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 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 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.
Projected Benefit Obligation
Present value of additional benefits related to projected pay increases.
Accumulated Benefit Obligation
Present value of nonvested benefits at present pay levels.
Vested Benefit Obligation
Present value of benefits at present pay levels.
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 notformally recognized on the balance sheet.
Atrusteemanages the pension plan assets.Pension Plan Assets
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.Pension Plan Assets
Market value of plan assets is below the actuarial present value of all benefits earned by participants.
Describe how pension expense is a composite of periodic changes that occur in both the pension obligation and the plan assets.
Pension expense is the periods of employee service as defined by the net cost of:
Return on plan assets
Amortization of prior service costs
Gain or loss recognized.Pension Expense
You go to work for Matrix, Inc. on 1/1/06. 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 may 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, 2006, the end of your first year of service, the actuary must calculate the present value of the pension benefits earned by you during 2005. 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
A reconciliation of the VBO, ABO and PBO would look like this:
VBO $ 32
Non-vested benefits 128
ABO $ 160
Adjustment for future salary 478
PBO $ 638
The adjustment for future salary of $478, is determine by the plan actuary. If you are the only employee at Matrix, the computations would be similar for future years. Let’s assume Matrix funds $500 of its pension costs with the plan trustee on December 31, 2006. The journal entry to record the pension costs and funding would be:
Pension expense 638
Accrued pension cost 138
Let’s look at an example for Matrix, Inc.
Actuaries have determined that Matrix, Inc. has service cost of $150,000 in 2006 and $155,000 in 2007.
We can begin the process of determining pension expense for the company.Defined Benefit Plan
Interest cost of $150,000 in 2006 and $155,000 in 2007.is the growth in PBO during a reporting period.
Interest cost is calculated as:
PBOBeg × Discount rateInterest Cost
Actuaries determined that Matrix, Inc. had PBO of $500,000 on 1/1/06, and $640,000 on 1/1/07.
The actuary uses a discount rate of 10%.Interest Cost
2006: PBO 1/1/06 $500,000 × 10% = $50,000
2007: PBO 1/1/07 $640,000 × 10% = $64,000
Actual Return on 1/1/06, and $640,000 on 1/1/07.
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 1/1/06, and $600,000 on 1/1/07.
The trustee uses an expected return of 9% and the actual return is 10% in both years.
2007 on 1/1/06, and $640,000 on 1/1/07.
2006Return on Plan Assets
Prior service cost (PSC) on 1/1/06, and $640,000 on 1/1/07. 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.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.
If most of a plan’s participants are inactive, then amortize PSC over the participants’ remaining life expectancy.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 1/1/07, 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 1/1/07, 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 2007, pension expense for 2006 is not affected.
2007: $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 2006.
Let’s determine the amortization of the net gain in 2007.
$9,000 ÷ 9 years = $1,000 per year.
Matrix contributed $200,000 to the plan trustee at the end of 2007. The journal entry to record the pension expense is:
Understand the interrelationships among the elements that constitute a defined benefit pension plan.
Four “off-balance sheet” accounts: corridor amount, amortization is recognized as . . .
Unamortized Gain or LossReconciliation of Pension Amounts
The four amounts shown on the previous slide combine to account for the one pension account that is reported on the balance sheet:
prepaid pension asset or pension liability.
To discourage corridor amount, amortization is recognized as . . . underreporting of pension liability, SFAS No. 87 requires recognition of an additional minimum pension liability under certain circumstances.Minimum Liability
This amount is also called the corridor amount, amortization is recognized as . . . underfunded ABO.Measurement Issue
Accumulated Benefit Obligation (ABO)
- Plan Assets at Fair Value
Minimum Pension Liability
SFAS No. 87 requires offsetting of the pension liability and the plan assets when determining the minimum liability.
An additional pension liability is recognized if total minimum liability exceeds accrued pension cost.
Total minimum liability
Accrued pension cost balance (liability)
Additional pension liability balance
Total minimum liability
Prepaid pension cost balance (asset)
Additional pension liability balanceAdditional Liability
Describe how pension disclosures fill a reporting gap left by the minimal disclosures in the primary financial statements.
The pension information actually reported in the financial statements falls short of the conceptual ideal and even shy of the FASB’s own preferences. Here are the items included in the income statement and balance sheet.
Pension plan minimum liability settlements
Reduce PBO and are viewed as the realization of a portion of the net unrecognized gain or loss and a portion of the unrecognized transition asset.
Pension plan curtailments
Often reduce PBO, resulting in a gain, which reduces accrued pension cost.Settlements and Curtailments
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.
Determine the components of postretirement benefit expense.
Interest accrues on the APBO as time passes.
APBO at the beginning of the year times the
assumed discount rate equals the interest cost.
Unlike pension plans, many postretirement benefitplans are not funded currently. For funded plans, the
earnings on plan assets reduce postretirementbenefit expense.
Prior service cost is allocated over the averagetime from the date of the amendment to the datefor active employees, not the expectedretirement date.
The amount subject to amortization is the net gain or loss at
the beginning of the year in excess of 10% of the APBO or
10% of the plan assets. The excess is amortized over the
average remaining service period of active employees.
Amortization of the transition amount is part of expense in the
current period. For financial reporting, the amortization reduces
current earnings. For income tax purposes, income is reduced
when actual payments are made. This creates a temporary
difference between financial and taxable income.
An employer may choose to recognize: estimating pension benefits, but there are some additional assumptions required:
The entire transition obligation immediately,or
Amortize the transition obligation on a straight-line basis over the plan participants’ future service periods (or 20 years if that is longer).Amortization of Transition Amount
Recall our example of postretirement benefits.
Let’s calculate postretirement benefits expense.
Because most postretirement health plans
are not funded, there are no fund assets,
no credit for prior service, and no net loss.
The beginning APBO ($2,050) is the initial transition liability. Your service life is 24 years (30 - 6). The amortization amount is $85 rounded ($2,050 ÷ 24 years).
Description of the pension plan. estimating pension benefits, but there are some additional assumptions required:
Estimates of the obligations PBO, ABO, vested benefit obligation, EPBO, and APBO).Pension Disclosures
The disclosure requirement of pension plans and postretirement benefits are very similar. On this and the next three screens are the disclosures for FedEx in the Appendix to Chapter 1.
The percentage of total plan assets for each major category of assets (equity securities, debt securities, real estate, other) as well as a description of investment strategies, including any target asset allocations and risk management practices.
A breakdown of the components of the annual pension and postretirement benefit expenses for 2004, 2003, and 2002.Pension Disclosures
A reconciliation of the changes in the plans’ benefit obligation and fair value of assets over a two year period ended May 31, 2004, and a statement of the funded status.
The discount rates, the assumed rate of compensation increases used to measure the PBO, the expected long-term rate of return on plan assets and the expected rate of increase in future medical and dental benefit costs.Pension Disclosures
Estimated benefit payments presented separately for years 2005-2009 and in the aggregate for years 2010-2014.
Estimate of expected contributions to fund the plan for 2005.
Other information to make it possible for interested analysts to reconstruct the financial statements with plan assets and liabilities includedPension Disclosures
Service Method of Allocating Prior Service Cost 2005-2009 and in the aggregate for years 2010-2014.
30,000 2005-2009 and in the aggregate for years 2010-2014. 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: