Pensions and Other Postretirement Benefits

Pensions and Other Postretirement Benefits

Chapter 15

Robinson, Munter and Grant

Robinson, Munter & Grant

Chapter 15 2

Learning Objectives

• Retirement plans– Defined benefit– Defined contribution

• Pension liability• Pension expense• Actuarial assumptions• Health care and other benefits


Chapter 15 3

Types of Retirement Benefits

1. Defined Contribution Plans• Company promises to contribute a certain

amount to a plan each period

2. Defined Benefit Plans• Employer promises that the employees will receive a certain pension amount at retirement


Chapter 15 4

Defined Contribution Plans

• Firm’s periodic contribution is defined and can take many forms– Percentage of employee’s salary– Percentage of firm profits

• Plan assets may be controlled by employee– Stock mutual funds– Employee bears the risk associated with returns


Chapter 15 5

Defined Benefit Plans

• Employee will receive a certain amount at retirement– Non-Pay-Related– Pay-Related

• Employer bears risk of plan performance• Complex accounting


Chapter 15 6

Accounting for Defined Benefit Plans

• Company must report the funding status of the plan

• Liability if the present value of future benefits exceeds the value of the plan’s assets

• Asset if the present value of the future benefits is less than the value of the plan’s assets


Chapter 15 7

Accounting for Defined Benefit PlansSome terms

• Service cost: Change in pension obligation due to current period service

• Projected benefit obligation: liability based on projected salary increases

• Accumulated benefit obligation: liability excluding salary increases

• Vested benefit obligation: portion of liability that employee is entitled to


Chapter 15 8

Example

• Current salary: $100,000• Total employment = 20 years• Annual compensation increase: 3%

– Final salary: $175,351 (100,000*1.0319)• Discount rate: 7%• Pension: 2% per year of service

– 40% of final salary


Chapter 15 9

ExampleAfter One Year

• Projected annual pension: 2% * $175,351 = $3,507• 10-year pension is worth $25,356 at retirement• 10-year pension is worth $7,288 currently

Earn $100,000 with 3% annual increases

0 20 years 30 years

Receive $3,507 annual pension

1 yearPV $7,288 $26,356


Chapter 15 10

ExampleAfter One Year

• In this case, at the end of the first year, service cost = pension liability = pension expense = $7,288, the PBO

• ABO excludes all salary increases, $4,156– Use $100,000 instead of $175,351 in

calculations• VBO is 20% of ABO, $831

– Pension vests over 5 years, 20% per year


Chapter 15 11

ExampleAfter Two Years

• Projected annual pension: 2*2% * $175,351 = $7,014

• 10-year pension is worth $52,712 at retirement• 10-year pension is worth $15,596 currently

Earn $100,000 with 3% annual increases

0 20 years 30 years

Receive $7,014 annual pension

2 yearsPV $15,596 $52,712


Chapter 15 12

ExampleAfter Two Years

• PBO = $15,596– Pension expense = $15,596-$7,288 = $8,308– Interest on previous year’s obligation = $510

• $7,288*7%

– Service cost = $8,308-$510 = $7,798• ABO = $9,161

• Use $100,000 instead of $175,351 in calculations

• VBO = $3,664• Pension vests over 5 years, 20% per year


Chapter 15 13

AssumptionsHigher/Lower Discount rate

Higher/Lower Compensation rate increase

Higher/LowerExpected return on plan assets

PBO Lower/Higher Higher/Lower No impact

ABO Lower/Higher No impact/Higher No impact

VBO Lower/Higher No impact No impact

Pension expense Lower/Higher Higher/Lower Lower/Higher


Chapter 15 14

Components of Pension Expense

• Service Cost• Interest Cost• Return on Plan Assets• Amortization of unrecognized prior service

cost• Amortization and deferral of gain or loss• Amortization of the transition liability or

asset


Chapter 15 15

Service Cost

• The change in PBO during the period – Attributed to work performed during the period

• Recognized in pension expense in its entirety– Consistent with the matching principle


Chapter 15 16

Interest Cost

• Interest accrued on the PBO for the period– PBO is computed at each balance sheet date

• Discount rate * PBO = Interest cost

• Small changes in the interest rate may result in substantial changes in pension expense


Chapter 15 17

Return on Plan Assets

• Expected return = Beginning market-related value * Expected long-term rate of return

• Majority of companies use expected return on plan assets in calculating pension expense

– Actual return may not = expected return• Differences in actual vs. expected long-term rate of

return• Market-related value may not = actual value


Chapter 15 18

Return on Plan AssetsMarket-related Value

Beginning market-related value

+ Expected return on plan assets

+ Employer contributions

- Benefits paid to retirees

+/- % of deferred asset gains/losses (over 3 or 5 years)

= Ending market-related value


Chapter 15 19

Amortization of Prior Service Cost

PBO after plan amendment – PBO before plan amendment = Prior service cost from plan amendment

• Amortized over average remaining service life of all active employees


Chapter 15 20

Amortization and Deferral of Gain or Loss

• Gains/losses associated with differences between actual and expected PBO that arise as a result of changes in actuarial assumptions

• These gains/losses are deferred and amortized• Net the liability and asset gain/loss to a single

number– Liability item: change in life expectancy– Asset item: change in return on assets


Chapter 15 21

Amortization and Deferral of Gain or Loss, Continued

• Amortize amount above corridor threshold– 10% of the greater of the PBO or the market-

related value at the beginning of the year• Amortize over the average remaining service

life of current employees

• Remember, if assumptions are reasonable, gain and losses should net out over time.


Chapter 15 22

Amortization of the Transition Liability or Asset

• Asset or liability in place when current US standard was adopted

– 1987• Amortized over average remaining service

life• Most of this amount has already been

amortized


Chapter 15 23

Pension Liability

• PBO at the end of the period• Value of ending plan assets• Difference equals funded status• Also include unrecognized net gains, prior

service costs and transition asset• Liability = Funded status ± 3 adjustments


Chapter 15 24

Disclosure Requirements:US Standards

1. Reconciliation of the benefit obligation2. Reconciliation of the fair value of plan assets3. The funded status4. Pension expense recognized5. Key assumptions6. Explain significant changes in the benefit

obligation or plan assets


Chapter 15 25

International StandardsRetirement Plans

• Generally similar• Differences related to:

– Classification of defined benefit and defined contribution plans

– Amortization of gains and losses under the corridor approach

– Expensing of prior service costs– No recognition of minimum pension liability


Chapter 15 26

International StandardsReporting Requirements

• Accounting policy for actuarial gains/losses• Description of plan• Reconciliation of assets and liabilities• Components of fair value of plan assets• Reconciliation of changes to the net liability• Total expense• Actual return on plan assets• Principal actuarial assumptions


Chapter 15 27

Other Postretirement Benefits

• Non-pensions are typically not pay-related.– Report Accumulated postretirement benefit

obligation only• No minimum liability to report


Chapter 15 28

Other Postretirement BenefitsCurrent Period Expense

• Service cost• Interest cost• Less: actual return on plan assets• Plus (minus) loss (gain) recognized in excess of the

corridor• Plus (minus) gain (loss) deferred based on expected

return on plan assets• Amortization of prior service cost• Amortization of transition liability


Chapter 15 29

Retirement Benefit Disclosures

• Consider whether pension assets are invested in the company’s own stock

• Look for various types of plans– Regular, executive, supplemental

• Consider changes to actuarial assumptions• Compare to similar firms• Funded status


Chapter 15 30

Summary

• Pension plans• Pension expense and liability• Disclosures required• International standards• Other postretirement benefits

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Pensions and Other Postretirement Benefits