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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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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.
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
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
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)
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.
We can begin the process of determining pension expense for the company.Pension Expense
Interest cost is calculated as:
PBOBeg × Discount rateInterest Cost
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
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.
PSC is the present value of the retroactive benefits and increases PBO by that amount.Amortization of Prior Service Cost
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
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.
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.
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.
Group legal services, and
Other benefits.Postretirement Benefit Plan
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