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United States Government Accountability Office: 
GAO: 

Report to Congressional Requesters: 

January 2013: 

Pension Costs on DOD Contracts: 

Additional Guidance Needed to Ensure Costs Are Consistent and 
Reasonable: 

GAO-13-158: 

GAO Highlights: 

Highlights of GAO-13-158, a report to congressional requesters. 

Why GAO Did This Study: 

DOD contractors are among the largest sponsors of defined benefit 
pension plans in the United States and factor pension costs into the 
price of DOD contracts. Since the 2008 market downturn, these pension 
costs have grown—-thereby increasing DOD contract costs—-and recent 
changes in rules for calculating pension costs have raised the 
prospect of further cost increases. Given this possibility, GAO 
assessed how (1) contractor pension costs are determined; (2) DOD 
ensures the contractor pension costs it pays are appropriate; (3) DOD 
contractors’ defined benefit pension plans compare with plans 
sponsored by similar companies; (4) pension costs have affected DOD 
contract costs and the factors that contributed to these pension 
costs; and (5) the harmonization of CAS with ERISA will affect the 
amounts DOD will pay in pension costs in coming years. To do this, GAO 
analyzed defined benefit pension plans for the largest contractors; 
interviewed contractor and DOD officials; and reviewed relevant laws 
and regulations, including changes made to harmonize CAS with ERISA. 

What GAO Found: 

Labor costs are included in the prices contractors negotiate with the 
Department of Defense (DOD), and include pension costs as these are a 
normal element of employee compensation. Contractors make two sets of 
calculations for their defined benefit pension plans, following two 
sets of standards: (1) Cost Accounting Standards (CAS), which 
determine how pension costs are allocated to government contracts; and 
(2) Employee Retirement Income Security Act of 1974 (ERISA), which 
establishes the minimum contribution required to fund plans. In 2008, 
revised ERISA rules altered the minimum funding requirements, causing 
CAS costs and ERISA contributions to diverge further apart. ERISA 
contributions have therefore greatly exceeded CAS pension costs 
reflected in contract prices. In December 2011, almost 4 years after 
ERISA changes took effect, the CAS Board, which is part of the Office 
of Management and Budget (OMB), made changes to CAS that harmonized 
them to ERISA in order to gradually reduce the difference between the 
two calculation methods. 

DOD centralizes its technical expertise for management and oversight 
of defined benefit pension plans. DOD contracting officers at the 
corporate level negotiate pension costs with contractors and receive 
technical support from a team of DOD actuaries. DOD audits projected 
and actual costs for contracts, including pension costs, to ensure 
they are allowable, allocable, and reasonable. The Federal Acquisition 
Regulation requires that employee compensation, including pensions, be 
reasonable. However, the pension costs used for compensation reviews 
can be affected not only by the value of benefits earned by employees, 
but also by factors such as asset returns and interest rates. Also, 
oversight processes do not clearly assign responsibility for assessing 
the reasonableness of pension benefits, including those for executives. 

GAO analyzed the defined benefit plans of the 10 largest DOD 
contractors and found that nearly all of the contractors-—as well as a 
peer group of companies-—maintain some sort of tax-qualified, defined 
benefit plan for their employees. The largest contractors invest in 
similar types of pension plan assets as their peer group, and do so 
somewhat more conservatively. GAO also found that CAS pension costs 
reported by the contractors grew considerably over the last decade, 
from less than $500 million in 2002 to almost $5 billion in 2011, 
although not all of these costs were allocated to DOD contracts. 
Contractor CAS pension costs grew as the market downturn increased 
unfunded liabilities. 

Although pension cost projections are highly sensitive to economic 
assumptions, both contractors and DOD officials expect CAS pension 
costs to increase starting in 2014 due to harmonization. The CAS 
discount rates used to value liabilities will now be tied to the more 
volatile ERISA-based rates, making it harder to forecast future CAS 
pension costs and reducing the consistency of cost projections used in 
contract pricing. DOD issued limited guidance on projecting ERISA-
based discount rates for CAS calculations, but lack of specificity in 
the guidance can lead to great variation among the rates contractors 
use. Moreover, when a contractor curtails a plan, DOD and the 
contractor must settle pension costs; however, the discount rates used 
for settlements were not updated as part of harmonization, meaning 
liabilities will be calculated differently under CAS and ERISA rules. 
A schedule has not been set for addressing this issue. 

What GAO Recommends: 

GAO recommends that the Secretary of Defense clarify responsibility 
for and guidance on assessing pension reasonableness and determining 
discount rates for pension cost projections. GAO recommends that the 
CAS Board set a schedule for revising the parts of CAS that address 
the settlement of plan curtailments. DOD agreed with the 
recommendations to the Secretary of Defense, and OMB said that when 
the CAS Board meets it will consider a schedule for revision. 

View [hyperlink, http://www.gao.gov/products/GAO-13-158]. For more 
information, contact Cristina Chaplain at (202) 512-4841 or 
chaplainc@gao.gov; or Charles Jeszeck at (202) 512-7215 or 
jeszeckc@gao.gov. 

[End of section] 

Contents: 

Letter: 

Background: 

CAS and ERISA Rules Determine Pension Calculations but Have Diverged 
Over Recent Years: 

DOD Leverages Centralized Expertise Necessary to Provide Oversight but 
Lacks Full Picture of Defined Benefit Plan Reasonableness: 

The Largest DOD Contractors Maintain Their Defined Benefit Plans in 
Similar Ways to Peer Companies: 

CAS Pension Costs for Large DOD Contractors Have Increased in Recent 
Years Due to the Market Downturn: 

Harmonization Will Likely Increase the Magnitude and Volatility of 
Contractor Pension Costs: 

Conclusions: 

Recommendations for Executive Action: 

Agency and Third-Party Comments: 

Appendix I: Objectives, Scope, and Methodology: 

Appendix II: Comments from the Department of Defense: 

Appendix III: GAO Contacts and Staff Acknowledgments: 

Table: 

Table 1: Changes Affecting ERISA and CAS Discount Rates for 
Liabilities: 

Figures: 

Figure 1: Types of Contract Cost: 

Figure 2: Effect of Different Discount Rates on the Current Value of a 
Future Payment: 

Figure 3: Hypothetical Development and Discharge of Prepayment Credits: 

Figure 4: Interactions and Information Flows between DOD Contractors 
and Providers of Pension Cost Oversight at DOD: 

Figure 5: Asset-Weighted Year-End 2011 Pension Investment Allocations 
of Large DOD Contractors and Their Peer Group: 

Figure 6: Total CAS Pension Costs for Largest DOD Contractors with 
Defined Benefit Plans: 

Figure 7: Defined Benefit Plan Costs Relative to Direct Labor for 
Selected Weapon Systems Programs: 

Figure 8: Defined Benefit Plan Costs Relative to Total Costs for 
Selected Weapon Systems Programs: 

Figure 9: Sources of Current Unfunded Liabilities for the Largest DOD 
Contractors (as of Beginning of 2011): 

Figure 10: Breakdown of 2011 CAS Pension Costs for the Largest DOD 
Contractors (as of Beginning of 2011): 

Figure 11: Effect of Different Discount Rates and Different Asset 
Returns on Plan Costs for an Illustrative Plan: 

Figure 12: Long-Term Cost Projections for an Illustrative Plan under 
Different Discount Rate Scenarios: 

Abbreviations: 

CAS: Cost Accounting Standards: 

CIPR: Contractor Insurance/Pension Review: 

DCAA: Defense Contract Audit Agency: 

DCMA: Defense Contract Management Agency: 

DOD: Department of Defense: 

ERISA: Employee Retirement Income Security Act of 1974: 

FAR: Federal Acquisition Regulation: 

MAP-21: Moving Ahead for Progress in the 21st Century Act: 

OMB: Office of Management and Budget: 

PBGC: Pension Benefit Guaranty Corporation: 

PPA: Pension Protection Act of 2006: 

[End of section] 

United States Government Accountability Office: 
Washington, DC 20548: 

January 22, 2013: 

Congressional Requesters: 

Department of Defense (DOD) contractors are among the largest sponsors 
of defined benefit pension plans in the United States, with more than 
$100 billion in pension assets.[Footnote 1] Contractors factor the 
cost of employee wages and fringe benefits, including defined benefit 
pension costs, into the price of contracts with DOD. These pension 
costs had been relatively low for a number of years, principally 
because of strong returns on pension assets. However, over the last 
decade, and particularly since the financial market decline of 2008 
and 2009 reduced the value of major assets, these costs have grown--
almost 90 percent from 2008 to 2011 for the largest contractors--and 
increased DOD contract costs. Concerns have been raised that recent 
changes in the government's rules for calculating pension costs may 
lead to further cost increases in coming years. 

Given the possibility of increased contractor pension costs for DOD, 
you asked us to review contractor pension costs. As agreed, we 
assessed how (1) contractor pension costs are determined; (2) DOD 
ensures the contractor pension costs it pays are appropriate; (3) DOD 
contractors' defined benefit pension plans compare with plans 
sponsored by similar companies that are not among the largest DOD 
contractors; (4) pension costs have affected DOD contract costs and 
the factors that contributed to these pension costs; and (5) the 
December 2011 harmonization of Cost Accounting Standards (CAS) with 
the Employee Retirement Income Security Act of 1974 (ERISA)[Footnote 
2] will affect the amounts DOD will pay in pension costs in coming 
years.[Footnote 3] 

To conduct analysis across all objectives, we analyzed defined benefit 
pension plans for the 10 largest contractors based on DOD contract 
obligations for fiscal year 2011, selecting for deeper analysis the 35 
defined benefit plans that together covered at least 90 percent of 
each contractor's pension liabilities.[Footnote 4] At the 10 largest 
contractors, we interviewed officials whose responsibilities included 
benefits management and government accounting, as well as Defense 
Contract Management Agency (DCMA) and Defense Contract Audit Agency 
(DCAA) officials. We reviewed relevant laws, regulations, and DOD 
policy documents, in addition to reports written by the DCMA 
Contractor Insurance/Pension Review (CIPR) Center and DCAA that 
address contractor pension costs. 

Further, to understand how DOD oversees pension costs at smaller 
contractors, we reviewed seven publicly traded contractors that met 
criteria we set for DOD contract obligations, level of defined benefit 
pension plan assets, and amount of DOD business relative to non-DOD 
sales. To compare the pension plans of contractors to those sponsored 
by similar companies, we selected a peer group of 15 companies not 
among the largest DOD contractors and analyzed the peers' and 
contractors' audited financial statements for 2011. To identify trends 
in CAS pension costs, for the nine largest contractors we reviewed 
pension plan documents such as CAS valuation reports (generally 
certified by qualified and credentialed actuaries) and collected 
contractor data on incurred CAS pension costs from 2002 to 2011. To 
understand how pension costs make their way onto DOD contracts, we 
selected divisions at the five largest contractors and at each 
division selected a weapon system program, which together represent a 
mix of military services and platform types. For the five divisions 
and programs we collected contractor data on incurred pension costs 
from 2005 to 2011. To demonstrate the potential impact on CAS pension 
costs of CAS/ERISA harmonization and changing economic assumptions, we 
developed a model of an illustrative contractor defined benefit plan, 
based on a review of the model DOD uses, and reviewed by the Chief 
Actuary of the GAO for actuarial soundness. We also gathered 
contractor projections of CAS pension costs for 2012 to 2016. See 
appendix I for additional details on our scope and methodology. 

We conducted this performance audit from December 2011 to January 2013 
in accordance with generally accepted government auditing standards. 
Those standards require that we plan and perform the audit to obtain 
sufficient, appropriate evidence to provide a reasonable basis for our 
findings and conclusions based on our audit objectives. We believe 
that the evidence obtained provides a reasonable basis for our 
findings and conclusions based on our audit objectives. 

Background: 

Pension Costs Are Captured on DOD Contracts as Indirect Costs: 

DOD frequently purchases products that are not available in the 
commercial marketplace. For example, DOD awards contracts for the 
development or production of weapon systems including fighter 
aircraft, submarines, and radars. In these situations, DOD typically 
negotiates the price it will pay based on the cost to deliver the 
desired product. In negotiating prices, DOD seeks insight into 
contractors' costs such as for salaries, wages, and benefits, the last 
of which includes pensions. When a purchase occurs in the commercial 
marketplace, the price for a commercial product will include the 
sellers' costs for materials and labor (including salaries, wages, and 
benefits) but the buyer has little insight into these costs. 

Contractors' labor costs include pension benefits, since such benefits 
are a normal part of compensation. These pension costs are an indirect 
cost spread across multiple contracts at a particular contractor 
business division, as opposed to direct costs such as those labor and 
material costs that can be associated with a specific contract (see 
figure 1). They are typically allocated to contracts based on direct 
labor costs. Pension costs are generally considered a fringe benefit, 
a category that includes costs associated with health benefits, group 
insurance, and other forms of nonwage compensation. In previous work, 
we found that of the three main types of employee benefits (health 
insurance, paid leave, and retirement benefits), health insurance is 
generally the most expensive, and retirement benefits the least. 
[Footnote 5] 

Figure 1: Types of Contract Cost: 

[Refer to PDF for image: illustration] 

Total contract costs: 

Direct costs: 
* Direct materials; 
* Direct labor; 
Charged to a specific contract. 

Indirect costs: 
* Office supplies; 
* Travel and telephone; 
* Fringe benefits (including pensions); 
Costs shared across multiple contracts. 

Source: Defense Systems Management College. 

[End of figure] 

Oversight of DOD contracts is primarily provided by two agencies: 

1. Defense Contract Management Agency (DCMA), which includes 
contracting officers who, as part of their duties, negotiate and agree 
upon indirect costs applied to contracts awarded by DOD acquisition 
commands and other buying offices. 

2. Defense Contract Audit Agency (DCAA), which audits projected and 
actual costs associated with DOD contracts to ensure they are 
allowable, allocable, and reasonable in accordance with CAS and 
Federal Acquisition Regulation (FAR) rules. 

These indirect cost oversight processes are not limited to DOD, but 
apply to U.S. government contracts more broadly. DCMA and DCAA provide 
assistance related to indirect cost oversight for non-DOD agencies, 
such as the National Aeronautics and Space Administration (NASA) and 
the Department of Homeland Security. When DCMA, as the cognizant 
contract administration office, reaches an agreement on indirect 
costs, the agreement is applicable to all U.S. government contracts 
performed by that business unit. 

DOD Contractors Sponsor Different Types of Retirement Plans: 

DOD contractors, like other private sector companies, may sponsor 
traditional defined benefit plans, or defined contribution plans (such 
as 401(k) plans) which provide individual accounts for employees and 
allow for employer and employee contributions.[Footnote 6] They may 
sponsor multiple defined benefit plans, which typically cover 
different business lines or employee populations, such as salaried or 
hourly employees. Many defined benefit and defined contribution plans 
sponsored by DOD contractors are "tax-qualified" under the Internal 
Revenue Code.[Footnote 7] Tax qualification means the plans meet 
certain rules in the Internal Revenue Code, and have certain tax 
advantages. Minimum funding rules--that is, the amount required to be 
held in the trust fund to finance future benefit payments--are 
contained in the Internal Revenue Code and mirrored in ERISA, and 
apply to private sector "tax-qualified" defined benefit 
plans.[Footnote 8] Note that sponsor contributions to these plans are 
not the benefit payments themselves, but contributions that go into a 
trust fund, grow with investment returns, and eventually are paid out 
as benefits at a later date. These contributions are tax-deductible to 
the sponsoring company, investment returns on the trust fund is tax-
deferred, and plan participants pay tax only as they receive benefits 
in retirement.[Footnote 9] 

DOD contractors also sponsor "nonqualified plans."[Footnote 10] These 
plans do not meet the applicable requirements for tax-qualification 
under the Internal Revenue Code. Sponsors of these plans typically do 
not have to satisfy laws and regulations capping maximum benefits or 
requiring a minimum level of contributions to the plan. They also do 
not have to meet certain reporting, disclosure, bookkeeping, and core 
fiduciary requirements. Nonqualified plans are typically designed for 
highly compensated employees or selected company executives. 
Nonqualified plans may be operated on a pay-as-you-go basis or may be 
prefunded. Nonqualified plans do not have a minimum ERISA 
contribution, and, for pay-as-you-go plans, the CAS pension cost will 
be the cost of the benefit payments to the participants. 

Defined contribution plans shift investment risk away from the 
employer and onto employees, meaning that these plans have much more 
predictable yearly costs for the employer. While defined contribution 
plans often have employer matches which generally require annual 
contributions, we reported that from 1995 to 2002, very few sponsors 
of large defined benefit plans were required to make cash 
contributions to their plans.[Footnote 11] In terms of sponsor 
contributions, neither type of plan--defined benefit or defined 
contribution--is inherently more or less expensive to a plan sponsor, 
nor more or less generous to plan participants, than the other. 
Expense and generosity depend on the particular provisions of the 
plan, among other factors. Costs associated with defined contribution 
plans are typically more straightforward for sponsors to calculate and 
project than defined benefit plan costs. Defined benefit plans require 
actuarial support and management of sponsor contributions and invested 
assets in order to fund liabilities. These considerations do not apply 
to sponsors of defined contribution plans. 

CAS and ERISA Rules Determine Pension Calculations but Have Diverged 
Over Recent Years: 

CAS Rules Define How Much Pension Cost Can Be Allocated to Contracts 
While ERISA Rules Determine Required Pension Contributions: 

DOD contractors make two sets of calculations for each of their 
defined benefit pension plans, following two sets of standards. They 
calculate a CAS pension cost, which is the cost that serves as a basis 
for calculating what pension costs can be charged to contracts. This 
cost is allocated to contracts based on CAS rules. Like all plan 
sponsors, they also calculate the contribution they are required to 
make, or otherwise face penalties, under ERISA. Because the rules are 
different, the CAS pension cost is likely to be different from the 
required ERISA contribution. 

A contractor's total pension cost may also include costs that are not 
allocated to DOD or other U.S. government contracts, but instead 
allocated to commercial activities. Several large DOD contractors have 
significant commercial operations. For example, less than 20 percent 
of United Technologies Corporation's sales are to the U.S. government, 
and approximately half of Boeing's sales come from its commercial 
aircraft business. 

Cost Accounting Standards for Pensions: 

The FAR requires that costs be allowable, allocable, and reasonable. 
When contract costs are established through negotiation, the CAS 
provides the framework contractors use to determine allocable costs. 
In particular, pension costs for DOD contracts are measured, assigned, 
and allocated to contracts according to rules in CAS 412 and 413. CAS 
rules are set by the CAS Board, part of the Office of Federal 
Procurement Policy within the Office of Management and Budget (OMB), 
which includes members from government and industry. CAS is designed 
to ensure uniformity across contractors in how they allocate costs on 
government contracts, linking the costs incurred on contracts to the 
benefits the government receives as a result of those costs.[Footnote 
12] CAS also provides a framework for assigning costs to discrete cost 
periods and aims to minimize the volatility of pension costs in the 
pricing of government contracts. 

In addition to using CAS rules to measure pension costs incurred in a 
given year, contractors also use CAS rules to determine expected 
future pension costs, called "forward pricing projections." 
Contractors use these projections when they negotiate contracts 
covering multiple years. These contracts may be firm fixed priced--
with no adjustment to reflect actual costs under normal circumstances--
or flexibly priced. Flexibly priced contracts provide for price 
adjustment.[Footnote 13] When a regulatory change occurs--such as a 
change in the CAS--both fixed and flexibly priced contracts may be 
eligible for adjustments (also known as equitable price adjustments) 
to reflect the impact of the change. 

CAS 412 provides guidance to contractors and the government on how to 
determine and measure the components of pension cost for defined 
benefit plans in a given year. For most defined benefit plans, the 
components include: 

1. Normal cost: pension cost attributable to the employee's work in 
the given year. 

2. Other pension costs: the costs that include payment for part of any 
shortfall in assets required to pay for pension costs that are 
attributable to past service (the shortfall is known as the unfunded 
liability). 

Both of these components reflect actuarial present values, today, of 
benefits projected to be paid in the future, and not the actual 
benefits being paid today to plan participants. 

Sources of any shortfall may include: differences between actuarial 
assumptions and actual experience such as worse-than-expected asset 
performance in a given year (the difference is known as an actuarial 
loss); changes in actuarial assumptions that increase liabilities such 
as projections of inflation, mortality, and retirement age; and 
changes in the rules used for benefit computation or other plan 
amendments that increase liabilities. Plans with unfunded liabilities 
make installment payments to reduce these unfunded liabilities over a 
period of time that depends on the sources of the unfunded liabilities. 

[Side bar: 
How Contractors Pay for Gains and Losses under CAS: 
Each year, contractors measure whether their existing assets have 
grown as fast as their existing liabilities. If these assets have 
grown faster than liabilities because assets performed better than 
expected or because liabilities were not as high as estimated, 
contractors record an actuarial gain. In the opposite case, 
contractors record an actuarial loss. Gains and losses are amortized 
over 10 years with interest (similar to a level payment on a 
mortgage), and the sum of these annual installments is a component of 
each year's CAS cost. End of side bar] 

If a plan has more assets than liabilities in a given year, then the 
normal cost is offset by extra plan assets, and so overall CAS cost to 
the government is reduced by the excess assets, and can even be 
reduced to zero. Plans might have more assets than liabilities if, for 
example, assets perform more strongly than expected (the difference is 
known as an actuarial gain) or if changes in actuarial assumptions 
reduce liabilities, or if the plan sponsor reduces liabilities through 
plan amendments. Both actuarial gains and losses are incorporated into 
CAS pension cost in installments over a number of years. 

Allocation of CAS Pension Costs to Contracts: 

Supported by in-house or external actuaries, DOD contractors calculate 
their CAS pension costs at least annually, and produce CAS valuation 
reports for plans.[Footnote 14] The calculations provide the basis for 
projections of future CAS pension costs for use in forward pricing. 
These costs are then allocated to the various divisions of the 
contractor. Contractors use a range of methods such as payroll dollars 
or number of active participants to allocate CAS pension costs across 
divisions for application to contracts. Allocation methods are 
explained in required CAS disclosure statements, prepared at the 
corporate and division levels by contractors, and provided to DOD for 
review. At the division level, the combined cost of pension benefits 
with other employee benefit costs including health benefits and group 
insurance, is frequently referred to as the fringe benefit cost. The 
fringe benefit cost is projected over one or more future years based 
on factors such as estimated labor costs and the expected amount of 
future business. Projected fringe benefit costs are then submitted to 
DCMA officials at the division level for review. 

While forward pricing projects future costs for use in contract 
pricing, contractors also develop annual proposals for incurred costs 
including CAS pension costs. These are actual costs incurred by the 
contractor, which may differ from the projected costs used in the 
forward pricing process. These proposals are submitted to DOD and used 
as the basis for negotiating settlement of any cost differences when 
closing out flexibly priced contracts. 

ERISA Rules for Pensions: 

Congress enacted ERISA in 1974 to set certain protections for plan 
participants and minimum funding standards for pension plans sponsored 
by private employers.[Footnote 15] ERISA is designed to protect the 
interests of participants (and their beneficiaries).[Footnote 16] The 
administration of ERISA is divided among the Department of Labor, the 
Internal Revenue Service of the Department of the Treasury, and the 
Pension Benefit Guaranty Corporation (PBGC). According to PBGC, if 
sponsors are no longer able to fund or administer their plans, PBGC 
makes sure participants will get some or all of their promised 
benefits.[Footnote 17] 

Setting the Discount Rate Is a Key Decision in Calculation of Pension 
Contributions and Costs: 

The discount rate is a key part of determining both CAS pension costs 
and ERISA-required contributions.[Footnote 18] Pensions are promises 
to make a future stream of payments, and the discount rate determines 
the estimate of the present value of promises to pay a future benefit. 
As shown in figure 2, the higher the discount rate, the lower the 
liability today. 

Figure 2: Effect of Different Discount Rates on the Current Value of a 
Future Payment: 

[Refer to PDF for image: illustration] 

$614 liability today; 5.0% discount rate; 
$558 liability today; 6.0% discount rate; 
$508 liability today; 7.0% discount rate; 
$463 liability today; 8.0% discount rate; 
$1,000 benefit payable 10 years from today. 

Source: GAO analysis. 

[End of figure] 

Basic approaches to setting a plan's discount rate include: (1) basing 
the discount rate on the expected long-term return on plan assets 
(which includes expected long-term stock market returns to the extent 
plan assets are so invested, and which, in recent years, often would 
produce discount rates between 7.0 and 8.0 percent), or (2) basing the 
discount rate on relevant interest rates in the bond market (which, in 
turn, could be based on either current market interest rates, or an 
historical average over some period, and which, in recent years, often 
would produce discount rates around 4.0 percent).[Footnote 19] The 
first approach will more often produce a higher discount rate than the 
latter approach. 

The Pension Protection Act of 2006 (PPA), effective 2008, changed 
ERISA, strengthening the minimum funding requirements for defined 
benefit plans (although its provisions were altered by subsequent 
legislation).[Footnote 20] These changes required sponsors to use a 
measure of corporate bond interest rates to calculate their defined 
benefit plan liabilities instead of a discount rate based on the 
expected long-term rate of return on plan assets, which generally 
increased contributions.[Footnote 21] In contrast, CAS rules continued 
to use the expected long-term rate of return assumption as the 
discount rate, which would typically be higher than corporate bond 
interest rates. PPA mandated certain changes to CAS pension rules 
while delaying implementation of the new ERISA funding rules for 
several large DOD contractors until 2011.[Footnote 22] 

Growing Divergence between CAS Costs and ERISA Contributions Has 
Generated Over $26 Billion in CAS Prepayment Credits: 

The recent changes in the ERISA discount rate basis meant major 
differences in the methodology for CAS cost and ERISA contribution 
calculations, but CAS and ERISA rules were not fully aligned even 
before these changes. CAS pension cost rules were once similar to the 
rules for determining minimum ERISA contributions. However, as 
Congress amended ERISA over the years, the CAS Board did not make 
changes as frequently. For example, prior to PPA taking effect in 
2008, ERISA rules imposed additional funding charges for underfunded 
plans, which were not accounted for by the CAS rules. Table 1 
summarizes recent changes to discount rates used for CAS and ERISA 
calculations, including the most recent changes enacted in the 2012 
Moving Ahead for Progress in the 21st Century Act (MAP-21). 

Table 1: Changes Affecting ERISA and CAS Discount Rates for 
Liabilities: 

ERISA: 
Before 2008: Equal to assumed long-term rate of return on plan 
assets[A]; 
After 2008: Tied to recent corporate bond interest rates, per PPA; 
plans use rates that vary depending on when the actuary estimates the 
benefit payments will be made; 
After February 2012: No change; 
After July 2012: Bounded recent bond interest rates by a longer-term 
historical average, expected to temporarily increase discount rates to 
provide funding relief to plan sponsors, per MAP-21. 

CAS: 
Before 2008: Equal to assumed long-term rate of return on plan assets; 
After 2008: No change; 
After February 2012: ERISA-based measures phase in gradually from 2014 
until 2017; new rates will only be used to extent they produce higher 
measures than under traditional CAS measures; 
After July 2012: Change as ERISA discount rates change. 

Source: GAO analysis of ERISA and CAS. 

[A] Also contained an alternate calculation, tied since 2004 to recent 
corporate bond interest rates, that imposed an additional funding 
charge for underfunded plans. 

[End of table] 

For a qualified pension cost to be recognized under CAS, a contractor 
must make a contribution in a given year to a plan's trust fund. 
However, the past divergence of CAS and ERISA approaches is a driver 
of contractors contributing more to their pension plans than has been 
recognized under CAS and reflected in contract prices. This has 
generated CAS prepayment credits. In the future, the contractor can 
apply its CAS prepayment credits in lieu of a cash contribution to the 
plan in a given year. The largest DOD contractors had at least $26.5 
billion in CAS prepayment credits as of the beginning of 2011. Figure 
3 provides a hypothetical example of how a prepayment credit is 
generated and discharged. 

Figure 3: Hypothetical Development and Discharge of Prepayment Credits: 

[Refer to PDF for image: illustration] 

Contractor builds $5 million credit in 2012: 
* CAS is $10 million; 
* ERISA minimum contribution is $15 million; 
* The contractor contributes more than CAS cost; 

The credit is $7.3 million in 2017: 
* The credit grows at 8 percent for 5 years[A]; 
* CAS assets execute credit, increasing CAS cost. 

Prepayment credit reduced by $5 million to $2.3 million in 2017: 
* CAS cost in $20 million; 
* ERISA minimum contribution is $15 million; 
* The contractor contributes $15 million and used $5 million credit, 
collecting more from CAS than contributed under ERISA. 

Source: GAO analysis of Cost Accounting Standards rule. 

[A] The CAS prepayment credit would grow with the assumed rate of 
return on plan assets until 2013, after which time, it would grow with 
the actual rate of return on plan assets. 

[End of figure] 

Prepayment credits affect how contractors calculate their unfunded 
liabilities. When comparing assets to liabilities, prepayment credits 
are subtracted from CAS assets. This creates a higher unfunded 
liability and thus a higher CAS cost. 

Harmonization of CAS to ERISA Aims to Gradually Reduce Differences 
between the Two Methodologies: 

PPA required the CAS Board to harmonize CAS to ERISA by January 1, 
2010.[Footnote 23] The changes made by the CAS Board became effective 
in February 2012. However, the CAS Board did not make CAS rules 
exactly match ERISA, stating that this was not congressional intent, 
and recognizing that the two different systems have different goals. 
The CAS Board's final rule phased in the liability calculated with the 
ERISA-based discount rate--from 25 percent in 2014 to 100 percent in 
2017.[Footnote 24] This means that closer alignment between CAS 
pension costs and ERISA contributions will take several years. In 
addition to changes to the discount rate, the CAS Board also reduced 
the schedule of time to pay for actuarial losses (or get credit for 
actuarial gains) from 15 to 10 years, starting in 2013. This change 
aligns the CAS amortization schedule more closely with the 7-year 
amortization schedule mandated in the PPA. The CAS Board also designed 
harmonization so that if the cost calculation is lower under the new 
rules than the traditional rules, then the traditional rules would 
continue to apply. 

The most recent change to ERISA minimum contribution requirements can 
also affect CAS pension cost. Congress effectively increased, on a 
temporary basis, the ERISA-mandated discount rate by applying a new 
methodology for calculating it via the MAP-21 legislation. Because the 
CAS harmonization rules say the ERISA discount rate is an 
automatically acceptable ("safe harbor") rate, contractors that use 
the ERISA discount rate will see a matching change in their CAS 
discount rate. 

CAS rules (CAS 413) specify that the contractor and the government 
must "settle up" under certain circumstances. For example, a 
settlement would be triggered if a contractor curtails a plan, meaning 
that no new benefits can accrue for participants.[Footnote 25] This 
means that DOD and the contractors calculate whether the government 
has over-or underpaid for CAS pension costs over the years, with the 
balance being settled via payment by the government or the contractor. 
These CAS settlement rules use the traditional long-term rate of 
return discount rate, instead of the ERISA-based corporate bond 
interest rates. This means that the CAS liability for settling up 
would be similar to the old CAS liability and would not reflect 
changes from the harmonization rule. 

DOD Leverages Centralized Expertise Necessary to Provide Oversight but 
Lacks Full Picture of Defined Benefit Plan Reasonableness: 

DOD Relies on Centralized Expertise for Management and Oversight of 
Defined Benefit Pensions: 

Like contractors, DOD centralizes its technical expertise for 
management and oversight of defined benefit pension plans. DOD 
negotiates CAS pension costs with contractors at the corporate level. 
Figure 4 illustrates the range of interactions and information flows 
between large DOD contractors and those parts of DOD involved in 
pension cost oversight. 

Figure 4: Interactions and Information Flows between DOD Contractors 
and Providers of Pension Cost Oversight at DOD: 

[Refer to PDF for image: illustration] 

Contractor corporate office: 
Generates and submits to DCMA: 
* Forward pricing proposal that includes projected CAS pension costs; 
* Incurred pension cost proposal. 

DCMA corporate-level contracting officer: 
Can use information from CIPR Center and DCAA auditors when 
negotiating: 
* Pension forward pricing agreements; 
* Pension forward pricing recommendations; 
* Final indirect costs; 
; 
DCMA contracting officer, Division A: 
DCMA contracting officer, Division B: 
DCMA contracting officer, Division C: 
DCMA contracting officer, Division D: 
- Uses pension forward pricing agreements or recommendations in 
negotiations; 
- Monitors incorporation of allocated pension costs into fringe 
benefit costs; 
- Uses allocated final direct costs as the basis of adjustments to 
flexibly priced contracts before close-out. 

DCMA CIPR Center actuaries: 
* Review pension forward pricing proposals including CAS valuation 
reports; 
* Assess reasonableness of actuarial assumptions; 
* Perform independent pension cost measurement. 

DCAA auditors: 
* Question costs identified as not allowable, allocable, or reasonable; 
* Review contractor incurred pension cost proposals; 
* Compare previous pension cost estimates to actual costs; 
* Review adequacy of contractor CAS disclosure statements and 
determine compliance with CAS and FAR. 

Source: DOD instructions and guidance. 

[End of figure] 

DOD oversight of CAS pension costs parallels the central management of 
these costs by the largest DOD contractors at the corporate level. The 
corporate-level DCMA contracting officer receives contractor 
submissions such as pension forward pricing and incurred pension cost 
proposals. The corporate-level contracting officer negotiates CAS 
pension costs and either comes to agreement with the contractor or 
recommends an amount of CAS pension cost that DCMA contracting 
officers at the division level can use in negotiations. 

To monitor possible cost changes during contract performance, DCMA 
requires establishment of cost monitoring programs at contractor 
locations that meet certain government contracting cost and sales 
criteria. As contractors bill the government after contracts are 
awarded, DCMA cost monitors at the corporate level compare proposed 
costs with actual costs incurred. If actual costs diverge from the 
proposed costs, the cost monitor may recommend that an agreement be 
modified or even canceled. This can affect the cost of fixed-price 
contracts awarded in the future and existing flexibly priced contracts. 

The corporate-level contracting officer has two primary sources of 
technical expertise available to assist in determining that the 
contractor's CAS pension costs meet CAS and FAR requirements that they 
be allowable, allocable, reasonable, and compliant: the DCMA CIPR 
Center and auditors from DCAA. The corporate-level contracting officer 
can use information from these two sources in negotiations with the 
contractor that result in either pension forward pricing agreements or 
recommendations. 

The CIPR Center represents a key element in DOD's oversight process, 
giving recognition to the complexity and highly technical nature of 
defined benefit pension plans. As DOD's centralized source of 
actuarial expertise, it advises DCMA contracting officers on pensions 
as well as insurance, including review of forward pricing proposals. 
The CIPR Center assesses the reasonableness of actuarial assumptions, 
including the discount rates used to calculate liabilities. It also 
provides an independent measurement for projected pension costs. To 
test a contractor's estimate of pension costs for future years, the 
CIPR Center has developed a model that generates an independent 
projection of the contractor's CAS pension costs, which according to a 
CIPR Center official, is based on data and actuarial assumptions in 
CAS valuation reports. The CIPR Center compares the model's output 
with the contractor's proposal to evaluate whether the contractor's 
projections are reasonable, and then issues a report that includes the 
CIPR Center's methodology, calculations, and evaluation of 
reasonableness. For example, the CIPR Center has issued a recent 
report noting that a contractor's assumed rates of return used to 
project CAS pension costs were unreasonable. 

The CIPR Center is more likely to review proposed CAS pension costs 
annually for large contractors than for smaller contractors that also 
have significant defined benefit plans. From 2007 to 2011, the CIPR 
Center reviewed proposed pension costs for six of the nine largest 
contractors with defined benefit plans at least annually. Two other 
large contractors were reviewed in 4 of the 5 years from 2007 to 2011. 
The ninth large contractor, with relatively low CAS pension costs, had 
not been reviewed within the last 5 years. Four of the seven smaller 
contractors included in our review received CIPR Center reviews of 
proposed pension costs at least once between 2007 and 2011. Corporate-
level contracting officers have the discretion to determine if the 
potential risk associated with CAS pension costs merits specialized 
review by the CIPR Center. One contracting officer at a smaller 
contractor noted that over recent years he had requested and received 
regular CIPR Center reviews of the contractor's projected pension 
costs. Another contracting officer at a contractor whose pension plans 
have not received a recent CIPR Center review noted that he relied 
primarily on DCAA audits for insight into CAS pension cost issues, 
unless there had been significant pension plan changes such as a 
curtailment of benefits. 

DCAA auditors at the contractor's corporate office are responsible for 
reviewing other aspects of proposed pension forward pricing, such as 
previous CAS pension cost estimates to assess how close they were to 
actual CAS pension costs for those periods. DCAA employs technical 
specialists who provide auditors with additional support on pension 
issues. DCAA audits may question costs that they identify as not 
allowable, allocable or reasonable, which the contracting officer may 
incorporate into negotiations with the contractor. For example, DCAA 
audits have questioned costs in forward pricing proposals because 
estimated CAS pension costs were higher than the contractor's 
historical cost trends or the calculation methods were not compliant 
with CAS. 

Corporate-level contracting officers rely primarily on DCAA, and to a 
lesser extent the CIPR Center, to review contractors' annual proposals 
representing actual corporate-managed costs incurred in the previous 
year, including CAS pension costs. DCAA audits incurred CAS pension 
costs reported by the contractor to determine whether they are 
allowable, allocable, and reasonable, as well as compliant with CAS. 
According to a CIPR Center official, contracting officers may also 
request additional support from the CIPR Center to ensure information 
in the incurred cost proposal reflects what is in the corresponding 
CAS valuation reports. They usually respond to these requests for 
support in a less formal manner than is the case with proposed forward-
pricing requests, generally not issuing detailed reports. As with the 
forward-pricing process, the contracting officer may use the 
information from DCAA audits and CIPR Center reviews, including any 
questioned costs, when negotiating final indirect costs with the 
contractor. Once established, these costs are allocated to the 
divisions to form the basis of adjustments to flexibly priced 
contracts that can then be closed out. 

Paralleling the contractor's process, DCMA officials at the division 
monitor the incorporation of allocated pension costs into fringe 
benefit costs. Fringe benefit costs can also include defined 
contribution plan costs. Contractor and DOD officials we spoke with 
noted that it could be challenging to fully determine CAS pension 
costs applied to or incurred on a specific contract. For example, some 
CAS pension costs are captured among other indirect costs (such as 
shared service or corporate office costs). 

DCAA is also responsible for reviewing the adequacy of contractors' 
CAS disclosure statements at the corporate and division levels and 
determining their compliance with CAS and FAR. These statements 
contain information regarding how costs are allocated, and the 
corporate-level disclosure statement in particular contains many 
details about allocation of the contractor's pension plans. 

DCAA and the CIPR Center Provide Additional Support for Contracting 
Officers during Settlement of CAS Pension Costs When a Pension Plan Is 
Curtailed: 

In addition to overseeing CAS pension costs through the forward 
pricing and incurred cost processes, corporate-level contracting 
officers manage the process required by CAS for pension cost 
settlement when a contractor curtails a defined benefit pension plan. 
Curtailment under CAS means any situation where no new benefits can 
accrue for plan participants. When such a curtailment occurs, 
corporate-level contracting officers can receive assistance from the 
CIPR Center and DCAA to ensure that the related proposals submitted by 
the contractor are compliant with CAS. 

When a contractor initiates a curtailment, it calculates the affected 
plan's CAS pension costs to determine whether the plan is under-or 
overfunded and whether the government has over-or underpaid for CAS 
pension costs over the years. Based on the result of the calculation, 
one party may owe the other the balance of the difference in order to 
"settle up" the plan. The contractor submits a proposed settlement to 
the contracting officer, and the CIPR Center and DCAA provide support 
by reviewing the proposal in order to evaluate whether the 
calculations are correct and compliant with CAS. Both can issue 
reports which will help the contracting officer to negotiate a final 
settlement with the contractor. The resulting payment, whether from 
the contractor or the government, may either be immediately charged 
or, when the contractor has other government contracts, amortized as 
pension costs over future years. 

Settlements that resulted in potential payments to the contractor have 
resulted in litigation and long delays. According to DOD officials, 
three of the largest DOD contractors have pending settlements. Two of 
the smaller DOD contractors included in our review have settled cases 
within the last 4 years that resulted in payments to the government. 
DOD officials we met with noted that part of the reason for delayed 
settlements is the complicated nature of determining the appropriate 
government share of CAS pension costs, given that CAS rules on 
allocation of pension costs to contracts have changed over time. In 
response to court cases on the matter, DCAA and DCMA have issued joint 
guidance to address related issues. 

Pension Oversight Processes Do Not Address Reasonableness of Value of 
Defined Benefit Pension Plans: 

The FAR requires that total employee compensation, which includes many 
components such as salaries and bonuses, fringe benefits like 
retirement benefits and health insurance, and other nonwage 
compensation, must be reasonable in order to be claimed by the 
contractor as a contract cost. However, as part of assessing the 
reasonableness of total compensation, DOD's oversight processes do not 
clearly assign responsibility for assessing the reasonableness of the 
value of pension benefits to plan participants, focusing instead on 
the reasonableness of actuarial assumptions or fringe benefits as a 
whole. 

Fringe benefits are examined as part of compensation reviews that DCAA 
auditors perform to determine reasonableness, often as part of 
incurred cost audits or reviews of compensation system internal 
controls. DCAA guidance for compensation reviews states that all cost 
components of employee compensation--including the value of fringe 
benefits, bonuses, and stock options as well as salary--are considered 
to be reasonable if they do not exceed the comparative value of those 
costs from market survey data by more than 10 percent.[Footnote 26] 
Defined benefit pensions are generally part of that fringe benefit 
cost component, along with other benefits such as health and life 
insurance. Only if these collectively exceed the reasonableness 
threshold is an auditor instructed to review the individual cost 
components, such as pensions. In instances where questions arise about 
the reasonableness of pension costs, the auditor is instructed to turn 
to the CIPR Center as a resource for pension-related matters. Several 
auditors and DCMA contracting officers we spoke with also noted that 
if they had questions regarding the reasonableness of defined benefit 
plans, they would seek assistance from groups such as the CIPR Center 
or a centralized DCAA team that specializes in compensation issues, 
particularly those related to executive compensation. 

Auditors are instructed to review fringe benefit costs as a whole when 
determining their reasonableness, but CAS costs for defined benefit 
pensions are an imperfect measure of the value of pension benefits 
participants earned in a year as part of their total compensation. 
Multiple factors drive CAS pension costs. For example, the pension 
cost could be zero in a given year due to strong asset returns, and 
this pension cost would not capture any of the value of the benefits 
earned that year by employees. Conversely, the pension cost could be 
higher in a given year than the value of the benefits earned that year 
by employees as a result of actuarial losses. While they may be aware 
of the CAS costs of defined benefit pensions, auditors do not know the 
value of these benefits to an employee in a given year. They lack 
guidance on how to measure this value (containing, for example, 
acceptable methodologies, assumptions, or data sources), and therefore 
are unable to get a complete picture of the reasonableness of total 
compensation for contractor employees. 

Neither the CIPR Center nor DCAA's compensation team currently assess 
the reasonableness of benefits offered through defined benefit plans. 
While officials stated that the CIPR Center did perform reviews of 
employee benefit offerings more than a decade ago, to the extent that 
the CIPR Center does evaluate reasonableness today, it does so only in 
terms of the measurements and actuarial assumptions used by 
contractors to calculate their CAS pension costs. It does not consider 
the relative value of benefits offered. For non-executive employees, 
the DCAA compensation team only reviews the reasonableness of salaries 
for direct labor. In essence, DOD assesses whether the CAS cost is 
appropriate from a regulatory and actuarial standpoint. Whether the 
liability reflected in the CAS cost stems from a generous pension plan 
is not considered.[Footnote 27] 

GAO reviewed the most prevalent final average pay formulas among the 
contractors that have these plans and found that contractors offer a 
wide range of benefit formulas and plan designs. This means that 
employees' defined benefits can differ greatly from contractor to 
contractor. Plans offered by contractors include final average pay 
plans, which use a formula that considers a participant's final 
average pay and years of service, as well as cash balance plans that 
use a hypothetical individual account to calculate benefits based on a 
percentage of a participant's pay and a plan-specified rate of 
interest to be applied to a participant's hypothetical account. The 
final average pay plans generally had a "base" accrual rate that 
granted between 1 percent and 2 percent of final average pay for each 
year of service with the company.[Footnote 28] For example, two 
employees may have the same final average pay of $50,000 and the same 
30 years of service. However, the employee with the "base" accrual 
rate of 2 percent would have an annual base benefit of $30,000 in 
retirement, whereas the employee with the "base" accrual rate of 1 
percent would have an annual base benefit of $15,000. 

In addition, these plans had a variety of features which affect a 
participant's retirement benefit. For example, some plan formulas have 
the effect of reducing the base benefit by taking into account Social 
Security benefits to be received in the future. We noted other plan 
features, such as the presence or absence of a cost of living 
adjustment, which annually increases the benefit in retirement by a 
measure of inflation. Thus there was wide variation of plan designs 
across contractors and in the potential value of benefits to 
participants in different plans. However, neither DCAA corporate-level 
officials, the CIPR Center, nor the DCAA compensation team assessed 
the reasonableness of individual plans. 

Reasonableness Assessments of Executive Compensation Are Not Required 
to Include Defined Benefit Pensions: 

DCAA is responsible for reviewing executive compensation packages 
separately from compensation offered to other employees in order to 
evaluate whether these packages meet the FAR standard for 
reasonableness and do not exceed the dollar limitation specified in 
the FAR. However, defined benefit pension plans for contractor 
executives are not required to be included in these assessments. 

Executive compensation reviews are usually done as part of incurred 
cost audits, although they can also be performed on audits of forward 
pricing proposals. DCAA auditors at contractor corporate offices have 
access to the DCAA compensation team for assistance with such reviews. 
While this team has developed a methodology for determining executive 
compensation reasonableness, it does not require examination of 
defined benefit pensions in the determinations, similar to its 
approach to pension plans in general. Compensation team officials told 
us they analyze the total cost of fringe benefits, and only look at 
individual benefits such as pensions if they deem the total fringe 
benefit cost to exceed that indicated by market survey data by more 
than 10 percent. In addition, the defined benefit components of the 
market surveys used by the team do not specify the use of CAS for 
their calculations, and thus may not be directly comparable to CAS-
based pension cost. Compensation team officials noted that the most 
recent survey they use for this purpose was issued in 2008, and only 
included self-reported pension cost. Executive compensation reviews we 
analyzed that addressed the reasonableness of total compensation and 
fringe benefits did not discuss the details of defined benefit pension 
plans. 

To the extent that the compensation team does look specifically at 
defined benefit pensions, team officials told us that they evaluate 
the relative CAS cost of the pension. They do not examine the source 
of this cost, and therefore cannot identify whether, for example, a 
high relative CAS pension cost was largely driven by the generosity of 
pension plans or weak asset performance. 

The FAR also contains a dollar limitation on the allowable annual 
compensation for certain contractor personnel, currently set at 
$763,029. The FAR describes the elements of executive compensation 
that should be considered against this limit. These include salary, 
bonuses, deferred compensation other than pensions, and employer 
contributions to defined contribution pension plans. However, the FAR 
does not include defined benefit pension plans as an element of 
compensation that should be considered against the limit. 

Accurately applying the cost of a defined benefit pension to an 
individual employee's total compensation package is challenging due to 
the complexity and annual volatility of costs even if the value of the 
ultimate benefit does not change. DCAA compensation team officials 
noted that it is not clear how costs of a defined benefit plan should 
be evaluated. In addition, they lack current market survey data for 
defined benefit plans, and team officials noted that companies 
participating in these surveys do not consistently calculate and 
report their compensation costs. 

The Largest DOD Contractors Maintain Their Defined Benefit Plans in 
Similar Ways to Peer Companies: 

Many of the Largest DOD Contractors Have Frozen Defined Benefit Plans, 
As Have Companies in Their Peer Group: 

Nearly all of the largest DOD contractors--as well as the peer group 
of companies we examined--maintain some sort of tax-qualified, defined 
benefit pension plan for their employees. As noted previously, the 
benefit designs of these plans can differ greatly, and we found 
variations among certain contractors' final average pay plans. 
However, we were unable to compare the full range of plan designs 
across both contractors and their peer group.[Footnote 29] 

More generally, all of the largest contractors with defined benefit 
plans--and the majority of their peer group--have frozen at least one 
of their plans in some way. A plan freeze is a plan amendment that 
closes the plan to new entrants and may limit future benefit accruals 
for some or all employees that are active in the plan. Under a freeze, 
the plan continues to be maintained by the sponsor.[Footnote 30] 
Specifically, a majority of the largest contractors and their peer 
group have "soft frozen" plans, that is, closed at least one of their 
plans to new entrants, while allowing existing participants to 
continue to accrue benefits.[Footnote 31] Furthermore, over 75 percent 
of the contractors' largest defined benefit plans were frozen in some 
way. 

Some DOD contractors reported that when they froze their defined 
benefit plans they had either established a new defined contribution 
plan or changed the terms of an existing defined contribution plan for 
those employees who were no longer eligible to accrue benefits in a 
defined benefit plan. For example, one DOD contractor noted that 
employees not eligible for a defined benefit plan may receive a 
matching contribution under a defined contribution plan, whereas 
employees who are eligible for a defined benefit plan would not be 
eligible for such a match. In the short term, transitioning new 
employees to defined contribution plans may raise total costs since 
defined benefit plans generally are least expensive for young and new 
participants. 

Defined benefit plans that remained open to new participants often 
included collectively bargained participants, and all but one of the 
largest DOD contractors had at least one plan that remained open to 
new participants. Open plans with collectively bargained participants 
were generally among the contractors' smaller plans. Further, some DOD 
contractors said that they intended to close all of their defined 
benefit plans to new entrants and, subject to negotiation, they also 
expected plans with collectively bargained participants to be closed 
to new entrants in the future. For example, one DOD contractor noted 
that a number of its open plans were already "partially frozen," or 
open only for certain bargaining units, while some, but not all, 
bargaining units had agreed to close the plan to new entrants going 
forward. 

Generally, the number of private-sector companies sponsoring defined 
benefit plans has declined substantially over the last 20 years or so. 
A prior GAO survey of 94 of the largest firms sponsoring defined 
benefit plans showed that many firms made revisions to their plan 
offerings over that last 10 years.[Footnote 32] For example, large 
sponsors have changed benefit formulas, converted to hybrid plans, or 
frozen some defined benefit plans.[Footnote 33] Moreover, in another 
GAO survey among a broader population of sponsors that included all 
plan sponsors with 100 or more total participants, 51 percent of those 
sponsors had one or more frozen defined benefit plans.[Footnote 34] A 
2011 Aon Hewitt study of Fortune 500 companies found largely similar 
results over time.[Footnote 35] For example, the study noted that 80 
percent of Fortune 500 companies sponsored an open, defined benefit 
plan for salaried employees in 1995. However, as of 2011, only 31 
percent sponsored an open, defined benefit plan. 

Based on their fiscal year 2011 annual reports, members of the peer 
group were more likely than the largest DOD contractors to have 
instituted or planned to institute a "hard freeze" for one or more 
plans. With a hard freeze, the plan is closed to new entrants and also 
ceases accruals for existing participants. According to fiscal year 
2011 annual reports, none of the contractors had reported current or 
planned hard freezes, whereas 4 of the 15 peers did. In interviews, 
however, one contractor told us that they implemented a hard freeze on 
December 31, 2012, but none of the other large contractors told us 
they had hard frozen any of their largest plans.[Footnote 36] 
According to several DOD contractors, hard freezing pension plans can 
present challenges such as triggering CAS rules, discussed previously, 
that require settlement between the contractor and the government. 
This may result in the government owing the contractor or vice versa. 
[Footnote 37] For example, according to a representative of one large 
contractor, one of the contractor's plans that was settled in the late 
1990s was determined to be overfunded on a CAS basis, but underfunded 
on an ERISA basis. This meant that the contractor owed the government 
money for settlement despite the fact that the plan was underfunded on 
an ongoing ERISA basis. 

However, the settlement-related challenges may not be the sole reason 
that a DOD contractor would avoid instituting a hard freeze. Indeed, 
one DOD contractor noted that instituting a hard freeze could damage 
employee relations and that in general with employees it is easier to 
justify closure of plans to new entrants. Other DOD contractors told 
us they continually evaluate their pension offerings against those of 
peers, and the competitiveness of their plans compared to those of 
peers is a driver of pension management decisions. A few DOD 
contractors noted that they want to provide pension plans that allow 
them to attract skilled employees, while remaining cost-competitive. 

Nearly all of the largest DOD contractors and their peer group offer 
nonqualified defined benefit plans in addition to their tax-qualified 
defined benefit plans. In fact, all but one DOD contractor and one 
peer we reviewed maintained at least one nonqualified defined benefit 
plan.[Footnote 38] While the provisions of each nonqualified plan 
vary, in general, the most prevalent type that we found were 
"restoration" (or "excess benefit") plans. These are plans that 
typically extend the benefits provided by a tax-qualified defined 
benefit plan by supplementing the portion of benefits that are in 
excess of limits prescribed by the Internal Revenue Code.[Footnote 39] 
For example, one contractor noted that its restoration plans could 
include certain highly-paid engineers. Some types of nonqualified 
plans we reviewed appeared to be offered only to certain senior 
executives. 

The Largest DOD Contractors Invest in Similar Types of Assets as Their 
Peer Group and Generally Invest More Conservatively: 

Our review of the financial reports of the largest DOD contractors and 
their peer group shows that the DOD contractors invest in similar 
types of assets relative to their peer group. However, DOD contractors 
and their peer group employed a wide range of pension investment 
allocations between equities and fixed-income assets.[Footnote 40] For 
example, DOD contractors allocated as much as 64 percent or as little 
as 26 percent of pension investments to equity assets (i.e., stocks), 
while their peer group allocated as much as 74 percent or as little as 
26 percent of pension investments to such assets. Similarly, DOD 
contractors allocated as much as 46 percent or as little as 32 percent 
of pension investments to fixed-income assets (i.e., bonds), while 
their peer group companies allocated as much as 51 percent or as 
little as 25 percent of pension investments to such assets.[Footnote 
41] 

The DOD contractors' pension investment allocations appear to be 
somewhat more conservative than those of their peer group when 
analyzed in the aggregate.[Footnote 42] Aggregating the year-end 2011 
pension investment allocations of the DOD contractors and their peer 
group shows that contractors have allocated about 7 percentage points 
more of their investments to generally conservative assets, namely 
cash and fixed-income assets, than is the case with their peer group, 
as illustrated in figure 5. This means that, in the aggregate, the DOD 
contractors have a lower percentage of pension investments allocated 
to equities and "other" assets compared to their peer group. Equities 
and "other" assets, such as private equity, hedge funds, real estate, 
and commodities, are generally considered to be riskier than cash and 
fixed-income assets.[Footnote 43] 

Figure 5: Asset-Weighted Year-End 2011 Pension Investment Allocations 
of Large DOD Contractors and Their Peer Group: 

[Refer to PDF for image] 

Fixed income and cash: 
Contractor: 46%; 
Peer group: 39%. 
        
Equities and other assets:      
Contractor: 54%; 
Peer group: 62%. 

Source: GAO analysis of fiscal year 2011 company annual reports. 

Note: "Other" assets include private equity, hedge funds, real estate, 
and commodities. 

[End of figure] 

CAS Pension Costs for Large DOD Contractors Have Increased in Recent 
Years Due to the Market Downturn: 

CAS Pension Costs Started Relatively Low and Rose Significantly over 
the Last Decade: 

CAS pension costs for the largest DOD contractors grew considerably 
over the last decade. Costs went from less than $420 million dollars 
in 2002 (when most contractors reported at least one plan with zero 
costs, after a period when some plans were fully funded) to almost $5 
billion dollars in 2011.[Footnote 44] While growth in total CAS 
pension costs was relatively small and gradual until 2008, as shown in 
figure 6, costs jumped by almost $1.5 billion from 2008 to 2009. They 
increased almost 90 percent in nominal dollars from 2008 to 2011, a 
substantial share of which was allocable to DOD contracts. 

Figure 6: Total CAS Pension Costs for Largest DOD Contractors with 
Defined Benefit Plans: 

[Refer to PDF for image: vertical bar graph] 

Year: 2002; 
Total CAS pension costs: $0.4 billion. 

Year: 2003; 
Total CAS pension costs: $1.2 billion. 

Year: 2004; 
Total CAS pension costs: $1.3 billion. 

Year: 2005; 
Total CAS pension costs: $1.9 billion. 

Year: 2006; 
Total CAS pension costs: $2.4 billion. 

Year: 2007; 
Total CAS pension costs: $2.5 billion. 

Year: 2008; 
Total CAS pension costs: $2.6 billion. 

Year: 2009; 
Total CAS pension costs: $4.0 billion. 

Year: 2010; 
Total CAS pension costs: $4.4 billion. 

Year: 2011; 
Total CAS pension costs: $4.9 billion. 

Source: GAO analysis of contractor data. 

[End of figure] 

CAS Pension Costs at the Program Level: 

CAS pension costs are likely spread over thousands of contracts. All 
five weapon systems we analyzed showed an increase in defined benefit 
pension cost relative to labor cost from 2005 to 2011, as illustrated 
in figure 7.[Footnote 45] 

Figure 7: Defined Benefit Plan Costs Relative to Direct Labor for 
Selected Weapon Systems Programs: 

[Refer to PDF for image: vertical bar graph] 

Percentage of direct labor dollars: 

Year: 2005; 
Minimum: 0; 
Average: 2.8%; 
Maximum: 8%. 

Year: 2006; 
Minimum: 0; 
Average: 5.8%; 
Maximum: 11.4%. 

Year: 2007; 
Minimum: 0; 
Average: 6.4%; 
Maximum: 11.6%. 

Year: 2008; 
Minimum: 2.6%; 
Average: 6.3%; 
Maximum: 10.3%. 

Year: 2009; 
Minimum: 7%; 
Average: 11.3%; 
Maximum: 16.3%. 

Year: 2010; 
Minimum: 8.3%; 
Average: 11.5%; 
Maximum: 15.4%. 

Year: 2011; 
Minimum: 9.9%; 
Average: 12.8%; 
Maximum: 17.2%. 

Source: GAO analysis of contractor data. 

[End of figure] 

For the five weapon systems programs, CAS pension costs as a 
percentage of direct labor showed the most growth from 2008 to 2009, 
corresponding to trends seen in aggregate costs across the largest DOD 
contractors. As these costs increased, contractors took several 
actions to control them. For example, as previously discussed, 
contractors were closing a number of defined benefit plans to new 
entrants and several adjusted benefit formulas. 

CAS pension costs have also grown relative to total contract cost for 
the selected weapon systems programs. As shown in figure 8, average 
pension costs never exceeded 3 percent in any year--although this is 
still a significant dollar amount on large weapon systems 
contracts.[Footnote 46] Until 2009, average pension costs never 
exceeded 1 percent. However, note that this figure understates the 
impact of pension costs on programs since material costs--including 
the complex subsystems and components bought from subcontractors--may 
also include pension costs. Material costs for the systems we reviewed 
were as much as 81 percent of total program costs. 

Figure 8: Defined Benefit Plan Costs Relative to Total Costs for 
Selected Weapon Systems Programs: 

[Refer to PDF for image: vertical bar graph] 

Percentage of total program costs: 

Year: 2005; 
Minimum: 0; 
Average: 0.3%; 
Maximum: 0.6%. 

Year: 2006; 
Minimum: 0; 
Average: 0.7%; 
Maximum: 1.2%. 

Year: 2007; 
Minimum: 0; 
Average: 0.8%; 
Maximum: 1.3%. 

Year: 2008; 
Minimum: 0.3%; 
Average: 0.8%; 
Maximum: 1.2%. 

Year: 2009; 
Minimum: 0.9%; 
Average: 1.6%; 
Maximum: 2.6%. 

Year: 2010; 
Minimum: 1.1%; 
Average: 1.8%; 
Maximum: 3.4%. 

Year: 2011; 
Minimum: 1.2%; 
Average: 2.3%; 
Maximum: 5.3%. 

Source: GAO analysis of contractor data. 
[End of figure] 

Across this period, the trend for defined contribution plans differed. 
Defined contribution costs as a percentage of direct labor on the 
selected programs grew only slightly, and remained much steadier than 
the CAS pension costs for defined benefit plans. In 2005, defined 
contribution costs ranged between 0 and 6.9 percent for the five 
programs we examined. In 2011, the range was 0.6 percent to 7.0 
percent.[Footnote 47] Defined contribution plan costs will generally 
be higher than defined benefit plan costs when defined benefit plan 
assets perform well, and gains offset a plan's normal cost. Defined 
benefit plans will likely cost more than defined contribution plans 
when assets perform poorly, as the employer bears the investment risk. 
As demonstrated, defined contribution plan costs are generally more 
stable than defined benefit plan costs. 

CAS Pension Costs Grew as the Market Downturn Increased CAS Unfunded 
Liabilities: 

On a CAS basis (excluding prepayment credits), contractors' plan 
assets at the beginning of 2011 were approximately $15.1 billion less 
than would be needed to pay their pension liabilities.[Footnote 48] 
This gap, known as the unfunded liability, is largely a result of 
losses incurred during the market downturn in 2008 and 2009.[Footnote 
49] Indeed, as illustrated in figure 9, 59 percent of this unfunded 
liability is attributed to losses from just those 2 years. The 
remainder of the unfunded liability came from other sources, such as 
changes in the contractors' actuarial assumptions, other investment 
losses, and plan amendments (e.g., changes in rules for benefits 
computation). 

Figure 9: Sources of Current Unfunded Liabilities for the Largest DOD 
Contractors (as of Beginning of 2011): 

[Refer to PDF for image: vertical bar graph and associated pie-chart] 

CAS liabilities: $116.7 billion; 
CAS assets: $101.6 billion; 
* Unfunded liabilities of $15.1 billion: 
- 59% from 2008 and 2009 losses; 
- 41% from other sources. 

Source: GAO analysis of contractor CAS valuation reports. 

[End of figure] 

The largest DOD contractors' plans were, as of the beginning of 2011, 
about 87 percent funded in aggregate, based on how CAS directs 
contractors to calculate the level of plan funding; funded ratios 
ranged from 59 to 96 percent. The funded ratio (or percentage) is 
calculated by dividing plan actuarial assets by plan actuarial 
liabilities. CAS calculations subtract CAS prepayment credits from 
assets. When prepayment credits are included, the largest DOD 
contractors' pension plans were 110 percent funded at the beginning of 
2011, in aggregate, with funded ratios ranging between 84 and 127 
percent. 

In aggregate, about half of the contractors' CAS pension costs at the 
beginning of 2011 were a result of the need to pay installments on 
unfunded liabilities while half went to pay normal costs, which are 
the costs attributable to employees working an additional year. As 
shown in figure 10, about 24 percent of total 2011 CAS pension cost 
was payment on unfunded liabilities attributable specifically to plan 
losses in 2008 and 2009, and approximately 25 percent was to pay for 
unfunded liabilities from all other sources such as plan amendments, 
investment losses from other years, and changes in actuarial 
assumptions. The remaining 51 percent of CAS pension cost for 2011 was 
to pay normal costs.[Footnote 50] 

Figure 10: Breakdown of 2011 CAS Pension Costs for the Largest DOD 
Contractors (as of Beginning of 2011): 

[Refer to PDF for image: pie-chart] 

Normal cost: 51%; 
Payments on losses from 2008 and 2009: 24%; 
Payments for all other unfunded liability: 25%. 

Source: GAO analysis of contractor CAS valuation reports. 

Note: Contractors calculated interest cost for the year (an adjustment 
to account for the fact that contributions are not made all at once on 
the valuation date) differently, and we included these adjustments 
exactly as the contractor included them. One contractor also had a 
small adjustment for a CAS curtailment, which was included in assets. 

[End of figure] 

Under CAS rules, contractors have traditionally paid for incurred 
pension plan losses over the course of 15 years. As a result, the 
losses from 2008 may contribute to plan costs until 2023 unless those 
losses are offset by future gains. Additionally, changes in actuarial 
assumptions and plan amendments can be recognized over many more 
years, which could potentially affect CAS pension costs for up to 30 
years into the future, as contractors may elect to pay off these types 
of unfunded liabilities across as many as 30 years. 

Harmonization Will Likely Increase the Magnitude and Volatility of 
Contractor Pension Costs: 

Projected Pension Costs Are Sensitive to Economic Assumptions: 

Both contractors and DOD officials expect CAS pension costs to 
increase as discount rates used for CAS calculations fall to match the 
rates used for ERISA funding calculations. Indeed, in their 5-year 
pension cost forward pricing projections issued immediately following 
harmonization, large DOD contractors had estimated that CAS discount 
rates would fall by between 2.2 and 4.1 percentage points in 2014, 
depending on the demographics of the plan.[Footnote 51] This drop 
would, in turn, increase costs because decreases in the discount rate 
raise pension liabilities and the normal cost. Increases in unfunded 
liabilities also increase CAS pension costs because of the need to pay 
down those unfunded liabilities in installments. 

Harmonization ties the CAS discount rate to ERISA rules, making it 
harder to project future CAS pension costs. On July 6, 2012, a few 
months after harmonization went into effect, Congress enacted MAP-21, 
which changed the methodology for calculating ERISA discount rates. 
[Footnote 52] Before MAP-21, ERISA discount rates were based on a 2-
year average of corporate bond interest rates. Now, this 2-year 
average is bounded by a 25-year average of corporate bond interest 
rates, and as a result, contractors now project their CAS discount 
rates will drop only 1.5 to 3.1 percentage points, starting in 2014, 
to harmonize with ERISA.[Footnote 53] However, the effects of MAP-21's 
ERISA funding relief are expected to have the greatest impact in the 
near term, and to diminish after 2015. Therefore, contractors still 
expect their CAS discount rates to be 2.0 to 4.0 percentage points 
lower in 2016 than their pre-harmonization 2012 CAS discount rates. 

Costs under the new, harmonized CAS pension rules can vary 
dramatically based on small changes in the corporate bond interest 
rates used to discount liabilities. We modeled an illustrative pension 
plan's CAS pension costs from 2014 to 2017, the period over which the 
new CAS discount rate rules will be phased-in. In our model, a 1.0 
percentage point decrease in the discount rate (as determined by a 
measure of corporate bond interest rates) could increase CAS pension 
costs by 35 percent once the rule is fully implemented, and a 2.0 
percentage point decrease could almost double CAS pension costs, as 
shown in figure 11. Furthermore, changes in this rate can have a 
greater effect on CAS pension costs than similar changes in plan asset 
returns.[Footnote 54] 

Figure 11: Effect of Different Discount Rates and Different Asset 
Returns on Plan Costs for an Illustrative Plan: 

[Refer to PDF for image: multiple line graph] 

Year: 2014: 
1.0 percentage point higher discount rate: $305 million; 
1.0 percentage point lower market returns: $267 million; 
6.0 percent discount rates, expected market returns: $265 million;      
1.0 percentage point higher market returns: $264 million; 
1.0 percentage point lower discount rate: $230 million. 

Year: 2015: 
1.0 percentage point higher discount rate: $409 million; 
1.0 percentage point lower market returns: $333 million; 
6.0 percent discount rates, expected market returns: $329 million; 
1.0 percentage point higher market returns: $325 million; 
1.0 percentage point lower discount rate: $258 million. 

Year: 2016: 
1.0 percentage point higher discount rate: $513 million; 
1.0 percentage point lower market returns: $400 million; 
6.0 percent discount rates, expected market returns: $392 million; 
1.0 percentage point higher market returns: $385 million; 
1.0 percentage point lower discount rate: $285 million. 

Year: 2017: 
1.0 percentage point higher discount rate: $616 million; 
1.0 percentage point lower market returns: $469 million; 
6.0 percent discount rates, expected market returns: $455 million; 
1.0 percentage point higher market returns: $442 million; 
1.0 percentage point lower discount rate: $312 million. 

Cost difference from 1.0 percentage point increase or decrease in 
asset returns: 
1.0 percentage point lower market returns; 
6.0 percent discount rates, expected market returns; 
1.0 percentage point higher market returns. 

Cost difference from 1.0 percentage point increase or decrease in 
discount rates: 
1.0 percentage point higher discount rate; 
1.0 percentage point lower discount rate. 

Source: HAO analysis of contractor CAS valuation reports and DOD's 
pension forward pricing model. 

Note: This plan is intended to illustrate the effect of changes in 
asset and liability returns. The starting discount rate is based on 
GAO analysis of expected effective rates following MAP-21. This 
illustrative plan has about $6 billion in liabilities and $5 billion 
in assets in 2014. The plan is also 90 percent funded in 2010 to show 
some costs from actuarial losses. The increases or decreases in asset 
returns are repeated for 2013 to 2017. 

[End of figure] 

Under certain scenarios, CAS pension costs could begin to decline back 
to previous levels over the next decade, but the outcome is sensitive 
to what actually happens in the economy. For example, as shown in 
figure 12, projected CAS pension costs would begin to decline by the 
end of the decade and approach what they would have been under pre-
harmonization CAS rules if discount rates rise to 6.5 percent by 2017 
and stabilize at that level. However, if corporate bond interest rates 
do not stabilize and instead started to fall again after 2019, the 
discount rate would fall as well and CAS pension costs would then 
continue to rise. This example does not account for any asset gains or 
losses which could further raise or lower CAS pension costs. 

Figure 12: Long-Term Cost Projections for an Illustrative Plan under 
Different Discount Rate Scenarios: 

[Refer to PDF for image: multiple line graph] 

Year: 2012; 
If discount rates stabilize at 6.5%: $172 million; 
If harmonization never happened: $172 million. 

Year: 2013      
If discount rates stabilize at 6.5%: $202 million; 
If harmonization never happened: $202 million. 

Year: 2014      
If discount rates stabilize at 6.5%: $262 million; 
If harmonization never happened: $196 million. 

Year: 2015      
If discount rates stabilize at 6.5%: $316 million; 
If harmonization never happened: $196 million. 

Year: 2016      
If discount rates stabilize at 6.5%: $363 million; 
If harmonization never happened: $196 million. 

Year: 2017      
If discount rates stabilize at 6.5%: $403 million; 
If harmonization never happened: $196 million. 

Year: 2018      
If discount rates stabilize at 6.5%: $388 million; 
If harmonization never happened: $196 million. 

Year: 2019      
If discount rates stabilize at 6.5%: $370 million; 
If harmonization never happened: $196 million. 

Year: 2020      
If discount rates stabilize at 6.5%: $165 million; 
If discount rates fall to 6.25% again in 2020: $409 million; 
If harmonization never happened: $196 million. 

Source: GAO analysis of contractor CAS valuation reports and DOD's 
pension forward pricing model. 

Note: This plan is intended to illustrate how future discount rates 
can affect costs. The starting discount rate is based on GAO analysis 
of expected effective rates following MAP-21. This illustrative plan 
is 90 percent funded in 2010 to show some costs from actuarial losses. 
For the first CAS pension cost projection, we gradually increased the 
discount rate from 6.0 to 6.5 percent from 2014 to 2019 to model the 
effects of an increase in corporate bond interest rates and then kept 
the discount rate at 6.5 percent. For the alternative, we modeled cost 
if corporate bond interest rates fell such that the discount rate 
declined to 6.25 percent in 2020. We picked 6.5 percent based on our 
judgment of a discount rate between recent traditional CAS discount 
rates and what post-harmonization CAS discount rates would be based on 
recent corporate bond interest rates. 

[End of figure] 

Even with Temporary Funding Relief, Contractors Anticipate That CAS 
Pension Costs Will Rise Due to Harmonization Starting in 2014: 

As noted earlier, after harmonization went into effect in February 
2012, the largest DOD contractors submitted new pension forward 
pricing proposals to DOD and projected significant rises in CAS 
pension costs by 2016. Overall, these updated projections showed large 
increases in CAS pension costs when compared to the pre-harmonization 
projections for the 2012 to 2016 period. Most contractors' projections 
for 2012 and 2013 showed little or no change but all contractors 
projected increases from 2014 through 2016 as harmonization takes 
effect.[Footnote 55] After excluding the impact of changes such as 
changes to plan benefits to isolate the effects of harmonization, 
these CAS pension cost increases for individual contractors ranged 
from 10 percent to 55 percent for 2014, relative to their proposals 
that do not reflect the impact of harmonization. 

All of the large DOD contractors that submitted an updated pension 
forward pricing proposal after the enactment of MAP-21 still showed an 
increase in projected CAS pension costs, despite the temporary relief 
from ERISA funding requirements provided by the law. While MAP-21 
dampened the initial projected effect of harmonization, a few large 
DOD contractors noted that the impact of MAP-21 is likely to be 
temporary and that its long-term effect on discount rates and future 
CAS pension costs remain unknown. After taking into account MAP-21, 
projected CAS pension cost increases for individual contractors ranged 
from 7 percent to 37 percent for 2014, due solely to harmonization, 
relative to their proposals that do not reflect the impact of 
harmonization. In aggregate, that represents a projected increase for 
2014 of nearly $1.2 billion across the six contractors that submitted 
forward pricing proposals reflecting MAP-21. By contrast, the increase 
projected by those contractors in proposals prior to MAP-21 was almost 
$2 billion. 

CAS pension costs for defined benefit plans at the divisions we 
reviewed are expected to rise as a percentage of direct labor costs. 
At all five divisions, post-harmonization projections that were the 
basis of negotiations for most of 2012 showed a rise in CAS defined 
benefit pension costs as a percentage of projected direct labor costs 
of between 8 and 21 percentage points from 2012 to 2016.[Footnote 56] 
For those divisions, defined contribution costs stayed largely stable 
across the same period. 

Harmonization Presents Challenges to Projection of CAS Pension Costs 
for Forward Pricing: 

CAS rules are intended to provide consistent cost data for forward 
pricing of government contracts over future years for contracts 
implemented over multiple years. However, harmonization tied CAS 
discount rates to the more volatile ERISA-based discount rate, which 
can make CAS less consistent as a standard for generating pricing 
projections. DOD issued limited guidance to its acquisition 
organizations in March 2012 on projecting ERISA-based discount rates 
for CAS calculations, which indicates that contractors should increase 
their current ERISA-based rates for forward pricing to approach a 4-to 
6-year historical average rate.[Footnote 57] The guidance is not clear 
on the source for these rates or how quickly they should rise to 
historical averages. This lack of clarity can lead to great variation 
among the forward pricing rates of contractors, even if they have 
similar participant demographics, because small changes in the 
projected discount rate can create large changes in projected CAS 
pension cost. 

Additionally, DOD indicated that in its final guidance, yet to be 
issued, forward discount rates would approach average rates drawn from 
15 to 20 years of historical data. Rates based on long-term averages 
would ensure more consistency in pricing because these rates would 
change less year-to-year than rates based on short-term historical 
averages. In the near-term, rates for forward pricing based on a long-
term historical average would also very likely increase the 
contractors' discount rates, reducing CAS pension costs. This final 
guidance may provide greater clarity about discount rates contractors 
could use to calculate pension costs for forward pricing purposes. 
However, in the absence of this guidance, there is likely to be a 
broad range of discount rates in use and thus large variation in 
forward pricing rates, even if contractors have similar participant 
demographics. 

Adjustments to Pre-Harmonization Contracts Are Expected but Cost 
Impact Is Uncertain: 

Since harmonization was a mandatory regulatory change, contractors can 
ask for a contract adjustment to reflect the cost impact of the 
change. Although a general procedure exists that contractors can 
follow to seek any kind of adjustment, a March 2012 DOD memorandum 
stated that contracts would be eligible for adjustment if they were 
signed prior to February 27, 2012 and if their period of performance 
continues into 2014 or later, when use of the ERISA-based discount 
rate begins to phase in. The memorandum indicated that DOD would 
eventually release more guidance on the matter but did not specify a 
timeline for completing the negotiation of contract adjustments. As of 
November 2012, DOD had not yet issued additional guidance. 

The amount of additional CAS pension cost for DOD due to harmonization 
adjustments will depend, in part, on the number of contracts submitted 
by contractors for consideration, and this is yet to be determined. 
Some contractors said that a number of their contracts may be complete 
or no longer incurring costs by the time harmonization noticeably 
increases CAS pension costs. We reviewed four programs that have 
production or construction contracts that were both awarded before 
February 2012, and for which deliveries are scheduled in 2014 or 
beyond. These include large platforms with small quantities, such as 
Wideband Global SATCOM and Virginia Class Submarine; because 
satellites and submarines take several years to build, all the units 
on these contracts will be delivered in 2014 or later (as late as 2018 
for the submarine). Therefore, substantial costs could be incurred in 
2014 and beyond. In contrast, the bulk of costs on relevant contracts 
for F-35 Joint Strike Fighter aircraft and Tactical Tomahawk missiles 
will be incurred before 2014 when the main provisions of harmonization 
take effect. Over 80 percent of F-35 deliveries, and almost 60 percent 
of Tactical Tomahawk deliveries, are scheduled to take place before 
2014. Several contractors stated that they were waiting for DOD to 
issue additional guidance before submitting their requests for 
adjustment and one contractor commented that it could be beneficial 
for DOD to wait for interest rates to rise, as that could negate the 
effect of harmonization and the need for adjustment on some contracts. 

The CAS Board Did Not Update Rules for Settlement of Plan Curtailments 
as Part of Harmonization: 

The CAS Board did not harmonize the discount rates used for settling 
up if a contractor curtails a pension plan, meaning that liabilities 
could be calculated differently under ERISA and CAS rules if a 
contractor terminates a plan or freezes new benefit accruals for all 
participants. In such an event, the liability would be calculated 
using the old (likely higher) assumed long-term rate of return, 
instead of the new (likely lower) corporate bond interest rates. In 
the current environment, that would make the measurement of 
liabilities lower for a plan being curtailed than would be the case if 
the plan continued with new benefits accruing. 

According to CAS Board officials, the Board intends to begin a case on 
CAS 413 in the near future, although a schedule for such rule-making 
has not been created. The process of changing CAS rules can be time-
consuming. For example, while PPA, enacted in 2006, established a 
deadline for harmonization of January 1, 2010, the final ruling was 
not issued until December 2011, and not effective until February 2012. 

Conclusions: 

DOD faces new challenges as a result of changes to rules governing 
contractor pension costs and the growth in these costs, especially 
since the market downturn that started in 2008. The regulatory 
structure for government contracting generally allows contractors to 
receive payment for normal business costs incurred while working on 
government contracts, including employees' salaries and benefits such 
as pensions. DOD recognizes that understanding and overseeing pension 
costs requires highly specialized expertise, and has therefore 
centralized its pension oversight functions. However, while DOD 
processes ensure that contractors' CAS pension costs have been 
calculated correctly and that actuarial assumptions are reasonable, 
these processes do not assign responsibility for reviewing and valuing 
the benefits that participants will receive. Additionally, CAS pension 
cost is an imperfect measure of the value of pension benefits 
participants earned in a given year. As a result, DOD has an 
incomplete picture of the reasonableness of the total compensation 
offered by contractors. Further, DOD's assessment of executive 
compensation does not require inclusion of defined benefit pensions, 
and the assessment that does take place does not consider the value of 
benefits earned by participants. This could hamper DOD's efforts to 
ensure the reasonableness of the total compensation offered to 
contractor executives. 

CAS pension costs associated with defined benefit plans have grown 
substantially over the past decade, and can be expected to grow larger 
and more volatile with the harmonization of CAS to ERISA. We found 
that in this environment, DOD contractors, like their peer group, have 
limited employee entry to defined benefit plans. Defined benefit 
pension costs are highly sensitive to economic assumptions, and even a 
small change in conditions can have significant consequences. 
Increased volatility due to harmonization challenges the consistency 
of contract forward pricing. Under the previous rules, CAS discount 
rates were more stable and predictable, and therefore effective for 
consistent forward pricing. DOD has recognized the desirability of 
using long-term average rates in CAS calculations in order to smooth 
the impact of pension cost swings over time, and the need to provide 
more guidance to its acquisition organizations on the discount rates 
contractors should use. While DOD has stated that this guidance would 
be forthcoming, details are yet to emerge, and the longer it takes to 
issue the guidance, the longer DOD is likely to see a broad range of 
discount rates and large variation in forward pricing rates. Further, 
while harmonization changed how contractors will calculate their CAS 
pension costs, it did not update CAS 413 to harmonize the discount 
rates used for settling up in the event of a plan curtailment. The 
current interest rate environment means that a plan being curtailed 
would have significantly lower liabilities than if it had continued 
accruing new benefits, complicating settlements between contractors 
and the government. 

Recommendations for Executive Action: 

We recommend that the Secretary of Defense take the following four 
actions: 

* Assign responsibility for oversight of the reasonableness of pension 
plans offered by contractors, specifically the value of benefits 
earned by participants; 

* Provide guidance on how to measure the value of pension benefits 
that participants earn in a given year to get a complete picture of 
total compensation for contractor employees; 

* Provide guidance on the extent to which defined benefit plans should 
be included in assessments of the reasonableness of executive 
compensation packages; and: 

* Provide specific guidance to acquisition organizations, including 
DCMA and DCAA, on the discount rate or rates that would be acceptable 
for contractors to use in calculating pension costs for forward 
pricing purposes. 

In order to better align with the harmonized CAS 412, we recommend 
that the CAS Board set a schedule for revising the parts of CAS 413 
dealing with settlement of pension plan curtailments. 

Agency and Third-Party Comments: 

We provided a draft of this report to DOD, OMB, PBGC, the Department 
of the Treasury, and the 10 large DOD contractors covered by our 
review. We received formal written comments from DOD. DOD agreed with 
all four recommendations made to the Secretary of Defense. DOD also 
provided technical comments which were incorporated as appropriate. 
DOD comments are reproduced in appendix II. 

OMB provided comments stating that the CAS Board, when it meets, will 
consider a schedule for a case to revise the parts of CAS 412 and CAS 
413 relating to defined benefit plan segment closings and 
curtailments. OMB also offered technical comments which were 
incorporated as appropriate. 

We received comments from six contractors, who said that the report 
captures the complexities involved in determining pension costs. Four 
contractors indicated that they had no comments. Contractors also 
offered technical comments which were incorporated as appropriate. 

Both the Department of the Treasury and PBGC provided technical 
comments which were incorporated as appropriate. 

We are sending copies of this report to appropriate congressional 
committees; the Secretary of Defense; the Acting Director, Office of 
Management and Budget; and other interested parties. In addition, this 
report will be available at no charge on the GAO website at 
[hyperlink, http://www.gao.gov]. 

If you have any questions about this report, please contact Cristina 
Chaplain at (202) 512-4841 or chaplainc@gao.gov, or Charles Jeszeck at 
(202) 512-7215 or jeszeckc@gao.gov. Contact points for our Offices of 
Congressional Relations and Public Affairs may be found on the last 
page of this report. Key contributors to this report are found in 
appendix III. 

Signed by: 

Cristina T. Chaplain: 
Director: 
Acquisition and Sourcing Management: 

Signed by: 

Charles A. Jeszeck: 
Director: 
Education, Workforce, and Income Security: 

List of Requesters: 

The Honorable Carl Levin: 
Chairman: 
Committee on Armed Services: 
United States Senate: 

The Honorable Kelly Ayotte: 
United States Senate: 

The Honorable John McCain: 
United States Senate: 

The Honorable Claire McCaskill: 
United States Senate: 

[End of section] 

Appendix I: Objectives, Scope, and Methodology: 

Our objectives were to assess how (1) contractor pension costs are 
determined; (2) the Department of Defense (DOD) ensures the contractor 
pension costs it pays are appropriate; (3) DOD contractors' defined 
benefit pension plans compare with plans sponsored by similar 
companies that are not among the largest DOD contractors; (4) pension 
costs have affected DOD contract costs and the factors that 
contributed to these pension costs; and (5) the December 2011 
harmonization of Cost Accounting Standards (CAS) with the Employee 
Retirement Income Security Act of 1974 (ERISA) will affect the amounts 
DOD will pay in pension costs in coming years. 

To conduct analysis across all objectives, we analyzed defined benefit 
pension plans for the 10 largest contractors based on DOD contract 
obligations for fiscal year 2011. Those contractors were: 

* BAE Systems plc: 

* The Boeing Company: 

* General Dynamics Corporation: 

* L-3 Communications Holdings, Inc. 

* Lockheed Martin Corporation: 

* Northrop Grumman Corporation: 

* Oshkosh Corporation: 

* Raytheon Company: 

* SAIC, Inc. 

* United Technologies Corporation: 

For these contractors (with the exception of one that does not offer 
defined benefit plans), we selected for deeper analysis defined 
benefit plans that together covered at least 90 percent of each 
contractor's pension liabilities (35 plans in total). 

At the 10 largest contractors, we interviewed officials whose 
responsibilities included benefits management and government 
accounting, as well as a number of actuaries supporting those 
contractors. We also interviewed Defense Contract Management Agency 
(DCMA) and Defense Contract Audit Agency (DCAA) officials with 
responsibilities covering contractor costs at headquarters, and at a 
number of specialized centers such as the DCMA Contractor Insurance/ 
Pension Review (CIPR) Center and Contract Disputes Resolution Center, 
and the DCAA Compensation Team. We also interviewed DOD officials with 
cognizance for negotiation and oversight of pension costs at the 
corporate level for each of the 10 selected large contractors, 
including the DCMA Corporate Administrative Contracting Officer 
(CACO), and DCAA officials including regional audit managers, resident 
auditors, and pension technical specialists. We interviewed a 
representative of the American Academy of Actuaries, and also met with 
representatives of the Pension Benefit Guaranty Corporation (PBGC) and 
the Department of the Treasury. 

We reviewed various federal laws (e.g., the Pension Protection Act of 
2006). We also reviewed key rules and regulations, such as relevant 
sections of the Federal Acquisition Regulation (FAR) (e.g., FAR 
section 31.205-6, Compensation for Personal Services), the Defense 
Federal Acquisition Regulation Supplement (DFARS) (e.g., DFARS Subpart 
242.73, Contractor Insurance/Pension Review), and CAS (e.g., CAS 412, 
Cost Accounting Standard for Composition and Measurement of Pension 
Cost, and CAS 413, Adjustment and Allocation of Pension Cost). We 
reviewed DCMA documentation including guidance on forward pricing 
rates and final overhead rates, and reports written by the DCMA CIPR 
Center. We reviewed DCAA documentation such as relevant sections of 
the DCAA Contract Audit Manual (e.g., Chapter 8, Cost Accounting 
Standards), and audit reports that address contractor pension costs. 
We also reviewed prior GAO work concerning pensions. 

Further, to understand how DOD oversees pension costs at smaller 
contractors, we selected publicly traded contractors that: fell 
between the 11th and 50th places in terms of DOD contract obligations 
for fiscal year 2011; had total defined benefit pension plan assets of 
at least $1 billion; and had fiscal year 2011 DOD contract obligations 
representing at least 4 percent of total 2011 net sales.[Footnote 58] 
The following seven contractors met these criteria: 

* Alliant Techsystems Inc. 

* Computer Sciences Corporation: 

* Honeywell International Inc. 

* ITT Exelis: 

* Navistar International Corporation: 

* Rockwell Collins, Inc. 

* Textron Inc. 

At the seven smaller contractors we interviewed officials with pension 
management responsibilities. We also interviewed corporate-level DCMA 
officials with cognizance for the seven smaller contractors, and where 
available collected recent DCAA audit reports and CIPR Center reports 
related to pensions at those contractors. 

To compare the defined benefit pension plans of large DOD contractors 
to those sponsored by similar companies, we selected a peer group of 
15 companies not among the largest DOD contractors based on analysis 
of contractor audited financial statements. Many of the contractors 
list a peer group they use to benchmark executive compensation in 
their financial statements. These peer companies may be selected for 
generally comparability in terms of company size, industry, or 
operations as well as their overall competitiveness with respect to 
similar employee skill sets and talent. Eight of the largest DOD 
contractors publish lists of their peers and we selected the 15 most 
prevalent companies (not including the DOD contractors themselves) 
that appeared across all eight lists. For both the contractors and the 
peer group, we analyzed annual reports and proxy statements for fiscal 
year 2011 to identify the status of pension plans and understand how 
pension plan assets are allocated. 

To identify trends in CAS pension costs, for the nine largest 
contractors with defined benefit plans we reviewed pension plan 
documents such as CAS valuation reports (generally certified by 
qualified and credentialed actuaries), summary plan descriptions, and 
CAS disclosure statements. We collected contractor data on incurred 
CAS pension costs from 2002 to 2011. Our analysis of CAS valuation 
reports identified sources of current unfunded liabilities and CAS 
pension cost, as well as the difference between ERISA-required 
contributions and what the contractors have calculated as CAS pension 
cost. Note that for one large contractor, we excluded most pension 
data associated with a business that was recently spun off, in which 
the transaction included parts of several defined benefit pension 
plans. This was done in order to make the contractor's past and 
projected pension cost data more comparable. CAS pension costs 
provided by contractors may or may not reflect their PBGC premiums. 
Where we were able to identify the premiums separately from other 
pension costs, their relative size was insignificant. 

To understand how pension costs make their way onto DOD contracts, we 
selected divisions at the five largest contractors based on DOD 
contract obligations for fiscal year 2011, and at each division 
selected a weapon system program, which together represent a mix of 
military services and platform types. This selection was a 
nonprobability sample, and the findings from these programs are not 
generalizable to all programs. Those divisions and programs were: 

* Boeing Space and Intelligence Systems--Wideband Global SATCOM: 

* General Dynamics Electric Boat--SSN 774 Virginia Class Submarine: 

* Lockheed Martin Aeronautics--F-35 Joint Strike Fighter: 

* Northrop Grumman Electronic Systems--AN/PED-1 Lightweight Laser 
Designator Rangefinder: 

* Raytheon Missile Systems--Tactical Tomahawk R/UGM-109E: 

At the divisions, we interviewed contractor officials whose 
responsibilities included contracting and development of forward 
pricing rates. We were also briefed on how pension costs are 
incorporated into rates at each division. We interviewed DOD officials 
with cognizance at the division-level for the five selected divisions, 
including the DCMA Divisional Administrative Contracting Officer 
(DACO) and local auditors.[Footnote 59] For the five divisions, where 
available we collected contractor data on each division's incurred 
pension costs from 2005 to 2011, and within each division, the 
individual programs' incurred costs from 2005 to 2011. This period 
represents years for which data was generally available across 
selected programs. 

To demonstrate the potential impact on CAS pension costs of CAS/ERISA 
harmonization and changing economic assumptions, we developed a model 
of an illustrative contractor defined benefit plan, based on a review 
of the model DOD uses, and reviewed by the Chief Actuary of the GAO 
for actuarial soundness. For additional insight into the potential 
impact of harmonization, we gathered from the nine largest contractors 
projections (prior to and following harmonization and the Moving Ahead 
for Progress in the 21st Century Act (MAP-21)) of CAS pension costs 
for 2012 to 2016, where available. For the five selected divisions, we 
also gathered projections of pension costs for 2012 to 2016. We also 
interviewed the Project Director detailed to the CAS Board to lead the 
team that harmonized CAS with ERISA. We reviewed changes made to the 
CAS in December 2011 to harmonize it with ERISA. We also reviewed DOD 
policies related to CAS/ERISA harmonization, such as the Office of the 
Under Secretary of Defense for Acquisition, Technology, and Logistics 
memorandum providing guidance on harmonization. 

We conducted this performance audit from December 2011 to January 2013 
in accordance with generally accepted government auditing standards. 
Those standards require that we plan and perform the audit to obtain 
sufficient, appropriate evidence to provide a reasonable basis for our 
findings and conclusions based on our audit objectives. We believe 
that the evidence obtained provides a reasonable basis for our 
findings and conclusions based on our audit objectives. 

[End of section] 

Appendix II: Comments from the Department of Defense: 

Office of the Under Secretary of Defense: 
Acquisition, Technology and Logistics: 
3000 Defense Pentagon: 
Washington, DC 20301-3000: 

January 4, 2013: 
                
Ms. Cristina T. Chaplain: 
Director, Acquisition and Sourcing Management: 
U.S. Government Accountability Office: 
441 G Street, N.W. 
Washington, DC 20548: 

Dear Ms. Chaplain: 

This is the Department of Defense (DoD) response to the GAO Draft 
Report, GAO-13158, "Pension Costs on DOD Contracts: Additional 
Guidance Needed to Ensure Costs Are Consistent and Reasonable," dated 
December 6, 2012 (GAO Code 121028). DoD concurs with the 
recommendations of the report. Detailed comments on the report 
recommendations are enclosed. 

Sincerely, 

Signed by: 

Richard Ginman: 
Director, Defense Procurement and Acquisition Policy: 

Enclosure: As stated. 

GAO Draft Report Dated January, 2013: 
GAO-13-158 (GAO Code 121028): 

"Pension Costs On DOD Contracts Additional Guidance Is Needed To
Ensure Costs Are Consistent And Reasonable" 

Department Of Defense Comments To The GAO Recommendations: 

Recommendation 1: GAO recommends that the Secretary of Defense assign 
responsibility for oversight of the reasonableness of pension plans 
offered by contractors, specifically the value of benefits earned by 
participants. 

DoD Response: Concur. DCAA will be responsible for evaluating the 
reasonableness of pension plans offered by contractors. DCAA will 
review its current policy to ensure it assesses the value of benefits 
earned by participants. As specified in current DCAA policy, if an
evaluation requires technical assistance, DCAA will request such 
assistance from DCMA's CIPR team. If an initial review of the pension 
plan offered by the contractor indicates a potential for unreasonable 
compensation, the policy will require an evaluation of other parts of 
compensation to determine if total compensation is unreasonable as 
required by FAR 31.205-6(b)(2). As with any reasonableness 
determination, DCMA CACOs would ultimately render judgment on a plan's 
reasonableness and determine cost allowability. 

Recommendation 2: GAO recommends that the Secretary of Defense provide 
guidance on how to measure the value of pension benefits that 
participants earn in a given year to get a complete picture of total 
compensation for contractor employees. 

DoD Response: Concur. DCAA and DCMA will jointly develop guidance on 
how to measure pension benefits that participants earn in a given 
year. The guidance on measuring the value of pension benefits will 
require a joint DCAA/DCMA effort to ensure reasonable, understandable 
guidelines are issued that allow auditors to develop consistent audit 
programs and also ultimately link to actuarial principles used to 
develop CAS pension costs. 

Recommendation 3: GAO recommends that the Secretary of Defense provide 
guidance on the extent to which defined benefit plans should be 
included in assessments of the reasonableness of executive 
compensation packages. 

DoD Response: Concur. DCAA will reassess its guidance covering the 
evaluation of defined benefit pension plans as part of the assessment 
of reasonableness of executive compensation. If an initial review of 
the pension plan offered to executives indicates a potential for 
unreasonable compensation, the policy will require an evaluation of 
other parts of compensation to determine if total compensation is 
unreasonable as required by FAR 31.2056(b)(2). 

Recommendation 4: GAO recommends that the Secretary of Defense provide 
specific guidance to acquisition organizations, including DCMA and 
DCAA, on the discount rate or rates that would be acceptable for 
contractors to use in calculating pension costs for forward pricing 
purposes. 

DoD Response: Concur. The USD AT&L is currently working on this 
guidance. DCMA and DCAA have been coordinating with USD AT&L in the 
development of this guidance. 

[End of section] 

Appendix III: GAO Contacts and Staff Acknowledgments: 

GAO Contacts: 

Cristina T. Chaplain, (202) 512-4841 or chaplainc@gao.gov; Charles A. 
Jeszeck, (202) 512-7215 or jeszeckc@gao.gov. 

Staff Acknowledgments: 

In addition to the contacts named above, Karen Zuckerstein, Assistant 
Director; Kimberley Granger, Assistant Director; Robert Bullock; 
Robert Dacey; Charles Ford; Laura Greifner; John Krump; Gene 
Kuehneman; Kenneth Patton; David Reed; Matthew Shaffer; Roxanna Sun; 
Daren Sweeney; Aron Szapiro; Roger Thomas; Frank Todisco; and Jocelyn 
Yin made key contributions to this report. 

[End of section] 

Footnotes: 

[1] Defined benefit plans typically provide a specific retirement 
benefit often based on salary or years of service. 

[2] 29 U.S.C. § 1001 note. 

[3] CAS is a set of rules designed to ensure contractors consistently 
apply cost accounting practices to contracts with the government. 
ERISA sets certain protections for participants in defined benefit 
pension plans and minimum funding standards for pension plans 
sponsored by private employers. 

[4] Of the 10 largest DOD contractors, one does not sponsor defined 
benefit pension plans for employees. Throughout this report when we 
refer to the "largest DOD contractors", unless otherwise specified, we 
are referring to the nine largest DOD contractors based on DOD 
contract obligations for 2011 that also sponsor defined benefit 
pension plans. 

[5] See GAO, Employee Compensation: Employer Spending on Benefits Has 
Grown Faster Than Wages, Due Largely to Rising Costs for Health 
Insurance and Retirement Benefits, [hyperlink, 
http://www.gao.gov/products/GAO-06-285] (Washington, D.C.: Feb. 24, 
2006). 

[6] Defined benefit formulas vary widely, but in 2005 GAO found that a 
typical defined benefit plan gave participants 1.5 percent of their 
final average pay, multiplied by years of service, as a lifetime 
benefit. See GAO, Private Pensions: Information on Cash Balance 
Pension Plans, [hyperlink, http://www.gao.gov/products/GAO-06-42] 
(Washington, D.C.: Nov. 3, 2005). Note that this finding could change 
if a similar survey were undertaken today, because of plan freezes and 
benefit formula reductions in recent years. Note further that a plan 
participant's actual benefit would often be lower than what this base 
formula would produce, because of such factors as partial offsets for 
Social Security benefits and reduction for early retirement. 

[7] 26 U.S.C. § 401-436. 

[8] 26 U.S.C. § 430 and 29 U.S.C. § 1082, respectively. 

[9] Participants do not have to pay income tax on the employer's 
contribution to the plan on their behalf or on the earnings to those 
contributions until benefits are received. 26 U.S.C. § 404(a)(1) & (2). 

[10] 26 U.S.C. § 409 A. 

[11] GAO, Private Pensions. Recent Experiences of Large Defined 
Benefit Plans Illustrate Weakness in Funding Rules, [hyperlink, 
http://www.gao.gov/products/GAO-05-294] (Washington, D.C.: May 31, 
2005). 

[12] CAS rules for determining federal contract costs and ERISA rules 
for determining pension contributions are distinct from generally 
accepted accounting principles (GAAP) and related standards that apply 
to public financial reporting by pension plans and their sponsors. 

[13] Such contracts include fixed price incentive contracts, cost plus 
incentive fee contracts, and cost plus fixed fee contracts. 

[14] CAS valuation reports reflect an actuarial valuation, as of the 
start of the plan year, of a contractor pension plan. They contain 
details of the plan's CAS pension cost, assets and liabilities, as 
well as the plan's actuarial assumptions. They are typically produced 
by actuaries, whether in-house or external. 

[15] 29 U.S.C. § 1001 note. 

[16] 29 U.S.C. § 1001, 1001a and 1001b. 

[17] 29 U.S.C. § 1301-1461. 

[18] DOD actuaries also refer to the discount rate as the valuation 
rate. 

[19] Use of the latter approach with short or no smoothing would have 
typically produced discount rates of around 4.0 percent in recent 
years. 

[20] Pub. L. No. 109-280. 

[21] PPA requires plan sponsors to discount expected benefit payments 
based on a corporate bond interest rate yield curve. This means that 
liabilities are discounted at different rates, depending on when a 
plan expects to make a given benefit payment. 

[22] Until that time those contractors calculated liabilities under 
ERISA using a long-term rate of return assumption regardless of when 
benefit payments would be due. Companies required to delay 
implementation of the new funding rules were those whose primary 
source of revenue was derived from contracts with the U.S. government 
and whose revenue from such business in the previous fiscal year 
exceeded $5 billion. Several companies we reviewed delayed 
implementation under this provision (Section 106 of PPA) including BAE 
Systems, L-3 Communications, Lockheed Martin, Northrop Grumman, 
Raytheon, and General Dynamics. 

[23] Pub. L. No. 109-280 § 106(d). 

[24] For example, in 2014 the liability would be a weighted average 
equal to 25 percent of the liability calculated under the current 
ERISA rules and 75 percent of the liability calculated under the 
traditional (pre-harmonization) CAS rules. Alternatively, if corporate 
bond interest rates rise high enough (the exact amount would vary by 
plan), there could be no additional harmonization-related cost 
because, per CAS rules, the ERISA-based discount rate calculation 
would not be applicable. 

[25] CAS rules would also trigger a settlement for a business segment 
closure or a pension plan termination. For a pension plan termination, 
the liability is simply the amount needed to settle all benefit 
obligations. In the case of a curtailment, a company would retain the 
liability and assets. 

[26] Compensation costs established under "arm's length" labor-
management agreements negotiated under certain statutes are generally 
considered reasonable if they are otherwise allowable. 

[27] A possible method to assess pension plan reasonableness would be 
to examine the present value of future benefits, with similar 
assumptions mandated across contractors. 

[28] "Base" accrual rate refers to the fact that the accrual rate may 
be different for certain years of service; we use the term base to 
refer to the earliest years of service. Actual benefits could be 
reduced by taking into account Social Security benefits as well as for 
early retirement. 

[29] Due, in part, to a lack of available data, we were unable to 
evaluate plan designs across both contractors and their peer group. As 
noted previously, the contractor "base" accrual rates for the final 
average pay plans we analyzed ranged between 1 percent and 2 percent 
of participants' final average pay multiplied by years of service as a 
lifetime benefit. Also as noted, a previous GAO report from 2005 found 
that a typical defined benefit plan gave participants a "base" accrual 
rate of 1.5 percent of final average pay multiplied by years of 
service as a lifetime benefit. Note that this finding could change if 
a similar survey were undertaken today, because of plan freezes and 
benefit formula reductions in recent years. Note further that a plan 
participant's actual benefit would often be lower than what this base 
formula would produce, because of such factors as partial offsets for 
Social Security benefits and reduction for early retirement. 

[30] A freeze should not be confused with a termination whereby a plan 
sponsor ceases maintaining the plan. 

[31] In prior work, GAO defined a soft freeze as one which, at a 
minimum, closes the plan to new entrants. A soft freeze could include 
other changes that affect current participants. Throughout this report 
we use the term soft freeze to refer exclusively to the closing of a 
plan to new entrants. See Defined Benefit Pensions: Plan Freezes 
Affect Millions of Participants and May Pose Retirement Income 
Challenges, [hyperlink, http://www.gao.gov/products/GAO-08-817] 
(Washington, D.C.: July 21, 2008). 

[32] See GAO, Defined Benefit Pensions: Survey Results of the Nation's 
Largest Private Defined Benefit Sponsors, [hyperlink, 
http://www.gao.gov/products/GAO-09-291] (Washington, D.C.: Mar. 30, 
2009). 

[33] Hybrid plans include cash balance plans, which are defined 
benefit plans that contain certain plan features that resemble defined 
contribution plans. 

[34] [hyperlink, http://www.gao.gov/products/GAO-08-817]. 

[35] Aon Hewitt provides companies with services including retirement 
plan consulting. 

[36] Other large DOD contractors had hard frozen smaller plans but not 
plans that were among the contractors' largest plans (i.e., those that 
together covered at least 90 percent of each contractor's pension 
liabilities). DOD contractors reported that these plans were "legacy" 
plans which had been replaced by another plan, or plans that were hard 
frozen prior to the contractor's acquisition of the business divisions 
with those plans. 

[37] 48 C.F.R. 9904.413-50(c)(12). Because interest rates used to 
calculate liabilities under ERISA funding calculations are currently 
lower than interest rates for CAS settlements, contractors may 
calculate lower liabilities under a CAS settlement than if the plan 
was ongoing on an ERISA basis. Thus, contractors' plan liabilities and 
any recoveries from the government could be lower than under an ERISA 
valuation--leaving contractors responsible for what they may consider 
to be an inequitable share of any settlement. According to PBGC 
officials, CAS settlement would likely result in a significant 
underfunded liability for many plans on a PBGC termination basis, 
which could result in significant underfunded liability for the PBGC 
should it become trustee of the plan. 

[38] All large DOD contractors that maintain tax-qualified defined 
benefit plans also maintain nonqualified defined benefit plans. 

[39] 26 U.S.C. §§ 401(a)17 and 415. For defined benefit plans, these 
limits relate to the maximum annual compensation that may be counted 
towards benefit accruals and the maximum annual benefit that may be 
earned. 

[40] Asset allocations are from reported asset categories in 2011 
annual financial reports and are for U.S. plans only. Also note that 
financial reports list investments of all funded U.S. pension plans in 
aggregate. For sponsors that maintain multiple plans, each plan may 
select a unique investment policy and set of allocations for each 
plan. Alternatively, sponsors may maintain a common trust, called a 
master trust, which may employ a common set of investment allocations 
across all sponsored plans. 

[41] The DOD contractors' cash allocations ranged from 0 to 10 
percent, while the peer group allocated from 0 to 12 percent. "Other" 
asset allocations ranged from 0 to 24 percent for the largest DOD 
contractors, while peer group allocations for such assets ranged from 
0 to 38 percent. "Other" assets are assets that are not equities, 
fixed-income (i.e., bonds) or cash (or equivalents). Each contractor 
or peer may have different assets in the "other" category, but key 
asset classes in "other" include private equity, real estate, hedge 
funds, and commodities. 

[42] This could alternatively be referred to as the asset-weighted 
average allocation. 

[43] Our analysis categorized and analyzed reported asset categories 
in 2011 annual financial reports. However, sponsors define their asset 
categories in a variety of ways, and each asset category may encompass 
a wide range of risk. 

[44] A contractor's total pension cost may also include costs that are 
not allocated to DOD or other U.S. government contracts, but instead 
allocated to commercial activities. 

[45] For this analysis of CAS pension costs as a percentage of total 
direct labor cost, we included only defined benefit pension costs 
associated with direct labor on program contracts since this allowed 
for more comparability across programs. 

[46] We included pension costs for both direct and indirect labor that 
was associated with each program, as the total program cost includes 
some indirect labor. 

[47] To the extent that contractor defined contribution plans are 
largely either supplemental to defined benefit plans or cover 
relatively new employees, we would expect that defined contribution 
costs would generally represent a lower percentage of total program 
cost. 

[48] If certain plans are less than 80 percent funded on an ERISA 
basis (and if they are also less than 70 percent funded using a 
different set of assumptions), they are considered "at risk." While 
this review did not include analysis of ERISA funding reports, 
according to CIPR Center officials, no large contractors' defined 
benefit plans were less than 80 percent funded on an ERISA basis. 

[49] Investment losses are measured relative to the assumed rate of 
return. Thus, if the assumed rate of return was 8 percent, and assets 
actually lost 10 percent of their value, the loss would be 
approximately 18 percent. 

[50] Also included are any unusual adjustments or extraordinary 
payments that are paid for all at once instead of on a longer-term 
schedule. 

[51] The effective discount rate contractors will use is based on 
three segment rates published by the Department of the Treasury for 
benefit payments due in less than 5 years, 5 to 20 years, and 20 years 
or more. These segment rates reflect 2-year averaging and the maximum 
and minimum segment rate as required by MAP-21. These durations 
reflect actuarial predictions about when plan participants will claim 
benefits based on participant demographics. We excluded one contractor 
from this summary because its assumptions and demographics lead to 
only a very slight decline in the discount rate, which was atypical. 

[52] See § 40211(a) of MAP-21, Pub. L. No. 112-141, which adds § 
430(h)(2)(C)(iv) to the Internal Revenue Code. This legislation also 
increased premiums that plan sponsors must pay to the PBGC. 

[53] Note that CAS rules give contractors the option to use the ERISA 
interest rates for CAS calculations, but contractors could pick a 
different measure of the rate and use it consistently. None of the 
largest DOD contractors we spoke with used a rate other than the ERISA 
rates. 

[54] For example, even if a plan's assets outperformed expectations by 
as much as 5.0 percentage points a year from 2014 to 2017, the 
reduction in cost would still be lower than a 1.0 percentage point 
increase in the discount rate using our illustrative model over the 
same period. 

[55] A few DOD contractors projected decreases in CAS pension costs in 
2012 or 2013 due to changes separate from harmonization, such as 
changes to plan benefits. 

[56] For four of the five divisions included in this review, these 
projections did not account for MAP-21 or changes in interest rates 
since submission of initial post-harmonization projections. 

[57] Department of Defense, Office of the Under Secretary of Defense, 
Memorandum: Subject: Guidance on Cost Accounting Standards Board 
(CASB) Final Rule to Harmonize CAS 412 and 413 with the Pension 
Protection Act (PPA) of 2006: March 27, 2012. 

[58] Selection of 4 percent as a minimum level of DOD business 
relative to total sales excludes companies that, while large 
contractors in terms of total contract obligations, are overwhelmingly 
engaged in commercial business. 

[59] For one division, duties similar to those of DCMA at other 
contractors were performed by the Supervisor of Shipbuilding, 
Conversion and Repair. 

[End of section] 

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