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Pensions and Other Postretirement Benefits. 17. I agree to make payments into a fund for future retirement benefits for employee services. I am the employee for whom the pension plan provides benefits. Nature of Pension Plans. Sponsor. Participant. Nature of Pension Plans.

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Nature of pension plans

I agree to make payments into a fund for future retirement benefits for employee services.

I am the employee for whom the pension plan provides benefits.

Nature of Pension Plans

Sponsor

Participant


Nature of pension plans1
Nature of Pension Plans benefits for employee services.

  • For a pension plan to qualify for special tax treatment 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 a trust.

  • Benefits must vest after a specified period of service.

  • Complies with timing and amount of contributions.


Nature of pension plans2

The right to receive earned pension benefits benefits for employee services.vest (vested benefits) when it is no longer contingent on continued employment.

Nature of Pension Plans


Learning objectives
Learning Objectives benefits for employee services.

Explain the fundamental differences between a defined contribution pension plan and a defined benefit pension plan.

LO1


Pensions and other postretirement benefits

Defined Contribution Plans benefits for employee services.

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.


Pensions and other postretirement benefits

Defined Benefit Pension Plans benefits for employee services.

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.


Defined benefit plan

Pension expense is measured by assigning pension benefits to periods of employee service as defined by the pension benefit formula.

Defined Benefit Plan

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


Pension expense an overview
Pension Expense – An Overview periods of employee service as defined by the


Learning objectives1
Learning Objectives periods of employee service as defined by the

Distinguish among the vested benefit obligation, the accumulated benefit obligation, and the projected benefit obligation.

LO2


Pension obligation
Pension Obligation periods of employee service as defined by the

Projected Benefit Obligation

Present value of additional benefits related to projected pay increases.

Accumulated Benefit Obligation

Present value of nonvested benefits at present pay levels.

Vested Benefit Obligation

Present value of benefits at present pay levels.

VBO

ABO

PBO


Learning objectives2
Learning Objectives periods of employee service as defined by the

Describe the five events that might change the balance of the PBO.

LO3


Projected benefit obligation
Projected Benefit Obligation periods of employee service as defined by the


Pension obligation1
Pension Obligation periods of employee service as defined by the

Service cost is the increase in the PBO attributable to employee service performed during the period.


Pension obligation2
Pension Obligation periods of employee service as defined by the

Interest cost is the interest on the PBO during the period.


Pension obligation3
Pension Obligation periods of employee service as defined by the

Prior service costeffects result from changes in the pension benefit formula or plan terms.


Pension obligation4
Pension Obligation periods of employee service as defined by the

Loss or gain on PBOresults from required revisions of estimates used to determine PBO.


Pension obligation5
Pension Obligation periods of employee service as defined by the

Retiree benefits paidare the result of paying benefits to retired employees.


Learning objectives3
Learning Objectives periods of employee service as defined by the

Explain how plan assets accumulate to provide retiree benefits and understand the role of the trustee in administering the fund.

LO4


Pension plan assets

Pension plan assets (like the PBO) are periods of employee service as defined by the notformally recognized on the balance sheet.

Atrusteemanages the pension plan assets.

Pension Plan Assets


Pension plan assets1

OVERFUNDED periods of employee service as defined by the

Market value of plan assets exceeds the actuarial present value of all benefits earned by participants.

Pension Plan Assets

UNDERFUNDED

Market value of plan assets is below the actuarial present value of all benefits earned by participants.


Learning objectives4
Learning Objectives periods of employee service as defined by the

Describe how pension expense is a composite of periodic changes that occur in both the pension obligation and the plan assets.

LO5


Pension expense

Pension expense is the periods of employee service as defined by the net cost of:

Service cost

Interest cost

Return on plan assets

Amortization of prior service costs

Gain or loss recognized.

Pension Expense


Defined benefit plan1
Defined Benefit Plan periods of employee service as defined by the

You go to work for Matrix, Inc. on 1/1/06. 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

× 1.5%

Annual retirement benefits

You are 25 years old when you start work and may 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:

$200,000

× 40

× 1.5%

$120,000

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.


Defined benefit plan2
Defined Benefit Plan periods of employee service as defined by the

At December 31, 2006, the end of your first year of service, the actuary must calculate the present value of the pension benefits earned by you during 2005. 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.


Defined benefit plan3
Defined Benefit Plan periods of employee service as defined by the

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


Defined benefit plan4
Defined Benefit Plan periods of employee service as defined by the

A reconciliation of the VBO, ABO and PBO would look like this:

VBO $ 32

Non-vested benefits 128

ABO $ 160

Adjustment for future salary 478

PBO $ 638

The adjustment for future salary of $478, is determine by the plan actuary. If you are the only employee at Matrix, the computations would be similar for future years. Let’s assume Matrix funds $500 of its pension costs with the plan trustee on December 31, 2006. The journal entry to record the pension costs and funding would be:

Pension expense 638

Accrued pension cost 138

Cash 500


Defined benefit plan5
Defined Benefit Plan periods of employee service as defined by the

Let’s look at an example for Matrix, Inc.


Defined benefit plan6

Actuaries have determined that Matrix, Inc. has service cost of $150,000 in 2006 and $155,000 in 2007.

We can begin the process of determining pension expense for the company.

Defined Benefit Plan


Service cost
Service Cost of $150,000 in 2006 and $155,000 in 2007.


Interest cost

Interest cost of $150,000 in 2006 and $155,000 in 2007.is the growth in PBO during a reporting period.

Interest cost is calculated as:

PBOBeg × Discount rate

Interest Cost


Interest cost1

Actuaries determined that Matrix, Inc. had PBO of $500,000 on 1/1/06, and $640,000 on 1/1/07.

The actuary uses a discount rate of 10%.

Interest Cost


Interest cost2
Interest Cost on 1/1/06, and $640,000 on 1/1/07.

2006: PBO 1/1/06 $500,000 × 10% = $50,000

2007: PBO 1/1/07 $640,000 × 10% = $64,000


Return on plan assets

Actual Return on 1/1/06, and $640,000 on 1/1/07.

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


Return on plan assets1
Return on Plan Assets on 1/1/06, and $640,000 on 1/1/07.

The plan trustee reports that plan assets were $450,000 on 1/1/06, and $600,000 on 1/1/07.

The trustee uses an expected return of 9% and the actual return is 10% in both years.


Return on plan assets2

2007 on 1/1/06, and $640,000 on 1/1/07.

2006

Return on Plan Assets


Return on plan assets3
Return on Plan Assets on 1/1/06, and $640,000 on 1/1/07.


Amortization of prior service cost

Prior service cost (PSC) on 1/1/06, and $640,000 on 1/1/07. results from plan amendments granting increased pension benefits for service rendered before the amendment.

PSC is the present value of the retroactive benefits, and increases PBO.

Amortization of Prior Service Cost


Amortization of prior service cost1

Benefits attributable to prior service are assumed to benefit future periods by:

Improving employee productivity.

Improving employee morale.

Reducing turnover.

Reducing demands for pay raises.

Amortization of Prior Service Cost


Amortization of prior service cost2

PSC is benefit future periods by:amortized over the remaining service period of those employees active at the date of the amendment who are expected to receive benefits under the plan.

If most of a plan’s participants are inactive, then amortize PSC over the participants’ remaining life expectancy.

Amortization of Prior Service Cost


Amortization of prior service cost3

Two approaches to amortizing PSC: benefit future periods by:

Straight-line method

Amortize PSC over the average remaining service period.

Service method

Amortize PSC by allocating equal amounts to each employee’s service years remaining.

Amortization of Prior Service Cost


Amortization of prior service cost4

Effective 1/1/07, Matrix, Inc. amends the retirement plan to provide increased benefits attributable to service performed before 1/1/03, for all active employees.

The present value of the increased benefits (PSC) at 1/1/07, is $60,000.

The average remaining service life of the active employee group is 12 years.

Amortization of Prior Service Cost


Amortization of prior service cost5
Amortization of Prior Service Cost provide increased benefits attributable to service performed before 1/1/03, for all active employees.

Since the amendment was not effective until the beginning of 2007, pension expense for 2006 is not affected.

2007: $60,000 PSC ÷ 12 = $5,000


Amortization of prior service cost6
Amortization of Prior Service Cost provide increased benefits attributable to service performed before 1/1/03, for all active employees.


Gains and losses
Gains and Losses provide increased benefits attributable to service performed before 1/1/03, for all active employees.


Corridor amount

Amortization is not required if the net unrecognized gain or loss at the beginning of the period is a minimum amount (corridor amount).

Corridor Amount


Corridor amount1
Corridor Amount loss at the beginning of the period is a minimum amount

PBO 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.


Gains and losses1

If the beginning net unrecognized gain or loss exceeds the corridor amount, amortization is recognized as . . .

Net unrecognized gain or loss

at beginning of year

Corridor amount

Average remaining service period of active employees expected to receive benefits under the plan

Gains and Losses


Gains and losses2
Gains and Losses corridor amount, amortization is recognized as . . .

There was no gain or loss amortized in 2006.

Let’s determine the amortization of the net gain in 2007.


Gains and losses3
Gains and Losses corridor amount, amortization is recognized as . . .

$9,000 ÷ 9 years = $1,000 per year.


Pension expense1
Pension Expense corridor amount, amortization is recognized as . . .


Pension expense2
Pension Expense corridor amount, amortization is recognized as . . .

Matrix contributed $200,000 to the plan trustee at the end of 2007. The journal entry to record the pension expense is:


Learning objectives5
Learning Objectives corridor amount, amortization is recognized as . . .

Understand the interrelationships among the elements that constitute a defined benefit pension plan.

LO6


Reconciliation of pension amounts

Four “off-balance sheet” accounts: corridor amount, amortization is recognized as . . .

PBO

Plan Assets

Unamortized PSC

Unamortized Gain or Loss

Reconciliation of Pension Amounts


Reconciliation of pension amounts1
Reconciliation of Pension Amounts corridor amount, amortization is recognized as . . .

The four amounts shown on the previous slide combine to account for the one pension account that is reported on the balance sheet:

prepaid pension asset or pension liability.


Minimum liability

To discourage corridor amount, amortization is recognized as . . . underreporting of pension liability, SFAS No. 87 requires recognition of an additional minimum pension liability under certain circumstances.

Minimum Liability


Measurement issue

This amount is also called the corridor amount, amortization is recognized as . . . underfunded ABO.

Measurement Issue

Accumulated Benefit Obligation (ABO)

- Plan Assets at Fair Value

Minimum Pension Liability


Offsetting
Offsetting corridor amount, amortization is recognized as . . .

SFAS No. 87 requires offsetting of the pension liability and the plan assets when determining the minimum liability.


Additional liability

An additional pension liability is recognized if total minimum liability exceeds accrued pension cost.

Total minimum liability

Accrued pension cost balance (liability)

Additional pension liability balance

Total minimum liability

Prepaid pension cost balance (asset)

Additional pension liability balance

Additional Liability

+


Learning objectives6
Learning Objectives minimum liability

Describe how pension disclosures fill a reporting gap left by the minimal disclosures in the primary financial statements.

LO7


Pension disclosures a compromise
Pension Disclosures – A Compromise minimum liability

The pension information actually reported in the financial statements falls short of the conceptual ideal and even shy of the FASB’s own preferences. Here are the items included in the income statement and balance sheet.


Settlements and curtailments

Pension plan minimum liability settlements

Reduce PBO and are viewed as the realization of a portion of the net unrecognized gain or loss and a portion of the unrecognized transition asset.

Pension plan curtailments

Often reduce PBO, resulting in a gain, which reduces accrued pension cost.

Settlements and Curtailments


Learning objectives7
Learning Objectives minimum liability

Describe the nature of postretirement benefit plans other than pensions and identify the similarities and differences in accounting for those plans and pensions.

LO8


Postretirement benefit plan

Encompass all types of retiree health and welfare benefits including . . .

Medical coverage,

Dental coverage,

Life insurance,

Group legal services, and

Other benefits.

Postretirement Benefit Plan


Postretirement health benefits and pension benefits compared

Pension Plan Benefits including . . .

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


The net cost of benefits
The Net Cost of Benefits including . . .

Estimated medical

costs in each

year of retirement

Retiree

share of

cost

Medicare

payments

Less:

Estimated net

cost of benefits

Equals:


The net cost of benefits1

Estimating postretirement health care benefits is like estimating pension benefits, but there are some additional assumptions required:

Current cost of providing health care benefits (per capita claims cost).

Demographic characteristics of participants.

Benefits provided by Medicare.

Expected health care cost trend rate.

The Net Cost of Benefits


Learning objectives8
Learning Objectives estimating pension benefits, but there are some additional assumptions required:

Explain how the obligation for postretirement benefits is measured and how the obligation changes.

LO9


Postretirement benefit obligation
Postretirement Benefit Obligation estimating pension benefits, but there are some additional assumptions required:

  • Expected (EPBO)

    • The actuary’s estimate of the total postretirement benefits (at their discounted present value) expected to be received by plan participants.

  • Accumulated (APBO)

    • The portion of the EPBO attributed to employee service to date.


Measuring the obligation
Measuring the Obligation estimating pension benefits, but there are some additional assumptions required:

On December 31, our actuary estimates that the present value of the expected benefit obligation for your postretirement health care costs is $10,250. You have worked for the company for 6 years and are expected to have 30 years of service at retirement. The actuary uses a 6% discount rate.

Let’s calculate the APBO.


Measuring the obligation1

Fraction estimating pension benefits, but there are some additional assumptions required:

attributed to

service to

date

×

=

EPBO

APBO

6

30

$10,250

×

= $2,050

APBO at the beginning of the year.

Measuring the Obligation


Measuring the obligation2

EPBO estimating pension benefits, but there are some additional assumptions required:

Beginning

of Year

EPBO

End

of Year

×

=

(1 + Discount Rate)

$10,250 × 1.06 = $10,865

7

30

APBO End

of Year

$10,865

×

= $2,535

Measuring the Obligation

To calculate the APBO at the end of the year, we start by determining the ending EPBO.


Measuring the obligation3

APBO may also be calculated like this: estimating pension benefits, but there are some additional assumptions required:

Measuring the Obligation

The APBO increases because of interest

and the service fraction (service cost).


Attribution
Attribution estimating pension benefits, but there are some additional assumptions required:

The process of assigning the cost of benefits to the years during which those benefits are assumed to be earned by employees.


Learning objectives9
Learning Objectives estimating pension benefits, but there are some additional assumptions required:

Determine the components of postretirement benefit expense.

LO10


Postretirement benefit expense
Postretirement Benefit Expense estimating pension benefits, but there are some additional assumptions required:


Postretirement benefit expense1
Postretirement Benefit Expense estimating pension benefits, but there are some additional assumptions required:

Interest accrues on the APBO as time passes.

APBO at the beginning of the year times the

assumed discount rate equals the interest cost.


Postretirement benefit expense2
Postretirement Benefit Expense estimating pension benefits, but there are some additional assumptions required:

Unlike pension plans, many postretirement benefitplans are not funded currently. For funded plans, the

earnings on plan assets reduce postretirementbenefit expense.


Postretirement benefit expense3
Postretirement Benefit Expense estimating pension benefits, but there are some additional assumptions required:

Prior service cost is allocated over the averagetime from the date of the amendment to the datefor active employees, not the expectedretirement date.


Postretirement benefit expense4
Postretirement Benefit Expense estimating pension benefits, but there are some additional assumptions required:

The amount subject to amortization is the net gain or loss at

the beginning of the year in excess of 10% of the APBO or

10% of the plan assets. The excess is amortized over the

average remaining service period of active employees.


Amortize net losses or gains
Amortize Net Losses or Gains estimating pension benefits, but there are some additional assumptions required:


Postretirement benefit expense5
Postretirement Benefit Expense estimating pension benefits, but there are some additional assumptions required:

Amortization of the transition amount is part of expense in the

current period. For financial reporting, the amortization reduces

current earnings. For income tax purposes, income is reduced

when actual payments are made. This creates a temporary

difference between financial and taxable income.


Amortization of transition amount

An employer may choose to recognize: estimating pension benefits, but there are some additional assumptions required:

The entire transition obligation immediately,or

Amortize the transition obligation on a straight-line basis over the plan participants’ future service periods (or 20 years if that is longer).

Amortization of Transition Amount


Determining the expense
Determining the Expense estimating pension benefits, but there are some additional assumptions required:

Recall our example of postretirement benefits.

Let’s calculate postretirement benefits expense.


Determining the expense1
Determining the Expense estimating pension benefits, but there are some additional assumptions required:

Because most postretirement health plans

are not funded, there are no fund assets,

no credit for prior service, and no net loss.

The beginning APBO ($2,050) is the initial transition liability. Your service life is 24 years (30 - 6). The amortization amount is $85 rounded ($2,050 ÷ 24 years).


Pension disclosures

Description of the pension plan. estimating pension benefits, but there are some additional assumptions required:

Estimates of the obligations PBO, ABO, vested benefit obligation, EPBO, and APBO).

Pension Disclosures

The disclosure requirement of pension plans and postretirement benefits are very similar. On this and the next three screens are the disclosures for FedEx in the Appendix to Chapter 1.


Pension disclosures1

The percentage of total plan assets for each major category of assets (equity securities, debt securities, real estate, other) as well as a description of investment strategies, including any target asset allocations and risk management practices.

A breakdown of the components of the annual pension and postretirement benefit expenses for 2004, 2003, and 2002.

Pension Disclosures


Pension disclosures2

A reconciliation of the changes in the plans’ benefit obligation and fair value of assets over a two year period ended May 31, 2004, and a statement of the funded status.

The discount rates, the assumed rate of compensation increases used to measure the PBO, the expected long-term rate of return on plan assets and the expected rate of increase in future medical and dental benefit costs.

Pension Disclosures


Pension disclosures3

Estimated benefit payments presented separately for years 2005-2009 and in the aggregate for years 2010-2014.

Estimate of expected contributions to fund the plan for 2005.

Other information to make it possible for interested analysts to reconstruct the financial statements with plan assets and liabilities included

Pension Disclosures


Pensions and other postretirement benefits

Service Method of Allocating Prior Service Cost 2005-2009 and in the aggregate for years 2010-2014.

Appendix 17


The service method

30,000 2005-2009 and in the aggregate for years 2010-2014. 2,000

15 average service years

=

The Service Method

The allocation approach that reflects the declining service pattern of employees is called the service method. The method requires that the total number of service years for all employees be calculated. This calculation is usually done by the actuary.

Assume Matrix, Inc. has 2,000 employees and the company’s actuary determined that the total number of service years of these employees is 30,000. We would calculate the following amortization fraction:


End of chapter 17
End of Chapter 17 2005-2009 and in the aggregate for years 2010-2014.