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Postretirement Benefit Plans

Postretirement Benefit Plans. Based on a June 2011 amendment to IAS 19 , “Employee Benefits.”. . . Strategic Accounting. PENSION PLANS.  Pension plans provide income to individuals during their retirement years.

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Postretirement Benefit Plans

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  1. Postretirement Benefit Plans Based on a June 2011 amendment to IAS 19, “Employee Benefits.”. . Strategic Accounting

  2. 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.

  3. TYPES OF PENSION PLANS Defined contribution pension plans promise fixed annual contributions to a pension fund (say, 10% of the employees' pay). The employee chooses (from designated options) where funds are invested – usually stocks or fixed-income securities. Retirement pay depends on the size of the fund at retirement. Defined benefit pension plans promise fixed retirement benefits “defined” by a designated formula. Typically, the pension formula bases retirement pay on the employees' (a) years of service, (b) annual compensation [often final pay or an average for the last few years], and sometimes (c) age. Employers are responsible for ensuring that sufficient funds are available to provide promised benefits.

  4. Defined Contribution Plans 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.

  5. 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.

  6. DEFINED BENEFIT PENSION PLANS 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 40 years of service, with a final salary of $100,000, would be: 1 1/2 % x 40 years x $100,000 = $60,000

  7. PENSION OBLIGATION Defined benefit obligation (DBO) – The actuary's estimate of the total retirement benefits (at their discounted present value) earned so far by employees, applying the pension formula to estimated future compensation levels. called Projected benefit obligation (PBO) under U.S. GAAP

  8. DEFINED BENEFIT OBLIGATION Jessica Farrow was hired by Global Communications in 2002. The company has a defined benefit pension plan that specifies annual retirement benefits equal to: 1.5% x service years x final year’s salary Farrow is expected to retire in 2041 after 40 years 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. What is the company’s Defined benefit obligation with respect to Jessica Farrow?

  9. DEFINED BENEFIT OBLIGATION Steps to calculate the defined benefit obligation: 1. Use the pension formula (including a projection of future salary levels) to determine the retirement benefits. 2. Find the present value of the retirement benefits as of the retirement date. 3. Find the present value of retirement benefits as of the current date.

  10. DBO IN 2011  present value [n=30, i=6%]  actuary estimates employee has of retirement benefits at 2011 is earned (as of 2011) retirement benefits of $688,195 x .17411 = 1.5% x 10 years x $400,000 = $119,822$60,000 per year 2002 2011 2041 2061 ____________________________________________________________ 10 years 30 years 20 years Service period Retirement  present value [n=20, i=6%] of the retirement annuity at the retirement date is $60,000 x 11.46992 =$688,195 This is the DBO

  11. If the actuary’s estimate of the final salary hasn’t changed, the DBO at the end of 2012 would be $139,715:

  12. DBO IN 2012  actuary estimates employee has earned (as of 2012) retirement benefits of 1.5% x 11 years x $400,000 = $66,000 per year 2002 2012 2041 2061 ____________________________________________________________ 11 years29 years 20 years Service period Retirement  present value [n=20, i=6%] of the retirement annuity at the retirement date is $66,000 x 11.46992 =$757,015 2011 10 years 30 years

  13. DBO IN 2012  present value [n=29, i=6%]  actuary estimates employee has of retirement benefits at 2012 is earned (as of 2012) retirement benefits of $757,015 x .18456 = 1.5% x 11 years x $400,000 = $139,822$66,000 per year 2002 2012 2041 2061 ____________________________________________________________ 11 years29 years 20 years Service period Retirement  present value [n=20, i=6%] of the retirement annuity at the retirement date is $66,000 x 11.46992 =$757,015

  14. Changes in the DBO Notice that the DBO increased during 2012 from $119,822 to $139,715 for two reasons: 1. One more service year is included in the pension formula calculation. 2. The employee is one year closer to retirement, causing the present value of benefits to increase due to the time value of future benefits.

  15. HOW THE DBO CHANGED IN 2012 DBO at the beginning of 2012 (end of 2011) $119,822 Service cost: (1.5 x 1 yr. x $400,000) x 11.46992 x .18456 12,701 annual retirement benefits to discount to discount from 2012 service to 2041 * to 2012 ** Interest cost: $119,822 x 6% 7,189 DBO at the end of 2012 $139,712 * present value of an ordinary annuity of $1: n=20, i=6% ** present value of $1: n=29, i=6%

  16. Defined Benefit Obligation

  17. Defined Benefit Obligation Service cost is the increase in the DBO attributable to employee service performed during the period.

  18. Defined Benefit Obligation Past service costis the increase in the DBO from using a new, more generous pension formula to determine the pension obligation for prior years.

  19. Past Service Cost Assume the formula’s salary percentage is increased in 2012 from 1.5% to 1.7%: 1.7% x Service years x Final year’s salary [Revised Pension Formula] The increase in the DBO attributable to making a plan amendment retroactive is referred to as past service cost.

  20. Past Service Cost DBO Without Amendment DBO With Amendment 1.5 x 10 years x $400,000 = $60,000 1.7 x 10 years x $400,000 = $68,000  $60,000 x 11.46992 = $688,195 $68,000 x 11.46992 = $779,955 $688,195 x .17411 = $119,822$779,955 x .17411 = $135,798 $15,976Prior service cost

  21. Pension Obligation Interest cost is the high quality bond rate times the DBO during the period.

  22. Defined Benefit Obligation Remeasuement Loss or gain is the increase or decrease in the DBO from a change in an assumption used to calculated the DBO.

  23. REMEASUREMENT GAIN OR LOSS  Many estimates are needed to derive the DBO. When one or more of these estimates requires revision, the estimate of the DBO also will require revision. The resulting decrease or increase in the DBO is referred to as a remeasurement gain or loss, respectively.

  24. REMEASUREMENT GAIN OR LOSS Assume the estimate of Farrow’s final salary should be increased by 5% to $420,000. This would affect the estimate of the DBO as follows: DBO Without DBO With Revised Estimate Revised Estimate 1.7 x 12 years x $400,000 = $81,600 1.7 x 12 years x $420,000 = $85,680  $81,600 x 11.46992 = $935,945 $85,680 x 11.46992 = $982,743  $935,945 x .19563 = $183,099$982,743 x .19563 = $192,254 $9,155 Loss on DBO

  25. GAIN OR LOSS ON THE PBO Assume the estimate of Farrow’s final salary should be increased by 5% to $420,000. This would affect the estimate of the DBO as follows: DBO Without PBO With Revised Estimate Revised Estimate 1.7 x 12 years x $400,000 = $81,600 1.7 x 12 years x $420,000 = $85,680  $81,600 x 11.46992 = $935,945 $85,680 x 11.46992 = $982,743  $935,945 x .19563 = $183,099$982,743 x .19563 = $192,254 $9,155 Loss on PBO

  26. Pension Obligation Retiree benefits paidare payments to retired employees.

  27. ILLUSTRATION EXPANDED TO THE ENTIRE EMPLOYEE POOL ($ in millions) DBO at the beginning of 2013 (amount assumed) $400 Service cost, 2013(amount assumed) 41 Interest cost: $400 x 6% 24 Loss (gain) on DBO(amount assumed) 23 Less: Retiree benefits paid(amount assumed) (38) DBO at the end of 2013 $450

  28. Interest Rate We use the rate for “high grade corporate bonds” to determine the interest cost on the defined benefit obligation. We also use that same rate to determine the interest income on the plan assets. In fact, we multiply that rate, say 6%, times the net difference between the DBO and plan assets and report the net interest cost/income in the profit and loss statement: Net interest cost (6% x [$400 – 300])6 Plan assets (6% x $300: interest income)18 DBO (6%x $400: interest cost) 24

  29. Interest Rate • We use the rate for “high grade corporate bonds” to determine the interest cost on the defined benefit obligation. • We also use that same rate to determine the interest income on the plan assets. • In fact, we multiply that rate, say 6%, times the net difference between the DBO and plan assets and report the net interest cost/income in the profit and loss statement: • ($ in millions) • Net interest cost (6% x [$400 – 300])6 • Plan assets (6% x $300: interest income)18 • DBO (6%x $400: interest cost) 24 • When the actual return ($30M in this situation) is more or less than the interest income, the difference ($12M) is a Remeasurement gain or loss. Like other remeasurement gains and losses this is reported as OCI in the statement of comprehensive income.

  30. PENSION PLAN ASSETS Global Communications funds its defined benefit pension plan by contributing each year the year’s service cost plus a portion of the Past service cost. 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 rate of return in 2013 was 10%. Retirement benefits of $38 million were paid at the end of 2013 to retired employees. What is the value of the company’s pension plan assets at the end of 2013? ($ in millions) Plan assets at the beginning of 2013 $300 Interest income (6% x $300) 18 Remeasurement gain on plan assets($30 – 18) 12 Cash contributions (amount assumed) 48 Less: Retiree benefits paid (amount assumed) (38) Plan assets at the end of 2013 $340

  31. OVERFUNDED Market value of plan assets exceeds the obligation to pay benefits, the DBO. Funded Status of Pension Plan UNDERFUNDED Market value of plan assets is below the obligation to pay benefits, the DBO.

  32. This amount is reported in the balance sheet as a Net Pension Deficit or Net Pension Surplus. Funded Status of Pension Plan Defined Benefit Obligation (DBO) - Plan Assets at Fair Value Underfunded / Overfunded Status

  33. REPORTING THE FUNDED STATUS OF THE PENSION PLAN ($ in millions)2013 2012 Defined benefit obligation (DBO) $450 $400 Fair value of plan assets 340 300 Underfunded status $110 $100 Because the plan is underfunded, Global reports a Net pension deficit of $110 million in its 2013 balance sheet and $100 million in 2012. If the plan becomes overfunded in the future, Global will report a net pension surplus instead.

  34. Balance Sheet

  35. NET PENSION COST PLAN ($ in millions)DBO ASSETS Beginning of 2013 $400†Beginning of 2013 $300 Service cost 41 Interest on plan assets, 6% 18 Past service cost 0† Remeasurement gain, $30 – 18 12 Interest cost, 6% 24 Cash contributions 48 Remeasurements 23 Less: Retiree benefits (38) Less: Retiree benefits (38) End of 2013 $450End of 2013 $340 †A past service cost of $60 million was incurred at the beginning of the previous year (2012) due to a plan amendment increasing the DBO. It also was reported along with last year’s service cost in profit and loss.

  36. CLASSIFYING COMPONENTS OF NET PENSION COST

  37. CLASSIFYING COMPONENTS OF NET PENSION COST Profit & Loss (Income Statement): Service cost: ($ in millions)  Service cost—2013 $41  Past service cost  0* $41 Net interest cost/income:  Net interest cost (6% x [$400 – 300]) 6 $47 Other Comprehensive Income (OCI): Remeasurement cost:  Loss (gain) on DBO—change in salary estimate $23  Loss (gain) on plan assets: (10% – 6%) x $300 (12) 11   Net pension cost $58 *Last year (2012) this amount was $60 million.

  38. REPORTING THE COMPONENTS OF NET PENSION COST Revenue   $xxx Operating expenses (including $41 pension service cost) (xx) Finance costs (including $6 net interest cost) xx Profit before tax    $xxx Tax expense   (xx) Profit from continuing operations  $xxx Gains or losses on discontinued operations xx Net income   $xxx Other comprehensive income: Remeasurement loss arising from change in pension assumption $23 Remeasurement gain on plan assets (12) Comprehensive income   $xxx * 6% x ($400 – 300) = $6M net interest cost (assuming 6% is the high quality corporate bond rate)

  39. RECORDING PENSION COSTS To Record Net Pension Cost($ in millions) Service cost 41 DBO (2013 service cost) 41 DBO (Past service cost) 0 Net interest cost (6% x [$400 – 300]) 6 Plan assets (6% x $300: interest income) 18  DBO (6% x $400: interest cost) 24 Plan assets (actual return in excess of 6%) 12  Remeasurement gain–OCI ([10% – 6%] x $300) 12 Remeasurement loss from change in assumption–OCI23  DBO (change in future salary estimate) 23 * Notice that Plan assets increase by $18 plus $12, or $30, which is the actual return on plan assets during the year.

  40. RECORDING FUNDING OF ASSETS AND PAYMENT OF BENEFITS To Record Funding: ($ in millions) Plan assets 48 Cash (contributions to plan assets) 48 To Record Payment of Benefits: DBO 38 Plan assets 38

  41. U.S. GAAP-Past Service Cost Under U.S. GAAP, past service cost (called prior service cost under U.S. GAAP) is included among OCI items in the statement of comprehensive income and thus subsequently becomes part of AOCI where it is amortized over the average remaining service period. [UnderIASNo. 19, past service cost is combined with service cost and reported in the income statement.]

  42. AMORTIZATION OF PAST SERVICE COST U.S. GAAP By the straight-line method, past service cost is recognized over the average remaining service life of the active employee group. ($ in millions) Service cost $41 Interest cost 24 Expected return on plan assets ($30 actual, less $3 gain) (27) Amortization of Past service cost-AOCI ($60 million ÷ 15 years) 4 Amortization of net loss-AOCI 1 Pension expense $43

  43. U.S. GAAP-Gains and losses Under both U.S. GAAP and IFRS we report gains and losses among OCI items in the statement of comprehensive income, thus subsequently become part of AOCI. • Under U.S. GAAP the gains and losses are subsequently amortized to expense and recycled from other comprehensive income when the accumulated net gain or net loss exceeds a10% threshold. [Under IFRS the gains and losses remain in AOCI and are not subsequently amortized recycled from other comprehensive income.]

  44. U.S. GAAP-Gains and losses The gain or loss on plan assets under GAAP is the difference in the actual and expected return, where the expected return is different from company to company and usually different from the interest rate used to determine the interest cost. Under IFRS, we use the same rate (the rate for “high grade corporate bonds”) for both the interest cost on the DBO and the interest income on the plan assets. In fact, under IFRS, we multiply that rate times the net difference between the DBO and plan assets and report the net interest cost/income. .

  45. Gains and Losses U.S. GAAP

  46. Actual Return Expected Return 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 U.S. GAAP

  47. Corridor Amount U.S. GAAP DBO 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.

  48. AMORTIZATION OF NET LOSS U.S. GAAP Assume a net loss-AOCI of $55 million at the beginning of 2013. The DBO and plan assets are $400 million and $300 million, respectively, at that time. ($ in millions) Net loss (previous losses exceeded previous gains) $55 10% of $400 ($400 is greater than $300) 40 Excess at the beginning of the year $15 Average remaining service period ÷ 15 yrs Amount amortized to 2013 pension expense $ 1

  49. Record Gains and Losses U.S. GAAP ($ in millions) Loss–OCI (from change in assumptions) 23 DBO 23 Plan assets 3 Gain–OCI (from actual return exceeding expected return) 3  Gains and losses are not immediately included in pension expense and net income.  Instead, they are reported in the statement of comprehensive income. 23­DBO 3­Less: plan assets 20 ­Net pension liability  The gain and loss become part of the net loss–AOCI account which is a shareholders’ equity account. Note: Any new Past service cost should it arise, is reported as Other comprehensive income in the same manner.

  50. U.S. GAAP – Reporting Net Pension Cost Under U.S. GAAP, the various components of pension expense are reported in the income statement as a single net amount: pension expense. Under IFRS the various components of pension expense are not reported as a single net amount. Instead, we separately report (a) service cost (including past service cost) and (b) net interest cost/income in profit and loss, and (c) remeasurement gains and losses as OCI.

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