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Unit 11 Employee Benefits Nature of Pension Plans

Unit 11 Employee Benefits Nature of Pension Plans. Pension plans provide income to individuals during their retirement years.

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Unit 11 Employee Benefits Nature of Pension Plans

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  1. Unit 11 Employee BenefitsNature of Pension Plans • Pension plans provide income to individuals during their retirement years. • This is accomplished by setting aside funds during an employee’s working years so that at retirement, the accumulated funds plus earnings from investing those funds are available to replace wages.

  2. Nature of Pension Plans An arrangement whereby an employer provides benefits to employees after they retire for services they provided while they were working. Pension Plan Administrator Pension Fund Investments Earnings Contributions Employer Benefit Payments Assets & Liabilities Retired Employees

  3. Nature of Pension Plans • For a pension plan to qualify for special tax treatment (qualified plans) 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 an irrevocable trust fund. • Benefits must vest after a specified period of service. • Complies with specific timing and amount of contributions. • In a qualified plan, the employer is permitted an immediate tax deduction for amounts paid into the pension fund (within specified limits). The employees, on the other hand, are not taxed at the time employer contributions are made

  4. Nature of Pension Plans Defined-Contribution Plan (e.g., 401K) Defined-Benefit Plan (e.g., Our Social Security) system • Employer contribution determined by plan (fixed), no other benefit obligations • Risk borne by employees • Benefits based on plan value from employee directed investment fund performance ( investment returns). • Employee’s contributions typically are matched to a specified extent by employers. Most employers match up to 50 percent of employee contributions up to the first 6 percent of salary. • Benefits are based on a formula that considers years of service, compensation level, and age. • Employer contribution varies (determined by Actuaries) • Pension fund performance risk borne by employer Actuariesestimate the employer contribution by considering mortality rates, employee turnover, interest and earning rates, early retirement frequency, future salaries, etc. Uncertainties complicate determine how much to set aside each year to ensure that sufficient funds are available to provide promised benefits.

  5. Accounting for Pensions Key Concepts: • What is the pension obligation that a company should report in the financial statements? • What is the pension expense for the period? • What is the plan assets? • Plan assets must be held by a trustee. A trustee • accepts employer contributions, invests the contributions, • accumulate the earnings on the investment (dividends, • interest, market price appreciation), and pays benefits to • retirees or their beneficiaries.

  6. Accounting for Pensions Alternative measures of the Liability Employer’s pension obligation is the deferred compensation obligation (future benefits) it has to its employees for their service under the terms of the pension plan. FASB’s choice

  7. The Pension Obligation Nonvested benefits: employees don’t have the right to receive any benefits if they terminate their employment today.

  8. The Pension Obligation • Vested benefit obligation (VBO) The portion of the accumulated benefit obligation that plan participants are entitled to receiveregardless of their continued employment. • Accumulatedbenefit obligation (ABO) The actuary’s estimate of the total retirement benefits (at their discounted present value) earned so far by employees, applying the pension formula using existingcompensation levels. It includes vested benefit obligation and non-vested ben obligation. • Projectedbenefit obligation (PBO) The actuary’s estimate of the total retirement benefit (at their discounted present value) earned so far by employees, applying the pension formula usingestimated future compensation levels. (If the pension formula does not include future compensation levels, the PBO and the ABO are the same.) • PBO is not formally recognized as a liability in the B/S, but it is • a liability nevertheless.

  9. Actual Return on Plan Assets • is based on the fair value of the plan assets at the beginning and end of the accounting period, adjusted for contributions and payments. • + Fair value – End of period • - Fair value – Beg. Of period • - Contributions to plan assets • + Benefits paid • Actual return on plan assets Plan Assets 90 Contribution 12 5 Actual return 3 100

  10. Accounting for Pensions – Pension Expenses Components of Annual Pension Expense (Cost) Actual return may include interest & dividends… FASB requires including actual return as pension expense component as well as amortizztion of the gain or loss (based on average remaining service period) on plan assets or on PBO: i.e., the difference; Actual return > Expected or Expected > Actual. Interest cost: PBO is a liability, interest accrues on its balance as time passes.

  11. Pension Expense—An Overview The annual pension expense formula: includes changes in both the pension obligation and the plan assets. (P 385 – 387) The annual pension expense reflects changes in both the pension obligation (VBO, ABO, PBO), amortization on prior service cost, and on gain or losses due to actuaries assumption revisions and the differences between expected return on plan Assets and actual return on plan assets. .

  12. Accounting for Pensions Components of Pension Expense Effect on Expense 1. Service Costs + Actuarial present valueof new benefits earned by employees during the period.

  13. Accounting for Pensions Components of Pension Expense Effect on Expense 2. Interest on the Liability + Interest for the period on the projected benefit obligation outstanding during the period. Interest rate (settlement rate) should be those based rates of return on high-quality fixed-income investments currently available, whose cash flows match the timing and amount of the expected benefit payments.

  14. Accounting for Pensions Components of Pension Expense Effect on Expense 3. Actual Return on Plan Assets +- Actual return on plan assets is the increase in pension funds from interest, dividends, and realized and unrealized changes in the fair-market value of the plan assets. Illustration 20-5

  15. Accounting for Pensions Effect on Expense Components of Pension Expense 4. Amortization of Prior Service Costs + • Plan amendments often increase benefits for service provided in prior years. • Company allocates the cost (prior service cost) of providing these retroactive benefits to pension expense in the future, specifically to the remaining service-years of the affected employees. • Amortization Method: • Board prefers a years-of-service method. • SFAS No. 158 allows use of the straight-line method.

  16. Accounting for Pensions Components of Pension Expense Effect on Expense 5. Gain or Loss +- • Unexpected swings (volatility) in pension expense can result from: • Sudden and large changes in the fair value of plan assets (not the same as “Actual return”), and • Changes in actuarial assumptions that affect the amount of the projected benefit obligation (PBO). • Must be amortized.

  17. Defined Contribution Pension Plans - example (e.g., 401k) • Let’s assume that the annual contribution is to be 3% of an employee’s salary. If an employee earned $110,000 during the year, the company would make the following entry: Pension expense 3,300 Cash 3,300 • The employee’s retirement benefits are totally dependent upon how well investments perform.

  18. A pension formula might define annual retirement benefits as: 1 1/2 % x Years of service x Final year’s salary By this formula, the annual benefits to an employee who retires after 30 years of service, with a final salary of $100,000, would be: 1 1/2 % x 30 years x $100,000 = $45,000 Defined Benefit Pension Plan - Example

  19. Defined Benefit Pension Plan An actuary assessesthe various uncertainties (employee turnover, salary levels, mortality, etc.) and estimates the company’s obligation to employees in connection with its pension plan. The key elements of a defined benefit pension plan are: The employer’s obligation to payretirement benefits in the future. The plan assets set aside by theemployer from which to pay theretirement benefits in the future. The periodic expense of having apension plan.

  20. Projected Benefit Obligation - example The PBO is a more meaningful measurement because it includes a projection of what the salary might be at retirement. Jessica Farrow was hired by Global Communications in 2002. She is 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 Farrow is expected to retire in 2041 after 40years of service. Her retirement period is expected to be 20 years. At the end of 2011, 10 years after being hired, her salary is $100,000. The interest rate is 6%. The company’s actuary projects Farrow’s salary to be $400,000 at retirement.

  21. Projected Benefit Obligation - Example • Step1.Use the pension formula to determine the retirement benefits earned to date (as of 2011). • $400,000 • × 10 years of service • × 1.5% • $ 60,000 per year • Step 2.Find the present value of the retirement benefits as of the retirement date. • The present value (n=20, i=6%) of the retirement annuity at the retirement date (beg. of the 20 yrs; 2041) is $688,195 ($60,000 × 11.46992). • Step 3.Find the present value of the retirement benefits as of the current date. • The present value [n=30 (40-10), i=6%] of the retirement benefits at 2011 is $119,822 ($688,195 × .17411). This is the PBO. • Plan Date Retirement Date End • 2011 2041 2061

  22. Projected Benefit Obligation – Example (Cont’d) If the actuary’s estimate of the final salary hasn’t changed, the PBO a year later at the end of 2012 would be $139,715. • Step 1. Use the pension formula to determine the retirement benefits earned to date. • $400,000 • × 11 • × 1.5% • $ 66,000 per year • Step 2. Find the present value of the retirement benefits as of the retirement date. • The present value (n=20, i=6%) of the retirement annuity at the retirement date is $757,015 ($66,000 × 11.46992). • Step 3. Find the present value of the retirement benefits as of the current date. • The present value (n=29, i=6%) of the retirement benefits at 2012 is $139,715 ($757,015 × .18456). This is the PBO.

  23. Projected Benefit Obligation Service cost is the increase in the PBO attributable to employee service performed (benefits earned by employee during the year), e.g., one more service year added to the formula.

  24. Projected Benefit Obligation Interest costis the interest expense on the PBO during the period. Prior service costis the increase in the PBO due to a plan change (amendment) that retroactively provides credit for employee service rendered in prior years, e.g., a change of salary % in the formula.

  25. Projected Benefit Obligation Loss or gain on PBO:results from revising estimates (benefit rate change, life expectancy, retirement date, discount rate change…) used to determine the PBO, e.g., a change of final year salary. Loss on PBO: projected obligation > previously expected. Retiree benefits paid reduce the PBO.

  26. Projected Benefit Obligation - example for entire employee pool *Of course, these expanded amounts are not simply the amounts for Jessica Farrow multiplied by 2,000 employees because her years of service, expected retirement date, and salary are not necessarily representative of other employees. Also, the expanded amounts take into account expected employee turnover and current retirees. †Includes the prior service cost that increased the PBO when the plan was amended in 2012. Assumptions: Global Communications has 2,000 active employees covered by the pension plan and 100 retired employees receiving retirement benefits. The illustration on this slide shows the expanded amounts in the 2013 PBO to represent all covered employees.

  27. Actual Return on Plan Assets • is based on the fair value of the plan assets at the beginning and end of the accounting period, adjusted for contributions and payments. • + Fair value – End of period • - Fair value – Beg. Of period • - Contributions to plan assets • + Benefits paid • Actual return on plan assets

  28. Pension Plan Assets & Funded Status Reporting The pension plan assets are not reported separately in the balance sheet but are netted together with the PBO. The net difference is referred to as the “funded status”. Report either a net pension asset (overfunded; debit balance) or a net pension liability (underfunded; credit balance), i.e., for Reporting: Plan assets - PBO = Net Pension Assets or = Net Pension Liabilities The higher the expected return on plan assets, the less the employer must actually contribute. On the other hand, a relatively low expected return means the difference must be made up by employer higher contributions.

  29. Global Communications funds its defined benefit pension plan by contributing the year’s service cost plus a portion of the prior service cost each year. Cash of $48 million was contributed to the pension fund in 2013. Plan assets at the beginning of 2013 were valued at $300 million. The expected rate of return on the investment of those assets was 9%, but the actual return in 2013 was 10%. Retirement benefits of $38 million were paid at the end of 2013 to retired employees. The plan assets at the end of 2013 will be: Pension Plan Assets - Calculation

  30. OVERFUNDED Plan assets (market value) > PBO. Funded Status of the Pension Plan UNDERFUNDED Plan assets (Market value) < PBO.

  31. The Relationship Between Pension Expense and Changes in the PBO and Plan Assets

  32. Interest cost is calculated as: PBOBeg × Discount rate e.g., Global had PBO of $400 million on 1/1/13. The actuary uses a discount rate of 6%. Interest Cost Service cost $41 is given. 2013 Interest Cost: PBO 1/1/13 $400,000,000 × 6% = $24,000,000

  33. Return on Plan Assets The plan trustee reports that plan assets were $300 million on 1/1/13. FASB requires using the expected return, 9%,rather than the actual return of 10% (300M x .09). Actual return on plan assets: is equal to the dividends, interest, and capital gains generated by the fund during the period. Expected return on plan assets: is the trustee’s estimate of the long-term rate of return on invested funds.

  34. In 2012, Global Communications amended the pension plan, increasing the PBO at that time. For all plan participants, assumed that the prior service cost was $60 million at 1/1/12. The average remaining service life of the active employee group is 15 years. Amortization of Prior Service Cost $60 million PSC ÷ 15 = $4 million per year

  35. Gains and Losses FASB’s Corridor Amortization Corridor Amortization FASB invented the corridor approachfor amortizing the accumulated net gain or loss balance of PBO or plan assets when it gets too large. How large is too large? 10% of the larger of the beginning balances of the projected benefit obligationorthe market-related value (which may equal fair value) of theplan assets. Any accumulated net gain or loss balance > 10% of … must be amortized.

  36. Corridor Amount PBO (beginning of the period). The corridor amount is 10% of the greater of Or Plan assets (fair value; beginning of the period. The existence of the corridor amount is an effort by the FASB to permit companies to smooth income.

  37. Gains and Losses • PBO > Expected: Loss • PBO < Expected: Gain • Return on Plan Assets (actual) > Expected: Gain • Return on Plan Assets (actual) < Expected: Loss • The aforementioned Gains and Losses are not reported as “Pension Expense”, • instead, they are reported as OCI. • Also, per FASB, if an accumulatednet gain or loss gets “too large”, i.e.,10% • of the period beginning PBO or 10% of beg. plan assets whichever is higher • (referred as corridor amount), amortizing and charging to pension expense is • required, i.e., when an accumulated net gain or net loss > the “corridor amount”, • amortize the gain or loss and then also report it as OCI.

  38. Plan Assets • Return on Plan Assets: Example: assuming Global’s expected rate of return is 9%, its expected return on plan assets in 2013 would be 9% times $300,000,000 (beginning plan assets in 2013), or $27,000,000. But the actual rate of return in 2013 was 10%, producing an actual return on plan assets of $30,000,000. • Return on plan assets reduces the amounts employer must contribute to the fund, i.e., reduces the net cost or pension expense (recorded) of having a pension plan. • The return on plan assets is not separately reported; it is a component of pension expense (the same as how PBO is treated). • In sum, both the interest and return on assets do not directly represent employee compensation; they are created only because the future obligation to retirees must be funded currently.

  39. Plan Assets • Loss or Gain on Plan Assets: It seems logical to reduce net cost of having a pension plan by using the actual return on plan assets. But, the FASB concluded that the actual return should first be adjusted by any difference between the actual return and expected return. So, it’s the expected return is actually used in the calculation of pension expense. Aloss or gain on plan assets is the difference between the actual and expected return. They are not part of pension expense, instead, they are amortized to OCI for income smoothing purpose.

  40. Net unrecognized gain or loss at beginning of year Corridor amount ־ Average remainingservice life of activeemployees Gains and Losses – Amortization For income smoothing purpose, amortize (instead of expense it all at once) the excess amount (i.e., beginning net unrecognized gain or loss > the corridor amount); use the following formula:

  41. Gains and Losses – Global’s example assuming a net loss—AOCI of $55 MM at the beginning of 2013 $15 million/15 years = 1MM amortization for 2013

  42. Determining Pension Expense

  43. Recording Pension Expense ($ in millions) Pension expense (calculated earlier or below) 43 Plan assets ($27 expected return on assets)27 PBO ($41 service cost + $24 interest cost)65 Prior service cost–OCI 4 Net loss–OCI 1 OCI = Other comprehensive income(PBO is included as a component of pension expense rather than being separately reported) Service cost and interest cost add to Global’s PBO. The return on plan assets adds to the plan assets. Amortization of prior service and net loss reduce each account.

  44. Recording Gains and Losses For 2013, the actual return on plan assets exceeded the expected return by $3 million. In addition, there was a $23 million loss from changes made by the actuary when it revised its estimate of future salary levels causing its PBO estimate to increase. Global would make the following journal entries to record the gain and loss: ($ in millions) Loss—OCI 23 PBO 23 Plan assets 3 Gain—OCI 3 OCI = Other comprehensive income

  45. Recording the Funding of Plan Assets When Global adds its annual cash investment of $48 million to its plan assets, the value of those plan assets increases by $48 million. ($ in millions) Plan assets 48 Cash (contribution to plan assets) 48 • It’s not unusual for the cash contribution to differ from that year’s pension expense. After all, determining the periodic pension expense and the funding of the pension plan are two separate processes.

  46. Recording the Funding of Plan Assets - Recording Payment of Benefits Global pays $38 million in retirement pension benefits. ($ in millions) PBO 38 Plan assets (payments to retired employees) 38

  47. U. S. GAAP vs. IFRS Important differences in accounting for actuarial gains and losses using U.S. GAAP and IFRS. • Gains and losses for plan assets are the difference between the actual and expected returns, where the expected return is different from company to company and usually different from the interest rate used to determine the interest cost. • Requires that we use the same rate (the rate for “high -grade corporate bonds”) for both the interest cost on the defined benefit obligation (called projected benefit obligation or PBO under GAAP) and the interest revenue on the plan assets.

  48. U. S. GAAP vs. IFRS Important differences in accounting for actuarial gains and losses using U.S. GAAP and IFRS. • Requires that gains and losses are to be (a) included among OCI items in the statement of comprehensive income when they first arise and then (b) gradually amortized or recycled out of OCI and into pension expense (P 1031, when the accumulated net gain or net loss exceeds the 10% threshold). • Gains and losses are included in OCI when they first arise, but unlike U.S. GAAP those amounts are not subsequently amortized out of OCI and into expense. Instead, under IFRSthose amounts remain in the balance sheet as accumulated other comprehensive income.

  49. Comprehensive Income Comprehensive income is a more expansive view of income than traditional net income.

  50. Pension Spreadsheet &Recording Net Pension Cost (expense) 56MM = 60MM – 4MM, amortized exp

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