resulting from the CAS change would not be eligible to be recovered through an equitable adjustment.
For contractors that receive at least one CAS-covered award after February 27, 2012, the Harmonized CAS must be used for the next contractor fiscal year starting after June 30, 2012. Thus, for most calendar year contractors, the new CAS would take effect January 1, 2013 (the effective dates discussed below are based on a calendar fiscal year). It is important to recognize that although the contractor is not required to change its accounting for pension costs to reflect the new rules until the "implementation date" (January 1, 2013 for calendar year contractors), failure to use forward pricing rates reflecting the Harmonized CAS by February 27, 2012 may jeopardize the recovery of costs in future years, particularly on negotiated fixed-price contracts.
The transition rules contained in the Harmonized CAS require the effect of the MAL and MNC provisions to be phased according to the following schedule:
|2017 and later
For example, suppose the actuary calculates the AAL to be $100 and the MAL to be $120 for 2015. Under the Harmonized CAS, in computing CAS pension cost, the MAL would be deemed to be $110 (that is, 50% of the way between the AAL and the MAL).
In the current interest rate environment, the MAL and the MNC would typically exceed their AAL and NC counterparts, which would tend to yield higher CAS pension costs than under the pre-harmonized regulations. By phasing-in the difference between the MAL vs. the AAL, and the MNC vs. the NC, the transition rules effectively postpone the additional cost recovery expected with CAS Harmonization to 2014 and later. Notwithstanding, if a contractor's CAS-covered business remains level in future years, that contractor will eventually recover the full economic value of the costs that were delayed pursuant to these transition rules because CAS pension costs include interest on unfunded pension liabilities. In other words, although the negative cash flow experienced by contractors in recent years (i.e., the excess of required PPA funding over recovery of CAS costs) will likely persist through 2013, contractors can expect to recover this negative cash flow through increases in recoverable CAS costs in 2014 and later.
Unlike the transition period for the MAL and MNC calculations, the change in the amortization period for actuarial gains and losses is effective January 1, 2013. In other words, gains and losses resulting from experience during 2012 will be amortized over 10 years when computing the 2013 pension cost. This could increase or decrease costs in 2013, depending on whether experience in 2012 results in net actuarial gains or losses. The Harmonized CAS do not affect amortizations of actuarial gains and losses recognized in 2012 and earlier, which will continue to be amortized on the 15-year schedule already established under the prior version of the Standard.
Considerations in Implementing the CAS Harmonization Rule
The following points should be considered in implementing the revised regulations:
- Basis for settlement rates. Contractors must identify the specific settlement rates to be used to compute the MAL and MNC, which will form a part of their disclosed cost accounting practices. Because CAS 412 provides that PPA rates as published by the IRS may be used as a safe harbor, we expect that many contractors will avail themselves of this PPA safe harbor to minimize disputes.
- Long-term asset return rate. Since the Employee Retirement Income Security Act ("ERISA") was enacted in the 1970s, pension plan sponsors have been required to assume a long-term rate of investment return for minimum funding purposes. Because CAS 412 has had a parallel requirement, Government contractors have generally used the ERISA rate for CAS purposes. With very few exceptions, if the contractor used the same rate for ERISA and CAS purposes, the Government accepted that rate.
With the advent of PPA, however, the long-term rate is no longer used for ERISA calculations. Because the CAS still requires the use of a long-term rate to compute the AAL and NC, however, we expect the Government to scrutinize this assumption more closely. In particular, the Government is likely to continue to assert the position it has taken on occasion in recent years where it has challenged assumed rates of return for CAS purposes that are lower (and hence yield a higher pension cost) than the corresponding long-term rates of return used for GAAP accounting purposes. Due to differing emphasis on past experience versus future expectations between CAS and GAAP, there are good reasons why these CAS and GAAP rates may differ. Notwithstanding, contractors should objectively review their long-term investment return expectations to support their CAS investment return rate and, if there is a CAS/GAAP difference, be prepared to explain the bases for the difference.
- Other actuarial assumptions. CAS 412 requires that the "going concern" AAL/NC and the "settlement" MAL/MNC amounts be measured using the same actuarial assumptions except for the mandated differences between (1) long-term asset return rates vs. settlement rates and (2) the presence of projected compensation increases and benefit improvements on a "going concern" basis but not on a "settlement" basis for benefits expected to be earned in future years. When implementing Harmonized CAS, contractors should review each actuarial assumption used for PPA, GAAP and CAS purposes to eliminate inconsistencies and, to the extent that appropriate differences remain, document the rationale for those differences.
- Prepayment credits. CAS prepayment credits arise when contractors make contributions to their pension plans that exceed the amounts of their CAS costs.
Many contractors have accumulated substantial prepayment credits, particularly in recent years when minimum funding obligations under PPA have exceeded CAS pension costs. Prepayment credits may be applied to fund CAS costs in future periods when CAS costs exceed plan contributions.
In the past, prepayment credits grew with interest at the assumed rate of return. Under Harmonized CAS, however, prepayment credits must be adjusted at the actual rate of return earned by the fund, net of pension investment and administrative expenses paid from the pension trust. By allocating a portion of administrative expenses to prepayment credits, those costs are not allocated to a contractor's business operations, which in turn reduces the costs allocated to contracts. To assure that these administrative costs are allocated to operations (and hence to Government and other contracts), some contractors may elect to pay such expenses from company funds rather than from the pension trust.
- Segment closings. A "segment closing" occurs when a contractor discontinues the operation of a segment, sells the segment, or stops seeking CAS-covered business in the segment. In addition, if the contractor terminates the pension plan or changes the plan so that no material future benefits are earned under the plan (referred to as a "curtailment") those events are also treated as segment closings. In very simple terms, the segment closing rules require the contractor to calculate the funding status of the plan on the date of the segment closing (as measured for CAS purposes). If the plan is overfunded, the contractor may owe the Government a share of the overfunding. If the plan is underfunded, the Government may owe the contractor a share of the underfunding.
In recent years, segment closings have accounted for many well-publicized disputes between the Government and contractors. The Harmonized CAS will affect future segment closing-type calculations in the following manner:
1) Assumptions at segment closing. As explained above, pension costs are based upon the greater of liabilities computed on a "going concern" and a "settlement" premise. Under Harmonized CAS, however, the "settlement" basis MAL and MNC only apply when computing pension costs for an ongoing segment. Thus, if a segment is closed, or if benefits are curtailed, the requisite segment closing calculations must be made solely on the basis of the "going concern" assumptions, but excluding any provision for future compensation or benefit increases. In addition to the irony of requiring "settlement" assumptions to be used for a going concern and "going concern" assumptions to be used at the time of final settlement, this requirement effectively reverses harmonization. That is because the cumulative excess of "settlement" liabilities over "going concern" liabilities would be eliminated from the calculation of segment closing liabilities, to the disadvantage of contractors. When a pension plan is terminated, however, the CAS generally do not require the contractor to give back pension costs that were previously recovered on a settlement basis.
2) PPA "curtailments." When funding levels drop below 60%, PPA requires plan sponsors to freeze all benefit accruals until plan funding improves. Prior to harmonization, such a curtailment of benefit accruals would have been treated as a segment closing. The Harmonized CAS state that the temporary elimination of benefit accruals under this provision is not to be treated as a "curtailment" under CAS 413, which means that this type of involuntary benefit freeze will not interrupt ongoing cost accounting.
3) Segment closing case. The CAS Board indicated that it is likely to open a separate case dealing with other segment closing issues … stay tuned …
- Asset allocation. In recent years, ERISA and GAAP pension accounting have evolved in a manner that limits "smoothing" in pension costs by requiring more rapid recognition of actuarial gains and losses (this process is often referred to as "mark to market"). To limit volatility, some pension plan sponsors have revised their investment strategy by shifting assets from equities to fixed income investments.
The segment closing "giveback" problem described in the preceding point (i.e., the requirement to make segment closing calculations based only on "going concern" assumptions) may encourage Government contractors to move more towards fixed income investments. In addition to reducing volatility, a move away from equity investments (which are riskier but have a higher expected rate of return) and towards fixed income investments (which are less risky but have a lower rate of return) would reduce a contractor's long-term rate of return expectation. The use of such a lower long-term rate would minimize the impact of the segment closing "giveback" issue. At the same time, however, this strategy would yield higher pension costs in the future if returns on equity investments do, in fact, exceed those on fixed income investments. Moreover, this approach would generally increase GAAP pension expense due to the reduction in expected pension fund returns.
The effective date of the Harmonized CAS is February 27, 2012. As discussed below, contractors may be entitled to an equitable adjustment for the impact of the new rules on contracts awarded before that date. Because the Government is unlikely to agree to adjustments on contracts awarded after that date, however, forward pricing rates should revised as soon as possible to incorporate the impact of the Harmonized CAS.
The first step in projecting costs for forward pricing purposes is to make the decisions discussed above that are necessary to implement the Harmonized CAS. Once the new cost accounting practices are in place, however, an important additional question concerns the "settlement" interest rates to be used for forward pricing purposes.
In general, the lower the assumed interest rate, the higher the pension cost. Because interest rates are at historically low levels at present, a critical forward pricing question concerns the future "settlement" rates to be projected for the period covered by the forward pricing. There are two schools of thought in projecting future "settlement" interest rates:
- Level future interest rates. Under this approach (sometimes referred to as the "flat line" method), today's rates are assumed to remain level in future years. In addition to simplicity, the flat line approach is urged by those who feel that the interest rates established by the market represent a consensus "average" view and that no one knows the future direction of these rates.
- Increasing future interest rates. This approach (sometimes called the "uptick" method) is based on the theory that today's low interest rates represent an aberration and that, over time, rates will trend upwards towards their historic norms. In contrast to flat line methodology, the uptick approach requires contractors to develop best estimates of future interest rates in each of the future years that are covered by the forward pricing and, within each year, for a range of different maturities.
When the Harmonized CAS were promulgated, the CAS Board web site also included several "frequently asked questions" concerning the revised regulation. The FAQs were issued by the CAS Board staff rather than the Board itself, so they are less authoritative than material published by the Board. From a practical perspective, however, it is likely that Government auditors and pension specialists will give deference to the FAQs in the course of reviewing contractor compliance with the Harmonized CAS. FAQ 11 addresses the future interest rate question for forward pricing purposes and, while reinforcing the notion that future interest rates must be set as a contractor's best estimate, seems to encourage the use of uptick methodology. Thus, the flat line approach is susceptible to challenge by Government auditors and pension specialists. Moreover, the flat line approach will yield higher pension costs than the uptick method, and the cost differential can be material.
In selecting an approach to projecting future interest rates under the uptick approach, contractors should ensure that projections of interest rates for unrelated purposes are consistent with those employed for pension forward pricing purposes, or if there is some justification for differences, those justifications are documented in the relevant records. For example, if a contractor estimates future PPA interest rates for purposes of projecting future PBGC premiums for forward pricing purposes, it would be advisable to maintain symmetry with the interest rates to be used for forward pricing of pension costs under Harmonized CAS. Similarly, contractors should examine projections of future interest rates that may have been made for internal projections of minimum funding obligations under PPA or for purposes unrelated to pension costs. In addition, the approach used to project interest rates for forward pricing purposes should be consistent with the corresponding rates to be used in the equitable adjustment process described below. Finally, the use of an objective and auditable basis for selecting future settlement rates may minimize disputes for both forward pricing and equitable adjustment purposes.
Generally, the Administration of CAS clause (FAR 52.230-6(b)(3)) requires that contractors give the Government 60 days of advance notice of a change in accounting practice, including one made to comply with a new CAS requirement. Because this is a FAR requirement instead of a CAS requirement, it is not addressed in the revised CAS regulations. Because the CAS harmonization rule effectively requires contractors to begin using forward pricing rates reflecting the new rules no later than 60 days following their promulgation, it would be impossible for contractors to change their Disclosure Statements 60 days before they begin to use those new rates.
There is a group at DOD that is working on guidance for implementing Harmonized CAS. We understand that this group is aware that there may be issues about when contractors must amend their Disclosure Statements to include changes required by the new rules.
Standard contractual CAS clauses provide that contractors are entitled to "equitable adjustments" on CAS-covered, fixed price Government contracts that are affected by the changes required by changes such as the Harmonized CAS. DOD is also working on guidance about the DOD position concerning these equitable adjustments. There should be no dispute about entitlement to adjustments on contracts entered into before February 27, 2012 that anticipate performance in 2014 and later ("Eligible Contracts"). If, for some reason, contractors are unable to incorporate revised pension costs into the price of new contracts awarded after February 27, 2012 that will be performed in 2014 or thereafter, it would be prudent to try to negotiate a "reopener" provision for pension costs in such contracts, particularly if the contracts are substantial in value.
In most situations, the amount of a CAS equitable adjustment is calculated based upon the difference between:
- The amount of pension cost that was actually priced into each Eligible Contract under the pre-harmonized version of CAS; and
- The amount of pension cost that would have been priced into each Eligible Contract under the Harmonized CAS.
The excess of the "would have been priced" amounts under the Harmonized CAS over the pension costs that were actually priced under the older version of CAS, adjusted for all relevant indirect cost allocations and profit margins, represents the amount of equitable adjustment due to the contractor under standard CAS clauses (the recovery of the adjustment can be accomplished in any way agreed upon by the parties).
In practice, contractors' ability to determine the amount of pension cost that actually was/would have been priced into each Eligible Contract may be limited and estimates may be required. Because of the practical difficulties that often arise in comparing what costs were actually included in the price of old contracts and what would have been priced if the new rules had been used, contractors and the Government may find it easier to base the adjustment on the difference between actual costs incurred under the two different sets of rules, particularly if that difference is not likely to be materially different from a proposed-cost-to-proposed-cost approach. Due to the extended implementation date and transition provisions, only backlog that is priced into 2014 and beyond will be affected, so the amount of equitable adjustment may be relatively small for many contractors.
Pine Cliff Consulting Contacts
John B. McQuade
Pine Cliff Consulting, Inc.
Pine Cliff Consulting, Inc.
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