Pensions and Other Postretirement Benefits

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIACynthia J. Rooney, Ph.D., CPA

Pensions and Other Postretirement Benefits

Chapter 17

17-2

Nature of Pension Plans

1. Pension plans provide income to individuals during their retirement years.

2. This is accomplished by setting aside funds during an employee’s working years so that at retirement, the accumulated funds plus earnings from investing those funds are available to replace wages.

17-3

Nature of Pension Plans

FFor a pension plan to qualify for special tax treatment it must meet the following requirements:1.Cover at least 70% of employees.2.Cannot discriminate in favor of highly compensated employees.3.Must be funded in advance of retirement through an irrevocable trust fund.4.Benefits must vest after a specified period of service.5.Complies with timing and amount of contributions.

17-4

Nature of Pension Plans

17-5

Contributions are defined

by agreement.

Contributions are defined

by agreement.

Employer deposits an agreed-upon amount into

an employee-directed

investment fund.

Employer deposits an agreed-upon amount into

an employee-directed

investment fund.

Employee bears all risk of pension

fund performance.

Employee bears all risk of pension

fund performance.

Plan CharacteristicsPlan Characteristics

Defined Contribution Pension Plans

17-6

Defined Contribution Pension Plans

Let’s assume that the annual contribution is to be 3% of an employee’s salary. If an employee earned $110,000 during the year, the company

would make the following entry:

Pension expense 3,300Cash 3,300

The employee’s retirement benefits are totally dependent upon how well investments perform.

17-7

Employer is committed to

specified retirement benefits.

Employer is committed to

specified retirement benefits.

Retirement benefits are based on a

formula that considers years of service,

compensation level, and age.

Retirement benefits are based on a

formula that considers years of service,

compensation level, and age.

Employer bears all risk of pension

fund performance.

Employer bears all risk of pension

fund performance.

Plan CharacteristicsPlan Characteristics

Defined Benefit Pension Plans

17-8

Defined Benefit Pension Plan

A pension formula might define annual retirement benefits as:

1 1/2 % x Years of service x Final year’s salary

By this formula, the annual benefits to an employee who retires after 30 years of service, with a final salary

of $100,000, would be:

1 1/2 % x 30 years x $100,000 = $45,000

17-9

Defined Benefit Pension Plan

The key elements of a defined benefit pension plan are:1.The employer’s obligation to payretirement benefits in the future.2.The plan assets set aside by theemployer from which to pay theretirement benefits in the future.3.The periodic expense of having apension plan.

An actuary assesses the various uncertainties (employee turnover, salary levels, mortality, etc.)

and estimates the company’s obligation to employees in connection with its pension plan.

17-10

Pension Expense—An Overview

The annual pension expense reflects changes in both the pension obligation and

the plan assets.

17-11

The Pension Obligation1. Accumulated benefit obligation (ABO) The actuary’s

estimate of the total retirement benefits (at their discounted present value) earned so far by employees, applying the pension formula using existing compensation levels.

2. Vested benefit obligation (VBO) The portion of the accumulated benefit obligation that plan participants are entitled to receive regardless of their continued employment.

3. Projected benefit obligation (PBO) The actuary’s estimate of the total retirement benefit (at their discounted present value) earned so far by employees, applying the pension formula using estimated future compensation levels. (If the pension formula does not include future compensation levels, the PBO and the ABO are the same.)

17-12

The Pension Obligation

17-13

Projected Benefit Obligation

Jessica Farrow was hired by Global Communications in 2002. She is eligible to participate in the company's defined benefit pension plan. The benefit formula is:

Annual salary in year of retirement

× Number of years of service

× 1.5%

Annual retirement benefits

 Farrow is expected to retire in 2041 after 40 years of service. Her retirement period is expected to be 20 years. At the end of 2011, 10 years after being hired, her salary is $100,000. The interest rate is 6%. The company’s actuary projects Farrow’s salary to be $400,000 at retirement.

The PBO is a more meaningful measurement because it includes a projection of what the salary

might be at retirement.

17-14

Projected Benefit ObligationStep 1. Step 1. Use the pension formula to determine the retirement benefits earned to date.

$400,000

× 10

× 1.5%

$ 60,000 per year 

Step 2. Step 2. Find the present value of the retirement benefits as of the retirement date.

The present value (The present value (nn=20, =20, ii=6%) of the retirement annuity at =6%) of the retirement annuity at the retirement date is $688,195 ($60,000 the retirement date is $688,195 ($60,000 × 11.46992).

Step 3. Step 3. Find the present value of the retirement benefits as of the current date.

The present value (The present value (nn=30, =30, ii=6%) of the retirement benefits at =6%) of the retirement benefits at 2011 is $119,822 ($688,195 2011 is $119,822 ($688,195 × .17411). This is the PBO.

17-15

Projected Benefit Obligation

Step 1. Step 1. Use the pension formula to determine the retirement benefits earned to date.

$400,000

× 11

× 1.5%

$ 66,000 per year 

Step 2. Step 2. Find the present value of the retirement benefits as of the retirement date.

The present value (The present value (nn=20, =20, ii=6%) of the retirement annuity at =6%) of the retirement annuity at the retirement date is $757,015 ($66,000 the retirement date is $757,015 ($66,000 × 11.46992).

Step 3. Step 3. Find the present value of the retirement benefits as of the current date.

The present value (The present value (nn==2929, , ii=6%) of the retirement benefits at =6%) of the retirement benefits at 2012 is $139,715 ($757,015 2012 is $139,715 ($757,015 × .18456). This is the PBO.

If the actuaryIf the actuary’’s estimate of the final salary hasns estimate of the final salary hasn’’t changed, t changed, the PBO a year later at the end of 2012 would be $139,715.the PBO a year later at the end of 2012 would be $139,715.

17-16

Projected Benefit Obligation

17-17

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

during the period.

Projected Benefit Obligation

17-18

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

Projected Benefit Obligation

17-19

Prior service cost is the increase in the PBO due to a plan change that provides credit for

employee service rendered in prior years.

Projected Benefit Obligation

17-20

Loss or gain on PBO results from revising estimates used to determine the PBO.

Projected Benefit Obligation

17-21

Retiree benefits paid reduce the PBO.

Projected Benefit Obligation

17-22

Projected Benefit Obligation

*Of course, these expanded amounts are not simply the amounts for Jessica Farrow multiplied by 2,000 employees because her years of service, expected retirement date, and salary are not necessarily representative of other employees. Also, the expanded amounts take into account expected employee turnover and current retirees.†Includes the prior service cost that increased the PBO when the plan was amended in 2012.

17-23

Pension Plan Assets

The pension plan assets are not reported separately in the balance sheet but are netted together with the PBO to report either a net pension asset (debit balance) or a

net pension liability (credit balance).

The higher the expected return on plan assets, the less

the employer must actually contribute. On the other hand,

a relatively low expected return means the difference must be made up by higher

contributions.

17-24

Pension Plan AssetsGlobal Communications funds its defined benefit pension plan by contributing the year’s service cost plus a portion of the prior service cost each year. Cash of $48 million was contributed to the pension fund in 2013.

Plan assets at the beginning of 2013 were valued at $300 million. The expected rate of return on the investment of those assets was 9%, but the actual return in 2011 was 10%. Retirement benefits of $38 million were paid at the end of 2013 to retired employees. The plan assets at the end of 2013 will be:

17-25

Funded Status of the Pension Plan

OVERFUNDED

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

actuarial present value actuarial present value of all benefits earned by of all benefits earned by

participants.participants.

UNDERFUNDED

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

actuarial present value actuarial present value of all benefits earned by of all benefits earned by

participants.participants.

17-26Reporting the Funded Status of

Pension Plan

Projected Benefit Obligation (PBO)

- Plan Assets at Fair Value

Underfunded / Overfunded Status

Projected Benefit Obligation (PBO)

- Plan Assets at Fair Value

Underfunded / Overfunded Status

17-27The Relationship Between Pension Expense

and Changes in the PBO and Plan Assets

17-28

Service Cost

Actuaries have determined that Global Communications has service cost of

$41 million in 2013.

Service cost 41$ Interest costExpected return on the plan assetsAmortization of prior service cost Amortization of net loss Pension expense

Global's 2013 Pension Expense ($ in millions)

17-29

Interest Cost

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

PBOPBOBegBeg × Discount rate × Discount rate

Global had PBO of $400 million on 1/1/13. The actuary Global had PBO of $400 million on 1/1/13. The actuary uses a discount rate of 6%.uses a discount rate of 6%.

2013 Interest Cost

PBO 1/1/13 $400,000,000 × 6% = $24,000,000

Service cost 41$ Interest cost 24 Expected return on the plan assetsAmortization of prior service cost Amortization of net loss Pension expense

Global's 2013 Pension Expense ($ in millions)

17-30

Return on Plan Assets

The plan trustee reports that plan assets were $300 million on The plan trustee reports that plan assets were $300 million on 1/1/13. The trustee uses an expected return of 9% and the 1/1/13. The trustee uses an expected return of 9% and the

actual return is 10%.actual return is 10%.

Service cost 41$ Interest cost 24 Expected return on the plan assets (27) Amortization of prior service cost Amortization of net loss Pension expense

Global's 2013 Pension Expense ($ in millions)

17-31

Amortization of Prior Service Cost

In 2012, Global Communications amended the pension plan, increasing the PBO at that time. For all plan participants, the prior service cost

was $60 million at 1/1/12. The average remaining service life of the active employee

group is 15 years.

$60 million PSC ÷ 15 = $4 million per year

Service cost 41$ Interest cost 24 Expected return on the plan assets (27) Amortization of prior service cost 4Amortization of net loss Pension expense

Global's 2013 Pension Expense ($ in millions)

17-32

Gains and Losses

Projected Benefits Obligation

Return on Plan Assets

Higher than Expected Loss Gain

Low er than Expected Gain Loss

Only if a net gain or net loss exceeds the “corridor” is a charge to pension

expense allowed.

17-33

Corridor Amount

The corridor The corridor amount is 10% of amount is 10% of

the the greatergreater of 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

17-34

Gains and Losses

If the beginning net unrecognized gain or loss

exceeds the corridor amount, amortization is

recognized using the following formula . . .

Net unrecognized gain or loss at beginning of year

Average remaining service period of activeemployees expected to receive benefits under the plan

Corridor amount

־

17-35

Gains and Losses

Net loss 55$

Corridor amount ($400 x 10%) 40

Excess at the beginning of the year 15$

$15 million $15 million ÷ 15 years = $1 million÷ 15 years = $1 million

17-36

Determining Pension Expense

Service cost 41$ Interest cost 24 Expected return on the plan assets (27) Amortization of prior service cost 4Amortization of net loss 1Pension expense 43$

Global's 2013 Pension Expense ($ in millions)

17-37

Recording Gains and Losses

For 2013, the actual return on plan assets exceeded the expected return by $3 million. In addition, there was a $23

million loss from changes made by the actuary when it revised its estimate of future salary levels causing its PBO

estimate to increase. Global would make the following journal entry to record the gain and loss:

OCI = Other comprehensive income

($ in millions)Loss—OCI 23

PBO 23

Plan assets 3Gain—OCI 3

17-38

Record Pension Expense ($ in millions)

Pension expense (calculated below) 43Plan assets ($27 expected return on assets) 27

PBO ($41 service cost + $24 interest cost) 65Prior service cost–AOCI 4Net loss–AOCI 1

OCI = Other comprehensive income

Service cost and interest cost add to Global’s PBO. The return on plan assets adds to the plan assets. Amortization of prior service and net loss reduce each account.

Service cost 41$ Interest cost 24 Expected return on the plan assets (27) Amortization of prior service cost 4Amortization of net loss 1Pension expense 43$

Global's Pension Expense ($ in millions)

17-39

Recording the Funding of Plan Assets

($ in millions) Plan assets 48

Cash (contribution to plan assets) 48

It’s not unusual for the cash contribution to differ from that year’s pension expense. After all,

determining the periodic pension expense and the funding of the pension plan are two separate

processes.

When Global adds its annual cash investment of $48 million to its plan assets, the value of those plan

assets increases by $48 million.

17-40

Recording the Funding of Plan Assets

($ in millions) PBO 38

Plan assets (payments to retired employees) 38

Global pays $38 million in retirement pension benefits.

17-41

U. S. GAAP vs. IFRS

Requires that we use the same rate (the rate for “high -grade corporate bonds”) for both the interest cost on the defined benefit obligation (called projected benefit obligation or PBO under GAAP) and the interest revenue on the plan assets.

Gains and losses are the difference between the actual and expected returns, where the expected return is different from company to company and usually different from the interest rate used to determine the interest cost.

Important differences in accounting for actuarial gains and losses using U.S. GAAP and IFRS.

17-42

U. S. GAAP vs. IFRS

Gains and losses are included in OCI when they first arise, but unlike U.S. GAAP those amounts are not subsequently amortized out of OCI and into expense. Instead, under IFRS those amounts remain in the balance sheet as accumulated other comprehensive income.

Requires that gains and losses are to be (a) included among OCI items in the statement of comprehensive income when they first arise and then (b) gradually amortized or recycled out of OCI and into expense (when the accumulated net gain or net loss exceeds the 10% threshold).

Important differences in accounting for actuarial gains and losses using U.S. GAAP and IFRS.

17-43

Comprehensive Income

Comprehensive income is a more expansive view of income than traditional net income.

17-44

Comprehensive Income

17-45

Pension Spreadsheet

17-46

U. S. GAAP vs. IFRS

Under IFRS we separately report (a) the service cost component (including past service cost) and (b)

the net interest cost/income component in the income statement and (c) remeasurement gains and

losses as other comprehensive income.

17-47Postretirement Benefits Other Than

Pensions

Estimated medicalEstimated medicalcosts in eachcosts in each

year of retirementyear of retirement

Estimated medicalEstimated medicalcosts in eachcosts in each

year of retirementyear of retirement

Estimated Estimated netnetcost of benefitscost of benefitsEstimated Estimated netnet

cost of benefitscost of benefits

RetireeRetireeshare ofshare of

costcost

RetireeRetireeshare ofshare of

costcost

MedicareMedicarepaymentspaymentsMedicareMedicarepaymentspayments

Less:Less:

Equals:Equals:

Net Cost of BenefitsMany companies also furnish other

postretirement benefits to their

retired employees.

17-48

Postretirement Benefit Obligation

1. Expected Postretirement Benefit Obligation (EPBO) – The actuary's estimate of the total postretirement benefits (at their discounted present value) expected to be received by plan participants.

2. Accumulated Postretirement Benefit Obligation (APBO) – The portion of the EPBO attributed to employee service to date.

17-49

Postretirement Benefit Obligation

She now has worked 11 of her estimated 35 years

Assume the actuary estimates the net cost of providing health care benefits to Jessica Farrow during her retirement years to have a present value of $10,842 as of the end of 2011. This is the EPBO. If the benefits (and therefore the costs) relate to an estimated 35 years of service and 10 of those years have been completed, the APBO would be:

2011 $10,842 x 10/35 = $3,098 EPBO fraction APBO

attributed

x 1.06

2012 $11,493 x 11/35 = $3,612 EPBO fraction APBO

attributed

Assume the obligation increases by the 6%.

17-50

How the APBO Changed

The two elements of the increase in 2012 can be separated as follows:

17-51

Attribution

The process of The process of assigningassigning the cost of the cost of benefits to the years during which benefits to the years during which those benefits are those benefits are assumed to be assumed to be

earned earned by employees.by employees.

17-52Accounting for Postretirement Benefit

Plans Other Than Pensions

Measuring Service Cost

Attribute a portion of the accumulated postretirement benefit obligation to each year

as the service cost for that year.

17-53Appendix 17: Service Method of

Allocating Prior Service Cost

The allocation approach that reflects the declining service pattern of employees is called the service

method. The method requires that the total number of service years for all employees be calculated. This calculation is usually done by the actuary.

Assume Global Communications has 2,000 employees and the company’s actuary determined that the total

number of service years of these employees is 30,000. We would calculate the following amortization

fraction:

Assume Global Communications has 2,000 employees and the company’s actuary determined that the total

number of service years of these employees is 30,000. We would calculate the following amortization

fraction:30,00030,0002,0002,000 == 15 average service years15 average service years

17-54

End of Chapter 17