Fair Value Measurements

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“FAS 157”) to provide enhanced guidance for using fair value to measure assets and liabilities. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. This standard clarifies the definition of fair value and expands financial statement disclosures about the use of fair value measurements.

FAS 157 may have a significant effect on the financial reporting for employee benefit plans depending upon the types of investments held by the plan, such as, but not limited to, investments in stocks that may not be traded in an active market, employer securities, corporate bonds, government securities, investment and insurance contracts, common collective trusts, pooled separate accounts, limited partnerships, private equity funds, funds of funds, real estate and other hard-to-value investments.

From the asset perspective, FAS 157 defines fair value as the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date. FAS 157 discusses acceptable valuation techniques available to plan sponsors, which would include a market approach, income approach and cost approach. The selection of a valuation technique or a combination of valuation techniques for each asset will depend on the circumstances. Generally, FAS 157 establishes a fair value hierarchy that distinguishes fair values based on quoted prices in active markets for identical assets (Level 1 Inputs); observable inputs, such as direct or indirect market-corroborated inputs (Level 2 Inputs); and unobservable inputs, such as values based on the reporting entity’s own estimations about the assumptions that market participants would use in pricing the asset (Level 3 Inputs).

FAS 157 requires expanded financial statement disclosures about the use of fair value to measure plan investments. These disclosures include information to assess the inputs used to measure fair value by identifying the level within the fair value hierarchy into which each investment falls and some additional disclosures for those investments with significant unobservable inputs (Level 3) such as the effect of the measurements on changes in net assets for the period and a reconciliation of the beginning and ending balances, separately presenting changes during the period.

Plan sponsors bear the responsibility for implementing FAS 157 and the valuation process. To prepare for implementation, plan sponsors should contact the plan’s service providers (trustees, custodians or other investment service providers) immediately to understand how the Level 2 and Level 3 assets are valued and what information the service providers will provide in reports and certifications to support the assertions of fair value. Plan sponsors must have a sufficient understanding of the nature of the plan’s investments and valuation methodologies, key assumptions and inputs used to determine fair value. Furthermore, plan sponsors must determine that the methods used are appropriate under the FAS 157 fair value definition, whether the values presented are as of the plan’s year end and obtain additional information about the valuation inputs to make the appropriate footnote disclosures required by FAS 157. Plan sponsors may face several challenges in implementing FAS 157, such as the recent liquidity freeze which has led to a lack of observable inputs and difficulty in measuring certain fair values in the absence of market transactions. Additionally, many plans outsource investment management activities to third party service providers, in which case information regarding the pricing and valuation of the plan’s investments may not be fully transparent to the plan sponsor. For certain investments, it may even be necessary to hire additional valuation service firms to assist in valuing investments for which year end fair value information is not available.