Contractors’ labor costs include pension benefits, since such benefits are  a normal part of compensation. 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. 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. This cost is allocated to  contracts based on CAS rules. 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. 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. The most recent change to ERISA minimum contribution requirements  can also affect CAS pension cost. 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. 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. Multiple  factors drive CAS pension 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. 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. As these costs increased, contractors took several actions to  control them. 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. Harmonization ties the CAS discount rate to ERISA rules, making it  harder to project future CAS pension costs. 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. 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. DOD agreed with all  four recommendations made to the Secretary of Defense. 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.
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.