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Actuarial 101 and 201 Accounting Concepts for Retirement and Welfare Plans. Pension Accounting Basics. Instructors: Joe Rankin David Grubb Vince Mannino. Goals Overview accounting issues for pensions and other postretirement benefit plans.

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Actuarial 101 and 201Accounting Concepts for Retirement and Welfare Plans

Pension Accounting Basics

Instructors: Joe Rankin

David Grubb

Vince Mannino


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Goals

  • Overview accounting issuesfor pensions and other postretirement benefit plans.

  • Distinguish between defined contribution and defined benefit plans and welfare benefit plans.

  • Define very high level accounting concepts; discuss why the concepts are important; elaborate on the most difficult itemsto understand.

    Non-Goals

  • Make Actuarial Science fun and exciting!

  • Differentiate between the funding, termination, tax and accounting issues.

  • Understand the difference between the plan perspective and the company perspective.


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Historical Perspective

FASB

  • It was difficult to compare the pension accounting of one company to that of another.

  • Broad use of varying assumptions and methods.

  • The first pension accounting statement, Statement No. 35, Accounting and Reporting by Defined Benefit Pension Plans provided for reporting annual financial statements of defined benefit plans at the plan level (as opposed to the employer level).


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Historical Perspective

FASB – FAS 87

  • The second pension statement, FAS 87, Employers' Accounting for Pensions, issued in the mid-1980s, is more conceptually “reliable” in that it matches the future benefits due the employee to the period in which the obligation is incurred.


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Historical Perspective

FASB – FAS 88

  • Also issued in the mid 1980s was FAS 88, Employers' Accounting for Settlements and Curtailments of Defined Benefit Plans and for Termination Benefits which prescribes an employer's accounting for defined benefit pension plans that are curtailed (i.e., ended) and/or settled.

  • FAS 106 deals with retiree medical and health plans; previously employers accounted for the costs associated with postretirement benefits on a pay-as-you-go basis.


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Historical Perspective

FASB – FAS 132

  • FAS 132 standardized the disclosures required for pension and other postretirement benefits, required some additional information from employers, and eliminated disclosures that were no longer considered useful.


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Historical Perspective

FASB – FAS 158

  • Financial Accounting Standards No. 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans; this standard generally requires plan assets and liabilities to be measured as of the same date as the other assets and liabilities appearing on the balance sheet.


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Retirement Plans

Defined Contribution Plans

  • For purposes of pension accounting, a defined contribution plan is one in which the sponsor (i.e., the employer) provides pension benefits to employees in return for services rendered.

  • The plan provides an individual account for each participant.

  • Defined contribution retirement plans include:

    • 401(k) plans

    • Simplified Employee Pension plans - SEPs

    • Savings Incentive Match Plan for Employees - SIMPLEs

    • KEOGH (HR10) plans

  • Individual participant bears the investment risk in most account balance plans.


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    Retirement Plans

    Defined Benefit Plans

    • Under a defined benefit plan, the responsibility of providing for the employee in retirement remains with the employer.

    • Employer bears the investment risk in most defined benefit plans.


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    Retirement Plans

    Defined Benefit Plans

    Benefit Formulas

    The employer agrees to provide the employee upon retirement a benefit amount based on a “definitely determinable” benefit formula. Typically, the formula is one of three general types:

    (1) Flat-Benefit Formula

    • The flat-benefit formula pays a flat dollar amount for each year of service recognized under the plan. For example, an employee's monthly pension might equal $20 multiplied by the number of years of service. An employee under this plan who worked for 25 years would receive a monthly benefit of $500 ($20 × 25 years).


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    Retirement Plans

    Defined Benefit Plans

    Benefit Formulas

    (2) Career-Average Formulas

    • There are variations of career-average formulas. Generally, the employee earns a percentage of the pay recognized for plan purposes in each year he or she is a plan participant. For example, assume that the benefit is based on 2% of an employee's career average monthly salary of $5,000 and that the employee has 25 years of service. The monthly benefit would be $2,500 (.02 × $5,000 × 25 years).


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    Retirement Plans

    Defined Benefit Plans

    Benefit Formulas

    (3) Final-Pay Formulas

    • Under final-pay formulas, benefits are based on a predetermined percentage of the average earnings of the employee for a stated period preceding retirement multiplied by the employee's years of service.

    • For example, assume that the plan uses 2% formula and that an employee's average monthly salary over the specified three-year period was $10,000 and that he or she worked for 25 years. The employee would receive monthly benefits of $5,000 in retirement (.02 × $10,000 × 25 years).


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    Retirement Plans

    Defined Benefit Plans

    Cash Balance Plans

    • Although classified as a defined benefit plan, a cash-balance pension plan is really a hybrid sharing many of the characteristics of a defined contribution plan; under a cash-balance plan, the employer contributes a percentage of an employee's salary (e.g., 2%- 5%) to the pension trust based on a formula. In addition, the employer guarantees the employee a certain rate of return on the funds invested.


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    Retirement Plans

    Defined Benefit Plans

    Cash Balance Plans

    • The FASB is concerned with the classification of the cash-balance plan since it contains features of both the defined benefit and defined contribution plans. In FAS 87, the FASB commented as follows:

      A pension plan having characteristics of both a defined benefit plan and a defined contribution plan requires careful analysis. If the substance of the plan is to provide a defined benefit as may be the case with some "target benefit" plans the accounting requirements shall be determined in accordance with the provisions of this statement [FAS 87] applicable to a defined benefit plan and the disclosure requirement shall be determined in accordance with the provisions of paragraphs 5 and 8 of statement 132(R).


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    Retirement Plans

    Defined Benefit Plans

    Single-Employer, Multi-Employer, and Multiple-Employer Plans

    • FAS 87 primarily addresses single-employer plans. Single-employer plans are generally maintained by one employer, although the term also describes plans maintained by related parties such as a parent company and its subsidiaries.

    • Employers may maintain more than one pension plan for employees or particular categories of employees.


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    Retirement Plans

    Defined Benefit Plans

    Multi-Employer Plans

    • Under a multi-employer plan, two or more unrelated employers contribute assets to one pension plan generally administered by a board of trustees.

    • A multi-employer plan usually results from a collective-bargaining agreement. As such, the board of trustees is often composed of representatives of management and unions.

    • Multi-employer plans are frequently referred to as joint trusts or union plans.


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    Retirement Plans

    PANEL DISCUSSION – Multiemployer Plans

    The FASB has issues an exposure draft on an “Employer’s Participation in a Multiemployer plan”.

    • How do multiemployer plans work – both at the plan level and the employer accounting level?

    • What is the FASB exposure draft intending to accomplish?

    • What is the likely impact on employer’s that participate in Multiemployer plans?


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    Actuarial 101 and 201Accounting Concepts for Retirement and Welfare Plans

    FAS 87

    Employers' Accounting for Pensions


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    FAS 87

    Although FAS 87 superseded all previous standards for employers' accounting for pensions, it did retain three fundamental features of preceding official pronouncements on pension accounting:

    • delayed recognition of certain events,

    • net cost, and

    • offsetting liabilities and assets.


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    FAS 87

    Features Retained from Previous Pronouncements

    1. Delayed Recognition

    • Rather than being expensed as they occur, certain changes in the pension obligation and plan assets are recognized gradually and systematically in net periodic pension cost over subsequent periods.

    • For example, assume an employer amends a current pension plan to increase the benefits paid to employees in retirement by five percent per year. Rather than charge this increase in benefit obligation to pension expense for the period, the employer gradually amortizes the expense over the average remaining service years of employees covered by the amended plan.


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    FAS 87

    Features Retained from Previous Pronouncements

    2. Net Cost

    • "Net periodic pension cost" refers to the amount recognized in an employer's financial statements as the cost of a pension plan for a period.

    • Net periodic pension cost has several components. Some of these components, such as service and interest costs, add to a company's net periodic pension expense. Others, such as the expected return on plan assets, reduce these expenses.


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    FAS 87

    Features Retained from Previous Pronouncements

    3. Offsetting Liabilities and Assets

    • Neither the assets contributed by the employer to the pension plan nor the full pension liability appears on the balance sheet. Rather, it is the difference between total employer contributions to the plan (plan assets) and the pension obligation (liability) that is included in the balance sheet.

    • If cumulative contributions exceed the pension obligation, the excess appears in an asset account, prepaid pension cost. If cumulative costs exceed cumulative contributions, the difference appears in a liability account, accrued pension cost.


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    FAS 87

    1. Basic Liability Terminology

    • Vested Benefit Obligation (VBO)

    • Accumulated Benefit Obligation (ABO)

    • Projected Benefit Obligation (PBO)


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    FAS 87

    2. Determining the Discount Rate

    • The higher the discount rate used, the lower the pension obligation. The lower the discount rate used, the larger the pension obligation.



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    FAS 87

    2. Determining the Discount Rate

    • The objective of selecting assumed discount rates is to measure the single amount that, if invested at the measurement date in a portfolio of high-quality debt instruments, would provide the necessary future cash flows to pay the accumulated benefits when due.

    • Discount rates are determined using current market conditions.


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    FAS 87

    2. Determining the Discount Rate

    • http://www.soa.org/professional-interests/pension/resources/pen-resources-pension.aspx


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    FAS 87

    PANEL DISCUSSION – Discount Assumption

    • What role does the discount rate play in determining liabilities?

    • Why is the discount rate an important consideration in today’s economic environment?

    • What other factors and assumptions require careful review? Why?

    • What is the role of auditor in reviewing the assumptions set by the actuary?


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    FAS 87

    3. Plan Assets

    • Generally, fair value is required to be used for FAS 87 underERISA. This method applies to investments held in the plan under FAS 87 as well.


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    FAS 87

    4. Measurement Date

    • Pension obligations need to be measured as of the date of the financial statements. Prior to FAS 158, the employer may select a date that is not more than three months prior to that date if used consistently from year to year.


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    FAS 87

    Pension Benefit Obligation (PBO)

    Projected Benefit Obligation (BOY)

      + Service cost

      + Interest cost

    – Benefits paid to retirees

      = Projected Benefit Obligation (EOY)


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    FAS 87

    Net Periodic Pension Cost

    • The amount recognized in an employer’s financial statements as the cost of a pension plan for a period.

    • Components of net periodic pension cost are service cost, interest cost, actual return on plan assets, gain or loss, amortization of prior service cost or credit, and amortization of the transition asset or obligation existing at the date of initial application of … Statement 87.

  • The basic formula is:

    Service cost + Interest cost – Expected return on plans assets


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    FAS 87

    Net Periodic Pension Cost

    a. Service Cost – Service cost is defined by FAS 87 as "the actuarial present value of benefits attributed by the pension benefit formula to services rendered by employees during that period.”

    b. Interest Cost – Interest cost recognizes the effect of the passage of another year on the pension obligation; it is a measure of the PBO multiplied by the assumed discount rates.

    c. Expected Return on Plan Assets – An expected rather than the actual return on plan assets.


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    FAS 87

    Net Periodic Pension Cost

    Additional Elements of Net Periodic Pension Cost

    • Prior Service Costs – FAS 87 allows for the gradual, amortized recognition of the amended benefits.

    • Unrecognized Actuarial Losses and Gains – gains and losses – resulting from experience different than assumed.


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    FAS 87

    Additional Issues

    1. Business Combinations

    2. Non-U.S. Pension Plans – (IAS 19 is the standards that governs most such arrangements.)

    3. Pension Accounting for Smaller Employees

    4. Insurance Companies Fail to Provide Annuity Benefits


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    FAS 87

    PANEL DISCUSSION – Pension Protection Act

    The Pension Protection Act of 2006 has had far reaching impact on employer funding of defined benefit pension plans.

    • How does the more aggressive funding requirement impact accounting?

    • How has subsequent legislation such as Pension Relief Act of 2010 impacted plan funding?


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    Actuarial 101 and 201Accounting Concepts for Retirement and Welfare Plans

    FAS 88

    Settlements and Curtailment of Benefits


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    FAS 88

    Settlements and Curtailment of Benefits

    • For purposes of this FAS 88, a curtailment is an event that significantly reduces the expected years of future service of present employees or eliminates for a significant number of employees the accrual of defined benefits for some or all of their future services. Curtailments include:

      • Termination of employees' services earlier than expected, which may or may not involve closing a facility or discontinuing a segment of a business.

      • Termination or suspension of a plan so that employees do not earn additional defined benefits for future services. In the latter situation, future service may be counted toward vesting of benefits accumulated based on past service.

        [FASB Statement No. 88]


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    FAS 88

    Settlements and Curtailment of Benefits

    • FAS 88 specifies when these previously unrecognized amounts are to be recognized in earnings and as adjustments to assets and liabilities.

    • Examples of a settlement or curtailment include:

      • Pension plan is terminated AND obligations are settled by the purchase of annuities.

      • Defined benefit plan is “frozen” where benefits no longer accrue to any participant – “hard freeze”.

      • Defined benefit plan is “frozen” where benefits no longer accrue to any new participant but some participants still accrue benefits – “soft freeze”.

      • A defined benefit plan exists where a substantial number of employees are terminated.


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    FAS 88

    Settlements and Curtailment of Benefits

    Settlements

    • A settlement is defined as a transaction that

      (a) is an irrevocable action,

      (b) relieves the employer (or the plan) of primary responsibility for a pension benefit obligation, AND

      (c) eliminates significant risks related to the obligation and the assets used to effect the settlement.

      [FASB Statement No. 88]


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    FAS 88

    Termination and Curtailment of Benefits

    Curtailments

    • FAS 88 defines a curtailment as "an event that significantly reduces the expected years of future service of current employees or eliminates for a significant number of employees the accrual of defined benefits for some or all of their future services.“ [FASB Statement No. 88]

    • This event may be the result of termination of the employee's services or of the defined benefit plan. Not all curtailments are settlements.


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    FAS 88

    Termination and Curtailment of Benefits

    Asset Reversion

    • In plans where plan assets exceed pension obligations, the excess assets MAY revert back to the employer.


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    FAS 88

    PANEL DISCUSSION – Curtailments

    • In what particular situations must settlement accounting used?

    • Generally, what is the impact of settlement accounting ?

    • Do different types of benefit “freezes” treated differently for settlement account?


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    Actuarial 101 and 201Accounting Concepts for Retirement and Welfare Plans

    FAS 106

    Accounting for Post-Employment Benefits Other Than Pensions

    Instructor: Joe Rankin


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    FAS 106 – Financial Accounting Standards FASB statement No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions.

    Benefits Reported Under FAS 106

    • Postretirement benefits include but are not limited to:

      • post-retirement health care

      • life insurance provided outside a pension plan

    • Other welfare benefits such as day care and tuition assistance.

      This kind of obligation may or may not be funded.


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    FAS 106 – Financial Accounting Standards FASB statement No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions.

    Benefits Reported Under FAS 106

    • FAS 106 applies to any arrangement – written or unwritten – that is in substance a post-retirement benefit plan.

      Benefits Not Reported Under FAS 106

    • FAS 106 does not apply to employer pension plans or life insurance benefits or other ancillary benefits provided through a pension plan.


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    FAS 106 – Financial Accounting Standards FASB statement No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions.

    … objectives in issuing this Statement are to improve employers' financial reporting for postretirement benefits in the following manner:

    • To enhance the relevance and representational faithfulness of the employer's reported results of operations by recognizing net periodic postretirement benefit cost as employees render the services necessary to earn their postretirement benefits.

    • To enhance the relevance and representational faithfulness of the employer's statement of financial position by including a measure of the obligation to provide post retirement benefits based on a mutual understanding between the employer and its employees of the terms of the underlying plan.


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    FAS 106 – Financial Accounting Standards FASB statement No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions.

    • To enhance the ability of users of the employer's financial statements to understand the extent and effects of the employer's undertaking to provide postretirement benefits to its employees by disclosing relevant information about the obligation and cost of the post retirement benefit plan and how those amounts are measured.

    • To improve the understandability and comparability of amounts reported by requiring employers with similar plans to use the same method to measure their accumulated postretirement benefit obligations and the related costs of the postretirement benefits.

      [FASB Statement No. 106]


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    FAS 106 – Financial Accounting Standards FASB statement No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions.


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    FAS 106 – Financial Accounting Standards FASB statement No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions.

    Basic Elements of Accounting for Postretirement Benefits Other Than Pensions

    Postretirement Benefit Obligation

    • The expected postretirement benefit obligation (EPBO) is "the actuarial present value as of a particular date of all non-pension benefits expected to be paid to an employee, the employee's spouse and eligible dependents based on the terms of the benefit plans.“


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    FAS 106 – Financial Accounting Standards FASB statement No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions.

    Basic Elements of Accounting for Postretirement Benefits Other Than Pensions

    Plan Assets

    • Similar to pension plans, plan assets for other postretirement benefits are defined by FAS 106 as "assets - usually stocks, bonds and other investments ... that have been segregated and restricted (usually in a trust) to be used for postretirement benefits.“ Assets are measured at fair value.


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    FAS 106 – Financial Accounting Standards FASB statement No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions.

    Basic Elements of Accounting for Postretirement Benefits Other Than Pensions

    Net Periodic Postretirement Benefit Cost

    The components of net periodic postretirement benefit cost are identical to those of net pension cost. The components consist of the following items:

    (a) service cost,

    (b) interest cost,

    (c) actual return on plan assets,


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    FAS 106 – Financial Accounting Standards FASB statement No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions.

    Basic Elements of Accounting for Postretirement Benefits Other Than Pensions

    Net Periodic Postretirement Benefit Cost (Cont.)

    The components of net periodic postretirement benefit cost are identical to those of net pension cost. The components consist of the following items:

    (d) amortization of unrecognized prior service cost,

    (e) amortization of unrecognized gain or loss on changes in actuarial assumptions and the difference between the actual and expected return on plan assets, and

    (f) amortization of the unrecognized transition obligation or asset.


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    FAS 106 – Financial Accounting Standards FASB statement No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions.

    Basic Elements of Accounting for Postretirement Benefits Other Than Pensions

    Net Periodic Postretirement Benefit Cost (Cont.)

    Service Cost – Actuarial present value of EPBO allocated to a period of employee service during attribution period.


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    FAS 106 – Financial Accounting Standards FASB statement No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions.

    Basic Elements of Accounting for Postretirement Benefits Other Than Pensions

    Net Periodic Postretirement Benefit Cost (Cont.)

    Interest Cost – Accrual of interest, to reflect effects of passage of time on the accumulated benefit obligation.


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    FAS 106 – Financial Accounting Standards FASB statement No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions.

    Basic Elements of Accounting for Postretirement Benefits Other Than Pensions

    Net Periodic Postretirement Benefit Cost (Cont.)

    Return on plan assets – Actual return based on fair value (FV) of plan assets at beginning and end of period, adjusted for contributions and benefit payments.

    Due to the absence of a tax incentive and the lack of federal funding requirements, postretirement benefit plans are typically unfunded or underfunded.


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    FAS 106 – Financial Accounting Standards FASB statement No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions.

    Basic Elements of Accounting for Postretirement Benefits Other Than Pensions

    Net Periodic Postretirement Benefit Cost (Cont.)

    Amortization of Unrecognized Prior Service Cost (PSC) – Plan initiations and amendments treated as retroactive except for plan initiations that specifically provide new benefits only in exchange for future service. Amortization is generally delayed; equal amount assigned to each future year of service to full eligibility date of each active plan participant.


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    FAS 106 – Financial Accounting Standards FASB statement No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions.

    Accounting for Settlement, Curtailment and Termination Benefits for a Postretirement Benefit Plan

    Besides instructing employers how to account for post-retirement benefits on an on-going basis, FAS 106 prescribes the accounting for settlements, curtailments and termination of benefits under a post-retirement benefit plan.


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    FAS 106 – Financial Accounting Standards FASB statement No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions.

    Accounting for Settlement, Curtailment and Termination Benefits for a Postretirement Benefit Plan

    1. Settlements

    In order for a transaction to qualify as a settlement of a postretirement benefit obligation, the following events must occur. First, the action must be irrevocable. Second, the employer of the plan no longer has the primary responsibility for the postretirement benefit obligation. Finally, the settlement must eliminate any significant risks related to the employer's obligation.


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    FAS 106 – Financial Accounting Standards FASB statement No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions.

    Accounting for Settlement, Curtailment and Termination Benefits for a Postretirement Benefit Plan

    1. Settlements

    FAS 106 provides the following transactions as examples of a settlement: (1) lump-sum cash payments to plan participants in exchange for their rights to receive specified postretirement benefits, and (2) the purchase of long-term nonparticipating insurance contracts for the postretirement benefit obligation for plan participants.


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    FAS 106 – Financial Accounting Standards FASB statement No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions.

    Accounting for Settlement, Curtailment and Termination Benefits for a Postretirement Benefit Plan

    2. Plan Curtailment

    A plan curtailment is "an event that significantly reduces the expected years of future service of active plan participants or eliminates the accrual of defined benefits for some or all of the future services of a significant number of active plan participants.“

    Examples of plan curtailments are suspensions of plans and termination of employees' services due to plant closures. As with defined benefit pension plans, settlements and curtailments can occur separately or jointly.


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    FAS 106 – Financial Accounting Standards FASB statement No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions.

    Accounting for Settlement, Curtailment and Termination Benefits for a Postretirement Benefit Plan

    3. Termination Benefits

    Temporary benefits that an employer offers employees whose employment soon will be terminated are accounted for similarly to that described above for pensions.

    When an employer offers special postretirement termination benefits to an employee, a liability and a loss are recognized at the time the employee accepts the offer provided the amount can be reasonably estimated.


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    FAS 106 – Financial Accounting Standards FASB statement No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions.

    Accounting for Settlement, Curtailment and Termination Benefits for a Postretirement Benefit Plan

    3. Termination Benefits

    In situations where the employer provides contractual termination benefits, the liability and loss are recognized when termination is probable and the amount can be reasonably estimated. A situation involving special or contractual termination benefits may also result in a curtailment.


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    FAS 106 – Financial Accounting Standards FASB statement No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions.

    Additional Issues

    • Rate-Regulated Enterprises

    • Plan Assets under FASB Statement No. 106

    • Transfer of Excess Pension Assets to a Retiree Health Care Benefits Account

    • Multi-Employer and Multiple Employer Plans

    • Business Combinations

    • Defined Contribution Plans