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.
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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
The right to receive earned pension benefits benefits for employee services.vest (vested benefits) when it is no longer contingent on continued employment.Nature of Pension Plans
Explain the fundamental differences between a defined contribution pension plan and a defined benefit pension plan.
Defined Contribution Plans benefits for employee services.
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 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.
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 benefits for employee services.
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.
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
Distinguish among the vested benefit obligation, the accumulated benefit obligation, and the projected benefit obligation.
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
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:
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.
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.
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
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
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
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
Describe the five events that might change the balance of the PBO.
Service cost is the increase in the PBO attributable to employee service performed during the period.
Interest cost is the interest on the PBO during the period.
Prior service costeffects result from changes in the pension benefit formula or plan terms.
Loss or gain on PBOresults from required revisions of estimates used to determine PBO.
Retiree benefits paidare the result of paying benefits to retired employees.
Explain how plan assets accumulate to provide retiree benefits and understand the role of the trustee in administering the fund.
Pension plan assets (like the PBO) are periods of employee service as defined by the notspecifically reported in the balance sheet.
Atrusteemanages the pension plan assets.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)
Describe the funded status of pension plans and how that amount is reported.
OVERFUNDED periods of employee service as defined by the
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.
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.
Describe how pension expense is a composite of periodic changes that occur in both the pension obligation and the plan assets.
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 of $150,000 in 2007 and $155,000 in 2008.is the growth in PBO during a reporting period due to the passage of time.
Interest cost is calculated as:
PBOBeg × Discount rateInterest Cost
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
2007: PBO 1/1/07 $500,000 × 10% = $50,000
2008: PBO 1/1/08 $640,000 × 10% = $64,000
Actual Return on 1/1/07, and $640,000 on 1/1/08.
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
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.
2008 on 1/1/07, and $640,000 on 1/1/08.
2007Return on Plan Assets
Prior service cost (PSC) on 1/1/07, and $640,000 on 1/1/08. 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
Benefits attributable to prior service are assumed to benefit future periods by:
Improving employee productivity.
Improving employee morale.
Reducing demands for pay raises.Amortization of Prior Service Cost
PSC is benefit future periods by: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
Two approaches to amortizing PSC: benefit future periods by:
Amortize PSC over the average remaining service period.
Amortize PSC by allocating equal amounts to each employee’s service years remaining.Amortization of Prior Service Cost
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
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
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
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.
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
Average remaining service period of active employees expected to receive benefits under the planGains and Losses
There was no gain or loss amortized in 2007.
Let’s determine the amortization of the net gain in 2008.
$12,000 ÷ 12 years = $1,000 per year.
Record for pension plans the periodic expense and funding as well as new gains and losses and new prior service cost as they occur.
Matrix contributed $200,000 to the plan trustee at the end of 2007. The journal entries to record the pension activity are:
Matrix contributed $200,000 to the plan trustee at the end of 2008.
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
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.
Understand the interrelationships among the elements that constitute a defined benefit pension plan.
Describe the nature of postretirement benefit plans other than pensions and identify the similarities and differences in accounting for those plans and pensions.
Encompass all types of retiree health and welfare benefits including . . .
Group legal services, and
Other benefits.Postretirement Benefit Plan
Pension Plan Benefits including . . .
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
costs in each
year of retirement
cost of benefits
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
Explain how the obligation for postretirement benefits is measured and how the obligation changes.
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.
Fraction estimating pension benefits, but there are some additional assumptions required:
APBO at the beginning of the year.Measuring the Obligation
EPBO estimating pension benefits, but there are some additional assumptions required:
(1 + Discount Rate)
$10,250 × 1.06 = $10,865
= $2,535Measuring the Obligation
To calculate the APBO at the end of the year, we start by determining the ending EPBO.
APBO may also be calculated like this: estimating pension benefits, but there are some additional assumptions required: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”.
Other Postretirement Benefits
No benefits untilfull eligibility.
Employees earnbenefits gradually.
Determine the components of postretirement benefit expense.
Service Method of Allocating Prior Service Cost estimating pension benefits, but there are some additional assumptions required:
30,000 estimating pension benefits, but there are some additional assumptions required:2,000
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: