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. 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, 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. 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. 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. 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. DOD contractors also sponsor “nonqualified plans.” 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. 26 U.S.C. § 409 A. 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. 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. 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. 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. 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. 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. 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. Supported by in-house or external actuaries, DOD contractors calculate their CAS pension costs at least annually, and produce CAS valuation reports for plans. 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.