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Pensions and Other Postretirement Benefits. 17. I agree to make payments into a fund for future retirement benefits for employee services. I am the employee for whom the pension plan provides benefits. Nature of Pension Plans. Sponsor. Participant. Nature of Pension Plans.

I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.
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nature of pension plans

I agree to make payments into a fund for future retirement benefits for employee services.

I am the employee for whom the pension plan provides benefits.

Nature of Pension Plans



nature of pension plans1
Nature of Pension Plans
  • For a pension plan to qualify for special tax treatment it must meet the following requirements:
  • Cover at least 70% of employees.
  • Cannot discriminate in favor of highly compensated employees.
  • Must be funded in advance of retirement through a trust.
  • Benefits must vest after a specified period of service.
  • Complies with timing and amount of contributions.
nature of pension plans2
The right to receive earned pension benefits vest (vested benefits) when it is no longer contingent on continued employment. Nature of Pension Plans
learning objectives
Learning Objectives

Explain the fundamental differences between a defined contribution pension plan and a defined benefit pension plan.



Defined Contribution Plans

Contributions are established by formula or contract.

Employer deposits an agreed-upon amount into an employee-directed investment fund.

Employee bears all risk of pension fund performance.

defined contribution pension plans
Defined Contribution Pension Plans

Defined contribution pension plans are becoming increasingly popular vehicles for employers to provide retirement income without the paperwork, cost, and risk generated by the more traditional defined benefit plans.

These plans promise defined periodic contributions to a pension fund, without further commitment regarding benefits at retirement.

defined contribution pension plans1
Defined Contribution Pension Plans

Accounting for these plans is quite simple. Let’s assume that an annual contribution of employee salaries is to be 4% of gross earnings. If employees earned $10,000,000 in salaries during the period, the company would make the following entry:


Defined Benefit Pension Plans

Employer is committed to specified retirement benefits.

Retirement benefits are based on a formula that considers years of service, compensation level, and age.

Employer bears all risk of pension fund performance.

defined benefit plan
Pension expense is measured by assigning pension benefits to periods of employee service as defined by the pension benefit formula.Defined Benefit Plan

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

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

learning objectives1
Learning Objectives

Distinguish among the vested benefit obligation, the accumulated benefit obligation, and the projected benefit obligation.


defined benefit plan1
Defined Benefit Plan

You go to work for Matrix, Inc. on 1/1/07. You are 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

You are 25 years old when you start work and will accumulate 40 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 benefits:


× 40

× 1.5%


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 age 65, you will receive payments for 15 years. The actuary uses an 8% discount rate in all present value computations.

defined benefit plan2
Defined Benefit Plan

At December 31, 2007, the end of your first year of service, the actuary must calculate the present value of the pension benefits earned by you during 2007. 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. After one year of service you will have earned $3,000 in pension benefits:

Pension benefits = .015 × 1 yr of service × $200,000

Pension benefits = $3,000

Service cost is the present value of these benefits and is calculated as follows:

Service cost = $3,000 × 8.559481× .0497132

Service cost = $1,277

1Present value of an ordinary annuity at 8% for 15 years.

2Present value of $1 at 8% for 39 years.

pension obligation
Pension Obligation

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

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

Retirement benefits = $375

ABO = $375 × 8.55948 × .049713

ABO = $160

Your Vested benefit obligation (VBO) is calculated as follows:

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

Vested benefits = $75

VBO = $75 × 8.55948 × .049713

VBO = $32

pension obligation1
Pension Obligation

The Projected benefit obligation (PBO) differs from the ABO by using your salaryprojected at retirement rather than your current salary. The actuary calculates your Projected benefit obligation (PBO) as follows:

Retirement benefits = .015 × 1 yr × $200,000

Retirement benefits = $3,000

PBO = $3,000 × 8.55948 × .049713

PBO = $1,277

pension obligation2
Pension Obligation

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

VBO $ 32

Non-vested benefits 128

ABO $ 160

Adjustment for future salary 1,117

PBO $ 1,277

pension obligation3
Pension Obligation

Projected Benefit Obligation

Present value of additional benefits related to projected pay increases.

Present value of nonvested benefits at present pay levels.

Accumulated Benefit Obligation

Present value of benefits at present pay levels.

Vested Benefit Obligation

learning objectives2
Learning Objectives

Describe the five events that might change the balance of the PBO.


pension obligation4
Pension Obligation

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

pension obligation5
Pension Obligation

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

pension obligation6
Pension Obligation

Prior service costeffects result from changes in the pension benefit formula or plan terms.

pension obligation7
Pension Obligation

Loss or gain on PBOresults from required revisions of estimates used to determine PBO.

pension obligation8
Pension Obligation

Retiree benefits paidare the result of paying benefits to retired employees.

learning objectives3
Learning Objectives

Explain how plan assets accumulate to provide retiree benefits and understand the role of the trustee in administering the fund.


pension plan assets
Pension plan assets (like the PBO) arenotspecifically reported in the balance sheet.

Atrusteemanages the pension plan assets.

Pension Plan Assets
pension plan assets1
Pension Plan Assets

Plan assets change as (a) the investments generate dividends, interest, capital gains, etc., (b) additional cash contributions are added by the employer, and (c) payments are made to retired employees. Assume the following balances and changes for Matrix: ($ in millions)

learning objectives4
Learning Objectives

Describe the funded status of pension plans and how that amount is reported.


funded status of the pension plan

Market value of plan assets exceeds the actuarial present value of all benefits earned by participants.

Funded Status of the Pension Plan


Market value of plan assets is below the actuarial present value of all benefits earned by participants.

funded status of the pension plan1
Funded Status of the Pension Plan

Projected Benefit Obligation (PBO)

- Plan Assets at Fair Value

Underfunded / Overfunded Status

This amount is reported in the balance sheet as a Pension Liability if underfunded or a Pension Asset if overfunded.

learning objectives5
Learning Objectives

Describe how pension expense is a composite of periodic changes that occur in both the pension obligation and the plan assets.


pension expense
Actuaries have determined that Matrix, Inc. has service cost of $150,000 in 2007 and $155,000 in 2008.

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

Pension Expense
interest cost
Interest costis the growth in PBO during a reporting period due to the passage of time.

Interest cost is calculated as:

PBOBeg × Discount rate

Interest Cost
interest cost1
Actuaries determined that Matrix, Inc. had PBO of $500,000 on 1/1/07, and $640,000 on 1/1/08.

The actuary uses a discount rate of 10%.

Interest Cost
interest cost2
Interest Cost

2007: PBO 1/1/07 $500,000 × 10% = $50,000

2008: PBO 1/1/08 $640,000 × 10% = $64,000

return on plan assets

Actual Return

Expected Return

The dividends, interest, and capital gains generated by the fund during the period.

Trustee’s estimate of long-term rate of return.

Return on Plan Assets
return on plan assets1
Return on Plan Assets

The plan trustee reports that plan assets were $450,000 on 1/1/07, and $600,000 on 1/1/08.

The trustee uses an expected return of 9% and the actual return is 10% in both years.

amortization of prior service cost
Prior service cost (PSC)results from plan amendments granting increased pension benefits for service rendered before the amendment.

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

Amortization of Prior Service Cost
amortization of prior service cost1
Benefits attributable to prior service are assumed to benefit future periods by:

Improving employee productivity.

Improving employee morale.

Reducing turnover.

Reducing demands for pay raises.

Amortization of Prior Service Cost
amortization of prior service cost2
PSC is amortized over the remaining service period of those employees active at the date of the amendment who are expected to receive benefits under the plan.Amortization of Prior Service Cost
amortization of prior service cost3
Two approaches to amortizing PSC:

Straight-line method

Amortize PSC over the average remaining service period.

Service method

Amortize PSC by allocating equal amounts to each employee’s service years remaining.

Amortization of Prior Service Cost
amortization of prior service cost4
Effective 1/1/08, Matrix, Inc. amends the retirement plan to provide increased benefits attributable to service performed before 1/1/03, for all active employees.

The present value of the increased benefits (PSC) at 1/1/08, is $60,000.

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

Amortization of Prior Service Cost
amortization of prior service cost5
Amortization of Prior Service Cost

Since the amendment was not effective until the beginning of 2008, pension expense for 2007 is not affected.

2008: $60,000 PSC ÷ 12 = $5,000

corridor amount
Amortization is not required if the net unrecognized gain or loss at the beginning of the period is a minimum amount (corridor amount).Corridor Amount
corridor amount1
Corridor Amount

PBO at the beginning of the period.

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


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

gains and losses1
If the beginning net unrecognized gain or loss exceeds the corridor amount, amortization is recognized as . . .

Net unrecognized gain or loss

at beginning of year

Corridor amount

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

Gains and Losses
gains and losses2
Gains and Losses

There was no gain or loss amortized in 2007.

Let’s determine the amortization of the net gain in 2008.

gains and losses3
Gains and Losses

$12,000 ÷ 12 years = $1,000 per year.

learning objectives6
Learning Objectives

Record for pension plans the periodic expense and funding as well as new gains and losses and new prior service cost as they occur.


pension expense and funding
Pension Expense and Funding

Matrix contributed $200,000 to the plan trustee at the end of 2007. The journal entries to record the pension activity are:

pension expense and funding1
Pension Expense and Funding

Matrix contributed $200,000 to the plan trustee at the end of 2008.

pension gains and losses
Pension Gains and Losses

For 2008, the actual return on plan assets exceeded the expected return by $4,500. In addition, there was a loss from the actuary change in certain underlying assumptions about the amount of the projected benefit obligation of $12,000. Matrix is required to make the following journal entry:

OCI = Other comprehensive income

comprehensive income
Comprehensive Income

Other comprehensive income (a) is reported periodically as it is created and (b) also is reported as a cumulative amount.

There are 3 options for reporting other comprehensive income created during the reporting period. The statement of comprehensive income can be presented as:

The accumulated amount of other comprehensive income is reported as a separate item of shareholders’ equity in the balance sheet.

As an expanded version of the income statement.

Within the statement of shareholders’ equity.

In a disclosure note.

learning objectives7
Learning Objectives

Understand the interrelationships among the elements that constitute a defined benefit pension plan.


learning objectives8
Learning Objectives

Describe the nature of postretirement benefit plans other than pensions and identify the similarities and differences in accounting for those plans and pensions.


postretirement benefit plan
Encompass all types of retiree health and welfare benefits including . . .

Medical coverage,

Dental coverage,

Life insurance,

Group legal services, and

Other benefits.

Postretirement Benefit Plan
postretirement health benefits and pension benefits compared
Pension Plan Benefits

Usually based on years of service.

Identical payments for same years of service.

Cost of plan usually paid by employer.

Vesting usually required.

Postretirement Health Benefits

Typically unrelated to service.

Payments vary depending on medical needs.

Company and retiree share the costs.

True vesting does not exist.

Postretirement Health Benefits andPension Benefits Compared
the net cost of benefits
The Net Cost of Benefits

Estimated medical

costs in each

year of retirement


share of





Estimated net

cost of benefits


the net cost of benefits1
Estimating postretirement health care benefits is like estimating pension benefits, but there are some additional assumptions required:

Current cost of providing health care benefits (per capita claims cost).

Demographic characteristics of participants.

Benefits provided by Medicare.

Expected health care cost trend rate.

The Net Cost of Benefits
learning objectives9
Learning Objectives

Explain how the obligation for postretirement benefits is measured and how the obligation changes.


postretirement benefit obligation
Postretirement Benefit Obligation
  • Expected (EPBO)
    • The actuary’s estimate of the total postretirement benefits (at their discounted present value) expected to be received by plan participants.
  • Accumulated (APBO)
    • The portion of the EPBO attributed to employee service to date.
measuring the obligation
Measuring the Obligation

On December 31, our actuary estimates that the present value of the expected benefit obligation for your postretirement health care costs is $10,250. You have worked for the company for 6 years and are expected to have 30 years of service at retirement. The actuary uses a 6% discount rate.

Let’s calculate the APBO.

measuring the obligation1


attributed to

service to










= $2,050

APBO at the beginning of the year.

Measuring the Obligation
measuring the obligation2



of Year



of Year



(1 + Discount Rate)

$10,250 × 1.06 = $10,865




of Year



= $2,535

Measuring the Obligation

To calculate the APBO at the end of the year, we start by determining the ending EPBO.

measuring the obligation3
APBO may also be calculated like this:Measuring the Obligation

The APBO increases because of interest

and the service fraction (service cost).


The process of assigning the cost of benefits to the years during which those benefits are assumed to be earned by employees, the date of hire to the “full eligibility date”.

measuring service cost
Measuring Service Cost

Pension Benefits

Other Postretirement Benefits



No benefits untilfull eligibility.

Employees earnbenefits gradually.

learning objectives10
Learning Objectives

Determine the components of postretirement benefit expense.


the service method


15 average service years


The Service Method

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 Matrix, Inc. 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: