1 / 68

Pensions and Postretirement Benefits

Pensions and Postretirement Benefits. Revsine/Collins/Johnson: Chapter 14. Learning objectives. The difference between defined contribution and defined benefit pension plans. What the components of pension expense are and their relation to pension assets and to the pension liability.

woody
Download Presentation

Pensions and Postretirement Benefits

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Pensions and Postretirement Benefits Revsine/Collins/Johnson: Chapter 14

  2. Learning objectives • The difference between defined contribution and defined benefit pension plans. • What the components of pension expense are and their relation to pension assets and to the pension liability. • The requirements for funding pension plans, computing the return on plan assets, and the role of the plan trustee. • How GAAP smoothes the volatility inherent in pension estimates and forecasts. • The determinants of the pension funding decision.

  3. Learning objectives:Concluded • How to analyze and use the funded status footnote and the reconciliation of pension asset and liability accounts. • When a minimum balance sheet pension liability must be recognized. • The financial reporting rules for other postretirement benefits. • What research tells us about the usefulness of the detailed pension and other postretirement benefits disclosures.

  4. Pension plans • A pension plan is an agreement by the firm to provide a series of payments (called a pension) to employees when they retire. • The firm makes periodic contributions to a pension trust. • The pension trust then makes periodic benefit payments to retired employees. • As we shall see, there are two types of pension plans: defined contribution plans and defined benefit plans. Firm (sponsor) Contributions Pension trust Benefit payments Retired employee

  5. Pension plans:Defined contribution • Defined contribution plans specify the amount of cash that the employer puts into the plan. • No explicit promise is made about the size of the periodic payments the employee will receive on retirement. Employees shoulder investment risk

  6. Pension plans:Defined benefit • Defined benefit plans specify the formula for determining the amount that will be paid out to the employee after retirement. Employers shoulder investment risk • Determining how much should be charged to pension expense each year and how much cash must be contributed to the fund is complex.

  7. Pension plans:Defined contribution and defined benefit plans

  8. Defined benefit pension plans:Accounting complications • The plan specifies the benefit formula but not the benefit amount. • To determine the periodic pension expense, the following factors must be estimated: • The proportion of the workforce the will remain with the firm long enough to qualify for benefits under the plan (called vesting). • The rate at which employee salaries will rise until retirement. • The anticipated life span of employees after retirement. • The rate of return that will be earned on pension investments. • The discount rate used to reflect the present value of future benefits earned by employees in the current period.

  9. Defined benefit pension plans:Evolution of GAAP • SFAS No. 87 specifies the measurement and disclosure requirements for defined benefit pension plans. • The disclosure aspects of SFAS No. 87 were amended in 1998 and again in 2003 as SFAS No. 132. • SFAS No. 87 was designed to avoid volatility in pension expense, but the result is arguably the most technically complicated financial reporting pronouncement ever issued.

  10. Defined benefit pension plans:Six components of pension expense Service cost (+) The increase in the discounted present value of the pension benefits due to an additional year’s employment. Interest cost (+) Measures the growth in the pension liability that arises from the passage of time. Expected return on pension assets (-) Dollar return management believes will be earned on pension investments. Recognized gains or losses (- or +) Smoothing device that adjusts for the difference between the expected and actual return on pension assets. Amortization of unrecognized transition asset or obligation (- or +) Smoothing device that adjusts for the initial SFAS No. 87 disparity between pension assets and liabilities. Recognized prior service cost (- or +) Smoothing device that adjusts for the costs of retroactive changes in plan benefits.

  11. Defined benefit pension plans:A simple example 2005 2006 2007 Wildcat adopts pension plan Cate retires Lump-sum benefit of $20,000 is paid

  12. Here’s the December 31, 2005 journal entry: DRPension expense $8,734 CR Cash $8,734 Defined benefit pension plans:Component 1—Service cost • Service cost is the increase in the discounted present value of the pension benefits ultimately payable that is attributable to an additional year’s employment. 2005 2006 2007 $10,000 Benefit earned Service cost $8,734

  13. Defined benefit pension plans:Component 1—Service cost for 2006 2005 2006 2007 $10,000 Additional benefit earned Service cost $9,346

  14. Defined benefit pension plans:Component 2—Interest cost for 2006 • The interest cost component of pension expense arises from the passage of time. $8,734 benefit liability $9,346 benefit liability 2005 2006 2007 Interest cost $611 = $8,734 x 0.07 Discount rate Benefit liability

  15. Defined benefit pension plans:Component 3—Expected return on plan assets • This component of pension expense reflects the long-term expected return earned on pension investments. $8,734 cash contribution to trust Increased value of plan assets 2005 2006 2007 Expected return on plan assets $611 = $8,734 x 0.07 Expected rate of return Plan assets

  16. Defined benefit pension plans:Pension expense for 2006 • The journal entry for 2006 is: Component 1 Component 2 Component 3 DRPension expense $9,346 CR Cash $9,346

  17. In our example, perfect certainty meant: Date of retirement was known in advance Amount of the pension was also known in advance Discount rates and earnings rates were equal and could be perfectly forecast Under these circumstances, pension expense is equal to service cost in every period. Accounting complications arise when: Higher or lower than anticipated employee turnover. Higher or lower employee mortality before retirement. Actual return on plan assets differs from the expected return. Companies retroactively alter the level of benefits promised under the plan. Defined benefit pension plans:Relaxing the perfect certainty assumption

  18. Defined benefit pension plans:Pension plan entities and relationships

  19. Defined benefit pension plans:Discount rate uncertainty • SFAS No. 87 requires that firms use a settlement rate as the assumed discount rate in their pension expense calculation.

  20. Defined benefit pension plans:Rates vary across firms Settlement Rate Expected Rate of Return

  21. Defined benefit pension plans:Compensation increase rates vary across firms Compensation Increase Rates 1997-2002

  22. Defined benefit pension plans:Component 4—Recognized gains and losses • The actual return on plan assets can differ considerably from the expected return in any year. • This volatility in asset returns would—in the absence of SFAS No.87—translate directly into net income volatility. Volatility in actual return

  23. Defined benefit pension plans:SFAS No. 87 and Component 4 • To avert the net income volatility, SFAS No. 87 allows firms to reduce pension expense by the expected return on plan assets rather than by the actual return: • Firms first select a target return that they expect to earn on plan assets in the long run. • Any difference between this expected return and the actual return earned in a given year is assigned to an off-balance sheet device called unrecognized gain or loss.

  24. Defined benefit pension plans:Actual and expected return at GE

  25. Defined benefit pension plans:Excerpts from GE’s pension footnotes Volatile actual returns Smooth expected returns

  26. Defined benefit pension plans:How volatility is eliminated

  27. Defined benefit pension plans:How Component 4 is measured • If gains and losses do not offset one another over time, the cumulative off-balance sheet deferred amounts will grow excessively large. • The role of Component 4 is to gradually reduce the cumulative deferred amounts. • Actual versus expected return on plan assets • Actuarial assumptions versus actual experience • Changes in assumptions (e.g., discount rate) Cumulative unrecognizedgains and losses

  28. Defined benefit pension plans:Computing Component 4—Step 1 Step 1 : Compute the 10% threshold Threshold equals 10% of MRAV or PBO, whichever is larger. Here the threshold is $1 million.

  29. Defined benefit pension plans:Computing Component 4—Step 2 Step 2 : Determine whether the threshold is triggered Because CUGOL exceeds the threshold amount, the threshold is triggered.

  30. Defined benefit pension plans:Computing Component 4—Step 3 Step 3 : Compute the current year component 4 amortization So, pension expense will be reduced by $40,000 in the current year.

  31. Defined benefit pension plans:Component 5—Transition amounts • When firms first adopted SFAS No. 87, they were required to determine the transition funding status of the plan: • This transition asset or liability is then amortized over the remaining service period of employees who are expected to receive benefits under the plan. Transition assets Transition liability $ $ $ $ Plan assets Pension liability Plan assets Pension liability

  32. Defined benefit pension plans:Component 6—Prior service cost • Pension plans are frequently amended to provide increased benefits to employees. • When benefits are retroactively enhanced, it means prior pension expense was too low.

  33. Defined benefit pension plans:Relative magnitude of expense components

  34. If Adess decides to fund $44,000 that year: DRPension expense $50,000 CR Cash $44,000 CR Unfunded accrued pension cost 6,000 Defined benefit pension plans:Journal entries illustrated • Here are the pension expense components for Adess Corp.: • If the entire amount of pension expense is funded by payments to the plan trustee, the entry is: DRPension expense $50,000 CR Cash $50,000

  35. Funding decisions are influenced by income tax laws, protective pension legislation, the availability of cash, and other incentives. Defined benefit pension plans:The pension funding decision Income tax laws ERISA • Firms with high marginal tax rates tend to overfund their pension plans. • Firms with less stringent capital constraints and larger union membership tend to have higher funding ratios. Competing cash needs Contracting and political cost incentives • Firms with more “precarious” debt/equity ratios tend to have lower funding ratios.

  36. The pension footnote:General Electric—Part 1 GE has pension income rather than pension expense. Used in later journal entry

  37. The pension footnote:General Electric—Part 2

  38. The pension footnote:General Electric—Part 3 Pension assets are larger than GE’s pension obligation Used in later journal entry

  39. The pension footnote:General Electric—Part 4 Used in later journal entry

  40. The pension footnote:General Electric—Part 5

  41. The pension footnote:Funded status disclosure—Plan assets Causes of Increases and Decreases in Plan Assets

  42. The pension footnote:Funded status disclosure—PBO Causes of Increases and Decreases in Projected Benefit Obligations (PBO)

  43. The pension footnote:Reconciling funded status to balance sheet General Electric Company

  44. The pension footnote:GE’s journal entry Change in account balance from Ex 14.8 “Effect on operations” from Ex 14.8 Employer contribution Change in account balance from Ex 14.8

  45. The pension footnote:Extracting analytical insights • The funded status reconciliation provides insights about future pension-related cash flows: • Firms are also now required to disclose anticipated pension benefit payouts for the next five years. Slightly overfunded $ • Suppose the firm did not contribute cash to their pensions trust this year. • Will cash contributions be required in futures years? $ Plan assets Pension benefit obligation

  46. The pension footnote:Extracting analytical insights (concluded) • Pension assets and liabilities are quite sensitive to changes in interest rates: • Changes in various pension rate assumptions also affect pension expense. Assumed rate of Compensation increase Service cost Spread between the discount rate and rate of Compensation increase

  47. Defined benefit plans:Cash-balance plans • Many U.S. companies are replacing existing pension plans with a new cash-balance plan. • Cash balance plans are attractive to employers, but they are also controversial. Contributes fixed amount per year, say 5% of salary Interest earned at T-bond rate Employer Trustee Pays annuity benefit to employee Employee

  48. Defined benefit plans:Minimum balance sheet liability • Firms are required to report a minimum balance sheet liability whenever the accumulated benefit obligation (ABO) exceeds the fair value of plan assets (FVPA). • The journal entry would be: Minimum balance sheet liability DRIntangible asset $2,000,000 CR Minimum pension liability $2,000,000

  49. Defined benefit plans:Minimum liability—complication 1 • Suppose the company already had an “accrued pension liability” of $400,000 on its books. In this case, the computation is: • The journal entry would then be: DRIntangible asset $1,600,000 CR Minimum pension liability $1,600,000 $2,000,000 - $400,000 =

  50. Defined benefit plans:Minimum liability—complication 2 • Assume the unrecognized prior service cost is only $1.5 million: • The journal entry would be: DRIntangible asset $1,500,000 DR Accumulated comprehensive loss 500,000 CR Minimum pension liability $2,000,000 Cannot exceed amount of UPSC

More Related