Defined Benefit Pension Plans
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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.

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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


Defined benefit plan1
Defined Benefit Plan periods of employee service as defined by the

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:

$200,000

× 40

× 1.5%

$120,000

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 periods of employee service as defined by the

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 periods of employee service as defined by the

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 periods of employee service as defined by the

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 periods of employee service as defined by the

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 periods of employee service as defined by the

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


Projected benefit obligation
Projected Benefit Obligation periods of employee service as defined by the


Pension plan assets

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


Pension plan assets1
Pension Plan Assets periods of employee service as defined by the

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)


Funded status of the pension plan

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

UNDERFUNDED

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 periods of employee service as defined by the

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.


Pension expense an overview
Pension Expense – An Overview periods of employee service as defined by the


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


Service cost
Service Cost of $150,000 in 2007 and $155,000 in 2008.


Interest cost

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 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 on 1/1/07, and $640,000 on 1/1/08.

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

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


Return on plan assets
Return on Plan Assets on 1/1/07, and $640,000 on 1/1/08.

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.


Return on plan assets1

2008 on 1/1/07, and $640,000 on 1/1/08.

2007

Return on Plan Assets


Return on plan assets2
Return on Plan Assets on 1/1/07, and $640,000 on 1/1/08.


Amortization of prior service cost

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


Amortization of prior service cost1

PSC is on 1/1/07, and $640,000 on 1/1/08. 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 cost2

Two approaches to amortizing PSC: on 1/1/07, and $640,000 on 1/1/08.

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 cost3

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 cost4
Amortization of Prior Service Cost provide increased benefits attributable to service performed before 1/1/03, for all active employees.

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 of prior service cost5
Amortization of Prior Service Cost provide increased benefits attributable to service performed before 1/1/03, for all active employees.


Gains and losses
Gains and Losses provide increased benefits attributable to service performed before 1/1/03, for all active employees.


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 loss at the beginning of the period is a minimum amount

PBO at the beginning of the period.

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

Or

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 corridor amount, amortization is recognized as . . .

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 corridor amount, amortization is recognized as . . .

$12,000 ÷ 12 years = $1,000 per year.


Pension expense1
Pension Expense corridor amount, amortization is recognized as . . .


Pension expense and funding
Pension Expense and Funding corridor amount, amortization is recognized as . . .

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 corridor amount, amortization is recognized as . . .

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


Pension gains and losses
Pension Gains and Losses corridor amount, amortization is recognized as . . .

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 corridor amount, amortization is recognized as . . .

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.


Pension spreadsheet
Pension Spreadsheet corridor amount, amortization is recognized as . . .


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 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



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