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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
Robinson, Munter & Grant
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
Robinson, Munter & Grant
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
Robinson, Munter & Grant
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
Robinson, Munter & Grant
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
Robinson, Munter & Grant
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
Robinson, Munter & Grant
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
Robinson, Munter & Grant
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 year
PV $7,288 $26,356
Robinson, Munter & Grant
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
Robinson, Munter & Grant
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 years
PV $15,596$52,712
Robinson, Munter & Grant
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
Robinson, Munter & Grant
Chapter 15 13
Assumptions
Higher/Lower Discount rate
Higher/Lower Compensation rate increase
Higher/Lower
Expected 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
Robinson, Munter & Grant
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
Robinson, Munter & Grant
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
Robinson, Munter & Grant
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
Robinson, Munter & Grant
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
Robinson, Munter & Grant
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
Robinson, Munter & Grant
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
Robinson, Munter & Grant
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
Robinson, Munter & Grant
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.
Robinson, Munter & Grant
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
Robinson, Munter & Grant
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
Robinson, Munter & Grant
Chapter 15 24
Disclosure Requirements:US Standards
1. Reconciliation of the benefit obligation
2. Reconciliation of the fair value of plan assets
3. The funded status
4. Pension expense recognized
5. Key assumptions
6. Explain significant changes in the benefit obligation or plan assets
Robinson, Munter & Grant
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
Robinson, Munter & Grant
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
Robinson, Munter & Grant
Chapter 15 27
Other Postretirement Benefits
• Non-pensions are typically not pay-related.– Report Accumulated postretirement benefit
obligation only
• No minimum liability to report
Robinson, Munter & Grant
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
Robinson, Munter & Grant
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