Pensions and Other Postretirement Benefits

1. Pensions and Other Postretirement Benefits Chapter 15 Robinson, Munter and Grant

2. Learning Objectives • Retirement plans • Defined benefit • Defined contribution • Pension liability • Pension expense • Actuarial assumptions • Health care and other benefits Chapter 15

3. Types of Retirement Benefits • Defined Contribution Plans • Company promises to contribute a certain amount to a plan each period • Defined Benefit Plans • Employer promises that the employees will receive a certain pension amount at retirement Chapter 15

4. Defined Contribution Plans • Firm’s periodic contribution is defined and can take many forms • Percentage of employee’s salary • Percentage of firm profits • Plan assets may be controlled by employee • Stock mutual funds • Employee bears the risk associated with returns Chapter 15

5. Defined Benefit Plans • Employee will receive a certain amount at retirement • Non-Pay-Related • Pay-Related • Employer bears risk of plan performance • Complex accounting Chapter 15

6. Accounting for Defined Benefit Plans • Company must report the funding status of the plan • Liability if the present value of future benefits exceeds the value of the plan’s assets • Asset if the present value of the future benefits is less than the value of the plan’s assets Chapter 15

7. Accounting for Defined Benefit PlansSome terms • Service cost: Change in pension obligation due to current period service • Projected benefit obligation: liability based on projected salary increases • Accumulated benefit obligation: liability excluding salary increases • Vested benefit obligation: portion of liability that employee is entitled to Chapter 15

8. Example • Current salary: $100,000 • Total employment = 20 years • Annual compensation increase: 3% • Final salary: $175,351 (100,000*1.0319) • Discount rate: 7% • Pension: 2% per year of service • 40% of final salary Chapter 15

9. ExampleAfter One Year • Projected annual pension: 2% * $175,351 = $3,507 • 10-year pension is worth $25,356 at retirement • 10-year pension is worth $7,288 currently Receive $3,507 annual pension Earn $100,000 with 3% annual increases 0 1 year 20 years 30 years PV $7,288 $26,356 Chapter 15

10. ExampleAfter One Year • In this case, at the end of the first year, service cost = pension liability = pension expense = $7,288, the PBO • ABO excludes all salary increases, $4,156 • Use $100,000 instead of $175,351 in calculations • VBO is 20% of ABO, $831 • Pension vests over 5 years, 20% per year Chapter 15

11. ExampleAfter Two Years • Projected annual pension: 2*2% * $175,351 = $7,014 • 10-year pension is worth $52,712 at retirement • 10-year pension is worth $15,596 currently Receive $7,014 annual pension Earn $100,000 with 3% annual increases 0 2 years 20 years 30 years $15,596 PV $52,712 Chapter 15

12. ExampleAfter Two Years • PBO = $15,596 • Pension expense = $15,596-$7,288 = $8,308 • Interest on previous year’s obligation = $510 • $7,288*7% • Service cost = $8,308-$510 = $7,798 • ABO = $9,161 • Use $100,000 instead of $175,351 in calculations • VBO = $3,664 • Pension vests over 5 years, 20% per year Chapter 15

13. Assumptions Chapter 15

14. Components of Pension Expense • Service Cost • Interest Cost • Return on Plan Assets • Amortization of unrecognized prior service cost • Amortization and deferral of gain or loss • Amortization of the transition liability or asset Chapter 15

15. Service Cost • The change in PBO during the period • Attributed to work performed during the period • Recognized in pension expense in its entirety • Consistent with the matching principle Chapter 15

16. Interest Cost • Interest accrued on the PBO for the period • PBO is computed at each balance sheet date • Discount rate * PBO = Interest cost • Small changes in the interest rate may result in substantial changes in pension expense Chapter 15

17. Return on Plan Assets • Expected return = Beginning market-related value * Expected long-term rate of return • Majority of companies use expected return on plan assets in calculating pension expense • Actual return may not = expected return • Differences in actual vs. expected long-term rate of return • Market-related value may not = actual value Chapter 15

18. Return on Plan AssetsMarket-related Value Chapter 15

19. Amortization of Prior Service Cost PBO after plan amendment – PBO before plan amendment = Prior service cost from plan amendment • Amortized over average remaining service life of all active employees Chapter 15

20. Amortization and Deferral of Gain or Loss • Gains/losses associated with differences between actual and expected PBO that arise as a result of changes in actuarial assumptions • These gains/losses are deferred and amortized • Net the liability and asset gain/loss to a single number • Liability item: change in life expectancy • Asset item: change in return on assets Chapter 15

21. Amortization and Deferral of Gain or Loss, Continued • Amortize amount above corridor threshold • 10% of the greater of the PBO or the market-related value at the beginning of the year • Amortize over the average remaining service life of current employees • Remember, if assumptions are reasonable, gain and losses should net out over time. Chapter 15

22. Amortization of the Transition Liability or Asset • Asset or liability in place when current US standard was adopted • 1987 • Amortized over average remaining service life • Most of this amount has already been amortized Chapter 15

23. Pension Liability • PBO at the end of the period • Value of ending plan assets • Difference equals funded status • Also include unrecognized net gains, prior service costs and transition asset • Liability = Funded status ± 3 adjustments Chapter 15

24. Disclosure Requirements:US Standards • Reconciliation of the benefit obligation • Reconciliation of the fair value of plan assets • The funded status • Pension expense recognized • Key assumptions • Explain significant changes in the benefit obligation or plan assets Chapter 15

25. International StandardsRetirement Plans • Generally similar • Differences related to: • Classification of defined benefit and defined contribution plans • Amortization of gains and losses under the corridor approach • Expensing of prior service costs • No recognition of minimum pension liability Chapter 15

26. International StandardsReporting Requirements • Accounting policy for actuarial gains/losses • Description of plan • Reconciliation of assets and liabilities • Components of fair value of plan assets • Reconciliation of changes to the net liability • Total expense • Actual return on plan assets • Principal actuarial assumptions Chapter 15

27. Other Postretirement Benefits • Non-pensions are typically not pay-related. • Report Accumulated postretirement benefit obligation only • No minimum liability to report Chapter 15

28. Other Postretirement BenefitsCurrent Period Expense • Service cost • Interest cost • Less: actual return on plan assets • Plus (minus) loss (gain) recognized in excess of the corridor • Plus (minus) gain (loss) deferred based on expected return on plan assets • Amortization of prior service cost • Amortization of transition liability Chapter 15

29. Retirement Benefit Disclosures • Consider whether pension assets are invested in the company’s own stock • Look for various types of plans • Regular, executive, supplemental • Consider changes to actuarial assumptions • Compare to similar firms • Funded status Chapter 15

30. Summary • Pension plans • Pension expense and liability • Disclosures required • International standards • Other postretirement benefits Chapter 15