© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter 17 Pensions

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Chapter 17Chapter 17

PensionsPensions


Slide17-2

Nature of Pension Plans

SponsorSponsor

I agree to make payments I agree to make payments into a fund for future into a fund for future

retirement benefits for retirement benefits for employee services.employee services.

ParticipantParticipant

I am the employee for I am the employee for whom the pension plan whom the pension plan

provides benefits.provides benefits.


Slide17-3


For a pension plan to qualify for special tax treatment it For a pension plan to qualify for special tax treatment it must meet the following requirement:must meet the following requirement:

1.1. Cover at least 70% of employees.Cover at least 70% of employees.

2.2. Cannot discriminate in favor of highly compensated Cannot discriminate in favor of highly compensated employees.employees.

3.3. Must be funded in advance of retirement through a trust.Must be funded in advance of retirement through a trust.

4.4. Benefits must vest after a specified period of service.Benefits must vest after a specified period of service.

5.5. Complies with timing and amount of contributions.Complies with timing and amount of contributions.


Slide17-4


The right to receive earned pension benefits The right to receive earned pension benefits vestvest (vested benefits) when it is no longer (vested benefits) when it is no longer

contingent on continued employment. contingent on continued employment.


Slide17-5

Contributions are Contributions are established by established by

formula or formula or contract.contract.

Contributions are Contributions are established by established by

formula or formula or contract.contract.

Employer deposits Employer deposits an agreed upon an agreed upon amount into an amount into an

employee-directed employee-directed investment fund.investment fund.

Employer deposits Employer deposits an agreed upon an agreed upon amount into an amount into an

employee-directed employee-directed investment fund.investment fund.

Employee Employee bears all risk of bears all risk of pension fund pension fund performance.performance.

Employee Employee bears all risk of bears all risk of pension fund pension fund performance.performance.

Defined Contribution Defined Contribution PlansPlans

Defined Contribution Defined Contribution PlansPlans


Slide17-6

Employer is Employer is committed to committed to

specified specified retirement retirement benefitsbenefits..

Employer is Employer is committed to committed to

specified specified retirement retirement benefitsbenefits..

Retirement Retirement benefits are based benefits are based on a formula that on a formula that

considers years of considers years of service, service,

compensation compensation level, and age.level, and age.

Retirement Retirement benefits are based benefits are based on a formula that on a formula that

considers years of considers years of service, service,

compensation compensation level, and age.level, and age.

Employer bears Employer bears all risk of all risk of

pension fund pension fund performance.performance.

Employer bears Employer bears all risk of all risk of

pension fund pension fund performance.performance.

Defined Benefit Defined Benefit Pension PlansPension Plans

Defined Benefit Defined Benefit Pension PlansPension Plans


Slide17-7

Defined Benefit Plan

Pension expense is measured by assigning Pension expense is measured by assigning pension benefits to periods of employee pension benefits to periods of employee service as defined by the service as defined by the pension benefit pension benefit

formulaformula..

Pension expense is measured by assigning Pension expense is measured by assigning pension benefits to periods of employee pension benefits to periods of employee service as defined by the service as defined by the pension benefit pension benefit

formulaformula..

A typical benefit formula might be:A typical benefit formula might be:1% 1% × Years of Service × Final year’s salary× Years of Service × Final year’s salary

So, for 35 years of service and a final salary of $80,000, So, for 35 years of service and a final salary of $80,000, the employee would receive:the employee would receive:1% × 35 × $80,000 = $28,000 per year. 1% × 35 × $80,000 = $28,000 per year.


Slide17-8

Pension Expense – An Overview

Components of Pension Expense+ Service cost ascribed to employee service this period+ Interest accrued on pension liability- Return on plan assets+ Amortized portion of Prior Service Cost

+ or - Losses or gains from revision of pension liability and plan assets= Pension expense


Slide17-9

Pension Obligation

Present value of Present value of benefits at present benefits at present

pay levels.pay levels.

Present value of Present value of nonvested benefits nonvested benefits

at present pay at present pay levels.levels.

Present value of Present value of additional benefits additional benefits related to projected related to projected

pay increases.pay increases.

VBOVBO ABOABO PBOPBO

Accumulated Accumulated Benefit ObligationBenefit Obligation

Projected Benefit Projected Benefit ObligationObligation

Vested Benefit Vested Benefit ObligationObligation


Slide17-10

Projected Benefit Obligation

The PBO changes as a result of:Cause Effect Frequency

Service Cost + Each period

Interest Cost+

Each period (except the first period of the plan)

Prior Service Cost +

Only if the plan is amended (or initiated) that period

Loss or Gain on PBO + or -

Whenever revisions are made in the pension liability estimate

Retiree Benefits Paid -

Each period (unless no employees have yet retired under the plan)



Interest Cost+









Slide17-11



Interest Cost+










Interest Cost+








Pension Obligation

Service cost Service cost is the increase in the is the increase in the PBO attributable to employee service PBO attributable to employee service

performed during the period.performed during the period.


Slide17-12



Interest Cost+










Interest Cost+








Pension Obligation

Interest costInterest cost is the accrued interest is the accrued interest on the PBO during the period.on the PBO during the period.


Slide17-13



Interest Cost+










Interest Cost+








Pension Obligation

Prior service costPrior service cost effects result from effects result from changes in the pension benefit changes in the pension benefit

formula or plan terms.formula or plan terms.


Slide17-14



Interest Cost+










Interest Cost+








Pension Obligation

Loss or gain on PBOLoss or gain on PBO results from results from required revisions of estimates used required revisions of estimates used

to determine PBO.to determine PBO.


Slide17-15



Interest Cost+










Interest Cost+








Pension Obligation

Retiree benefits paidRetiree benefits paid are the are the result of paying benefits to retired result of paying benefits to retired

employees.employees.


Slide17-16

Pension Plan Assets

Pension plan assets (like the PBO) are not formally recognized on the balance sheet.

A trustee manages the pension plan assets.


Slide17-17

Pension Plan Assets

OVERFUNDED

Market value of plan Market value of plan assets exceeds the assets exceeds the

actuarial present actuarial present value of all benefits value of all benefits

earned by earned by participants.participants.

UNDERFUNDED

Market value of plan Market value of plan assets is below the assets is below the actuarial present actuarial present

value of all benefits value of all benefits earned by earned by

participants.participants.


Slide17-18

Pension Expense

Pension expense is the Pension expense is the net costnet cost of: of: Service costService cost Interest costInterest cost Return on plan assetsReturn on plan assets Amortization of prior service costsAmortization of prior service costs Gain or loss recognized.Gain or loss recognized.


Slide17-19

Defined Benefit Plan You go to work for Matrix, Inc. on 1/1/00. You are eligible to You go to work for Matrix, Inc. on 1/1/00. You are eligible to participate in the company's defined benefit pension plan. The benefit participate in the company's defined benefit pension plan. The benefit formula is:formula is:

Annual salary in year of retirement

× Number of years of service

× 1.5%

Annual retirement benefits

You are 25 years old when you start work and may accumulate 40 You are 25 years old when you start work and may accumulate 40 years of service before retiring at age 65. If your salary is $200,000 years of service before retiring at age 65. If your salary is $200,000 during your last year of service, you will receive the following annual during your last year of service, you will receive the following annual benefits:benefits:

$200,000

× 40

× 1.5%

$120,000

You are not required to make any contributions. The plan vests at the You are not required to make any contributions. The plan vests at the rate of 20% per year. The plan actuary estimates that upon reaching rate of 20% per year. The plan actuary estimates that upon reaching age 65, you will receive payments for 15 years. The actuary uses an 8% age 65, you will receive payments for 15 years. The actuary uses an 8% discount rate in all present value computations.discount rate in all present value computations.


Slide17-20


At December 31, 2000, the end of your first year of service, the actuary At December 31, 2000, the end of your first year of service, the actuary must calculate the present value of the pension benefits earned by you during must calculate the present value of the pension benefits earned by you during 2000. Remember that you will not receive pension benefits until you are 65 2000. Remember that you will not receive pension benefits until you are 65 and the actuary estimates payments will be made for 15 years after you retire. and the actuary estimates payments will be made for 15 years after you retire. After one year of service you will have earned $3,000 in pension benefits:After one year of service you will have earned $3,000 in pension benefits:

Pension benefits = .015 Pension benefits = .015 ×× 1 1 ×× $200,000 $200,000

Pension benefits = $3,000.Pension benefits = $3,000. Service cost is the present value of these benefits and are calculated as Service cost is the present value of these benefits and are calculated as follows:follows:

Service cost = $3,000 Service cost = $3,000 ×× 8.55948 8.5594811 ×× .049713 .04971322

Service cost = $1,277.Service cost = $1,277.

11Present value of an ordinary annuity at 8% for 15 years.Present value of an ordinary annuity at 8% for 15 years.

22Present value of $1 at 8% for 39 years.Present value of $1 at 8% for 39 years.


Slide17-21


Based on the given information, the actuary calculates your Based on the given information, the actuary calculates your accumulated benefit obligation (ABO) as follows:accumulated benefit obligation (ABO) as follows:

Retirement benefits = .015 Retirement benefits = .015 ×× 1 1 ×× $25,000 $25,000

Retirement benefits = $375Retirement benefits = $375

ABO = $375 ABO = $375 ×× 8.55948 8.55948 ×× .049713 .049713

ABO = $160.ABO = $160. Your vested benefit obligation (VBO) is calculated as follows:Your vested benefit obligation (VBO) is calculated as follows:

Vested benefits = .015Vested benefits = .015 ×× 1 1 ×× $25,000 $25,000 ×× .2 .2

Vested benefits = $75Vested benefits = $75

VBO = $75 VBO = $75 ×× 8.55948 8.55948 ×× .049713.049713

VBO = $32VBO = $32


Slide17-22


A reconciliation of the VBO, ABO and PBO would look like thisA reconciliation of the VBO, ABO and PBO would look like this:

VBO

$ 32

Non-vested benefits

128

ABO

160

Adjustment for future salary

478

PBO

638

If you are the only employee at Matrix, the computations would be If you are the only employee at Matrix, the computations would be similar for future years. Let’s assume Matrix funds $500 of its pension similar for future years. Let’s assume Matrix funds $500 of its pension costs with the plan trustee on December 31, 2000. The journal entry costs with the plan trustee on December 31, 2000. The journal entry to record the pension costs and funding would be:to record the pension costs and funding would be:

Provision for Pension Costs

638

Accrued Pension Liability

138

Cash

500


Slide17-23


Let’s look at an example for Let’s look at an example for Cotton, Inc.Cotton, Inc.






Slide17-24


Actuaries have determined that Cotton, Inc. Actuaries have determined that Cotton, Inc. has service cost of $150,000 in 2002 and has service cost of $150,000 in 2002 and

$155,000 in 2003.$155,000 in 2003.

We can begin the process of determining We can begin the process of determining pension expense for the company,pension expense for the company,


Slide17-25

Service Cost


Slide17-26

Interest Cost

Interest costInterest cost is the growth in PBO during is the growth in PBO during a reporting period.a reporting period.

Interest cost is calculated as:Interest cost is calculated as:

PBOPBOBegBeg × Discount rate × Discount rate


Slide17-27

Interest Cost

Actuaries determined that Cotton, Inc. Actuaries determined that Cotton, Inc. had PBO of $500,000 on 1/1/02, and had PBO of $500,000 on 1/1/02, and

$640,000 on 1/1/03. $640,000 on 1/1/03.

The actuary uses a discount rate of 10%.The actuary uses a discount rate of 10%.


Slide17-28

Interest Cost

2002: PBO 1/1/02 $500,000 × 10% = $50,0002002: PBO 1/1/02 $500,000 × 10% = $50,000

2003: PBO 1/1/03 $640,000 × 10% = $64,0002003: PBO 1/1/03 $640,000 × 10% = $64,000


Slide17-29

Return on Plan Assets

Estimated each year Estimated each year to determine the to determine the

amount of funds to set amount of funds to set aside to pay retirement aside to pay retirement

benefits as they benefits as they become due.become due.

Expected Expected ReturnReturn

Expected Expected ReturnReturn

The dividends, interest, The dividends, interest, and capital gains and capital gains

generated by the fund generated by the fund during the period.during the period.

Actual Actual ReturnReturnActual Actual ReturnReturn


Slide17-30


The plan trustee reports that plan The plan trustee reports that plan assets were $450,000 on 1/1/02, assets were $450,000 on 1/1/02,

and $600,000 on 1/1/03. and $600,000 on 1/1/03.

The trustee uses an expected return The trustee uses an expected return of 9% and an actual return of 10%.of 9% and an actual return of 10%.


Slide17-31


Beginning value of plan assets 600,000$ Rate of return 10%Return on plan assets 60,000 Beginning value of plan assets 600,000$ Adjustment (10% - 9%) 1%Adjusted for gain on plan assets 6,000 Expected return on plan assets 54,000$




20022002

20032003


Slide17-32



Slide17-33

Amortization of Prior Service Cost

Prior service cost (PSC)Prior service cost (PSC) results from the results from the granting of pension benefits for service granting of pension benefits for service

rendered before the pension plan began rendered before the pension plan began or from plan amendments granting or from plan amendments granting

increased pension benefits for service increased pension benefits for service rendered before the amendment.rendered before the amendment.

PSC is the present value of the retroactive PSC is the present value of the retroactive benefits and increases PBO.benefits and increases PBO.


Slide17-34


Benefits attributable to prior service are Benefits attributable to prior service are assumed to benefit future periods by:assumed to benefit future periods by:

Improving employee productivity.Improving employee productivity.

Improving employee morale.Improving employee morale.

Reducing turnover.Reducing turnover.

Reducing demands for pay raises.Reducing demands for pay raises.


Slide17-35


PSC is PSC is amortizedamortized over the remaining service over the remaining service period of those employees active at the date period of those employees active at the date

of the amendment who are expected to of the amendment who are expected to receive benefits under the plan.receive benefits under the plan.

If most of a plan’s participants are inactive, If most of a plan’s participants are inactive, then amortize PSC over the participants’ then amortize PSC over the participants’

remaining life expectancy.remaining life expectancy.


Slide17-36


Two approaches to amortizing PSC:Two approaches to amortizing PSC:Straight-line methodStraight-line method

Amortize PSC over the average Amortize PSC over the average remaining service period. remaining service period.

Service methodService methodAmortize PSC by allocating equal Amortize PSC by allocating equal

amounts to each employee service year amounts to each employee service year remaining.remaining.


Slide17-37


Effective 1/1/03, Cotton, Inc. amends the Effective 1/1/03, Cotton, Inc. amends the retirement plan to provide increased benefits retirement plan to provide increased benefits

attributable to service performed before attributable to service performed before 1/1/03, for all active employees. 1/1/03, for all active employees.

The present value of the increased benefits The present value of the increased benefits (PSC) at 1/1/03, is $60,000.(PSC) at 1/1/03, is $60,000.

The average remaining service life of the The average remaining service life of the active employee group is 12 years.active employee group is 12 years.

Effective 1/1/03, Cotton, Inc. amends the Effective 1/1/03, Cotton, Inc. amends the retirement plan to provide increased benefits retirement plan to provide increased benefits

attributable to service performed before attributable to service performed before 1/1/03, for all active employees. 1/1/03, for all active employees.

The present value of the increased benefits The present value of the increased benefits (PSC) at 1/1/03, is $60,000.(PSC) at 1/1/03, is $60,000.

The average remaining service life of the The average remaining service life of the active employee group is 12 years.active employee group is 12 years.


Slide17-38


Since the amendment was not effective Since the amendment was not effective until the beginning of 2003, pension until the beginning of 2003, pension

expense for 2002 is not affected.expense for 2002 is not affected.

2003: $60,000 PSC 2003: $60,000 PSC ÷÷ 12 = $5,000 12 = $5,000


Slide17-39



Slide17-40

Gains and Losses

Projected Benefits

ObligationReturn on

Plan AssetsHigher than Expected Loss Gain

Lower than Expected Gain Loss


Slide17-41

Corridor Amount

Amortization is not required if the net Amortization is not required if the net unrecognized gain or loss at the unrecognized gain or loss at the

beginning of the period is within a beginning of the period is within a minimum amount minimum amount (corridor amount)(corridor amount)..


Slide17-42

Corridor Amount

The corridor The corridor amount is 10% of amount is 10% of the greater of . . .the greater of . . .

PBO at the PBO at the beginning of the beginning of the period.period.

Fair value of plan Fair value of plan assets at the assets at the beginning of the beginning of the period.period.

OrOr


Slide17-43

Gains and Losses

If the beginning net unrecognized gain If the beginning net unrecognized gain or loss exceeds the corridor amount, or loss exceeds the corridor amount,

amortization is recognized as . . . amortization is recognized as . . .

If the beginning net unrecognized gain If the beginning net unrecognized gain or loss exceeds the corridor amount, or loss exceeds the corridor amount,

amortization is recognized as . . . amortization is recognized as . . .

Net unrecognized gain or lossNet unrecognized gain or loss at beginning of yearat beginning of year

Average remaining service period of active employees Average remaining service period of active employees expected to receive benefits under the planexpected to receive benefits under the plan

Corridor Corridor amountamount

— —


Slide17-44

Gains and Losses

Let’s determine the amortization of the Let’s determine the amortization of the net gain in 2003.net gain in 2003.

Amounts at January 1, 2003

PBO 640,000$

Fair value of plan assets 600,000

Net gain for 2003 73,000

Average service life 9

There was no gain or loss amortized in 2002.There was no gain or loss amortized in 2002.


Slide17-45

Gains and Losses

Corridor amount ($640,000 x 10%) 64,000$

Net gain for 2003 73,000

Gain in excess of corridor 9,000$

$9,000 $9,000 ÷ 9 years = $1,000 per year.÷ 9 years = $1,000 per year.


Slide17-46

Pension Expense


Slide17-47

Pension Expense

Cotton contributed $200,000 to the plan Cotton contributed $200,000 to the plan trustee at the end of 2003. The journal entry trustee at the end of 2003. The journal entry

to record the pension expense is:to record the pension expense is:


Slide17-48

Reconciliation of Pension Amounts

Four “off-balance sheet” accounts:Four “off-balance sheet” accounts:PBOPBOPlan AssetsPlan AssetsUnamortized PSCUnamortized PSCUnamortized Gain or LossUnamortized Gain or Loss

Four “off-balance sheet” accounts:Four “off-balance sheet” accounts:PBOPBOPlan AssetsPlan AssetsUnamortized PSCUnamortized PSCUnamortized Gain or LossUnamortized Gain or Loss


Slide17-49

Reconciliation of Pension Amounts

These four amounts combine to These four amounts combine to account for the account for the oneone pension account pension account that is reported on the balance sheet:that is reported on the balance sheet:

prepaid pension asset prepaid pension asset oror pension pension liability. liability.

These four amounts combine to These four amounts combine to account for the account for the oneone pension account pension account that is reported on the balance sheet:that is reported on the balance sheet:

prepaid pension asset prepaid pension asset oror pension pension liability. liability.


Slide17-50

Minimum Liability

To discourage underreporting of pension To discourage underreporting of pension liability, liability, SFAS No. 87SFAS No. 87 requires requires

recognition of an additional minimum recognition of an additional minimum pension liability under certain pension liability under certain

circumstances.circumstances.


Slide17-51

Measurement Issue

Accumulated Benefit Obligation (ABO)

- Plan Assets at Fair Value

Minimum Pension Liability

Accumulated Benefit Obligation (ABO)

- Plan Assets at Fair Value

Minimum Pension Liability

This amount is also called the This amount is also called the underfundedunderfunded ABO. ABO.


Slide17-52

Offsetting

SFAS No. 87 requires offsetting of the SFAS No. 87 requires offsetting of the pension liability and the plan assets pension liability and the plan assets

when determining the minimum liability.when determining the minimum liability.

SFAS No. 87 requires offsetting of the SFAS No. 87 requires offsetting of the pension liability and the plan assets pension liability and the plan assets

when determining the minimum liability.when determining the minimum liability.


Slide17-53

Additional Liability

An additional pension liability is recognized if total minimum liability An additional pension liability is recognized if total minimum liability exceedsexceeds accrued pension cost. accrued pension cost.

Total minimum liability

Accrued pension cost balance (liability)

Additional pension liability balance

Total minimum liability

Prepaid pension cost balance (asset)

Additional pension liability balance

–

+


Slide17-54

Pension Disclosures

Description of the pension planDescription of the pension plan

Pension expense, service cost, interest cost, Pension expense, service cost, interest cost, return on plan assets (actual and expected), return on plan assets (actual and expected), and net total of other componentsand net total of other components

Description of the pension planDescription of the pension plan

Pension expense, service cost, interest cost, Pension expense, service cost, interest cost, return on plan assets (actual and expected), return on plan assets (actual and expected), and net total of other componentsand net total of other components


Slide17-55

Pension Disclosures

Reconciliation of the funded status of the plan with Reconciliation of the funded status of the plan with

(a) plan assets at fair value, (a) plan assets at fair value,

(b) PBO, (b) PBO,

(c) unrecognized PSC, (c) unrecognized PSC,

(d) unrecognized gain or loss, (d) unrecognized gain or loss,

(e) unrecognized transition asset or liability, (e) unrecognized transition asset or liability,

(f) additional minimum pension liability, and (f) additional minimum pension liability, and

(g) net pension asset or liability(g) net pension asset or liability

Reconciliation of the funded status of the plan with Reconciliation of the funded status of the plan with

(a) plan assets at fair value, (a) plan assets at fair value,

(b) PBO, (b) PBO,

(c) unrecognized PSC, (c) unrecognized PSC,

(d) unrecognized gain or loss, (d) unrecognized gain or loss,

(e) unrecognized transition asset or liability, (e) unrecognized transition asset or liability,

(f) additional minimum pension liability, and (f) additional minimum pension liability, and

(g) net pension asset or liability(g) net pension asset or liability


Slide17-56

Pension Disclosures

Discount rate, rate of compensation increase Discount rate, rate of compensation increase used to measure PBO, and the expected used to measure PBO, and the expected long-term rate of return on plan assetslong-term rate of return on plan assets

Amount and types of employer securities Amount and types of employer securities included in plan assetsincluded in plan assets


Slide17-57

Settlements and Curtailments

Pension plan Pension plan settlementssettlements Reduce PBO and are viewed as the Reduce PBO and are viewed as the

realization of a portion of the net realization of a portion of the net unrecognized gain or loss and a portion of unrecognized gain or loss and a portion of the unrecognized transition asset.the unrecognized transition asset.

Pension plan Pension plan curtailmentscurtailments Often reduce PBO, resulting in a gain, Often reduce PBO, resulting in a gain,

which reduces accrued pension cost.which reduces accrued pension cost.


Slide17-58

End of Chapter 17

Documents

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter 17 Pensions