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Pensions and Postretirement Benefits. Revsine/Collins/Johnson: Chapter 14. Learning objectives. The difference between defined contribution and defined benefit pension plans. What the components of pension expense are and their relation to pension assets and to the pension liability.

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pensions and postretirement benefits

Pensions and Postretirement Benefits

Revsine/Collins/Johnson: Chapter 14

learning objectives
Learning objectives
  • The difference between defined contribution and defined benefit pension plans.
  • What the components of pension expense are and their relation to pension assets and to the pension liability.
  • The requirements for funding pension plans, computing the return on plan assets, and the role of the plan trustee.
  • How GAAP smoothes the volatility inherent in pension estimates and forecasts.
  • The determinants of the pension funding decision.
learning objectives concluded
Learning objectives:Concluded
  • How to analyze and use the funded status footnote and the reconciliation of pension asset and liability accounts.
  • When a minimum balance sheet pension liability must be recognized.
  • The financial reporting rules for other postretirement benefits.
  • What research tells us about the usefulness of the detailed pension and other postretirement benefits disclosures.
pension plans
Pension plans
  • A pension plan is an agreement by the firm to provide a series of payments (called a pension) to employees when they retire.
  • The firm makes periodic contributions to a pension trust.
  • The pension trust then makes periodic benefit payments to retired employees.
  • As we shall see, there are two types of pension plans: defined contribution plans and defined benefit plans.

Firm (sponsor)

Contributions

Pension trust

Benefit payments

Retired employee

pension plans defined contribution
Pension plans:Defined contribution
  • Defined contribution plans specify the amount of cash that the employer puts into the plan.
  • No explicit promise is made about the size of the periodic payments the employee will receive on retirement.

Employees shoulder investment risk

pension plans defined benefit
Pension plans:Defined benefit
  • Defined benefit plans specify the formula for determining the amount that will be paid out to the employee after retirement.

Employers shoulder investment risk

  • Determining how much should be charged to pension expense each year and how much cash must be contributed to the fund is complex.
defined benefit pension plans accounting complications
Defined benefit pension plans:Accounting complications
  • The plan specifies the benefit formula but not the benefit amount.
  • To determine the periodic pension expense, the following factors must be estimated:
    • The proportion of the workforce the will remain with the firm long enough to qualify for benefits under the plan (called vesting).
    • The rate at which employee salaries will rise until retirement.
    • The anticipated life span of employees after retirement.
    • The rate of return that will be earned on pension investments.
    • The discount rate used to reflect the present value of future benefits earned by employees in the current period.
defined benefit pension plans evolution of gaap
Defined benefit pension plans:Evolution of GAAP
  • SFAS No. 87 specifies the measurement and disclosure requirements for defined benefit pension plans.
  • The disclosure aspects of SFAS No. 87 were amended in 1998 and again in 2003 as SFAS No. 132.
  • SFAS No. 87 was designed to avoid volatility in pension expense, but the result is arguably the most technically complicated financial reporting pronouncement ever issued.
defined benefit pension plans six components of pension expense
Defined benefit pension plans:Six components of pension expense

Service cost (+)

The increase in the discounted present value of the pension benefits due to an additional year’s employment.

Interest cost (+)

Measures the growth in the pension liability that arises from the passage of time.

Expected return

on pension assets (-)

Dollar return management believes will be earned on pension investments.

Recognized gains

or losses (- or +)

Smoothing device that adjusts for the difference between the expected and actual return on pension assets.

Amortization of

unrecognized transition

asset or obligation (- or +)

Smoothing device that adjusts for the initial SFAS No. 87 disparity between pension assets and liabilities.

Recognized prior

service cost (- or +)

Smoothing device that adjusts for the costs of retroactive changes in plan benefits.

defined benefit pension plans a simple example
Defined benefit pension plans:A simple example

2005

2006

2007

Wildcat adopts pension plan

Cate retires

Lump-sum benefit of $20,000 is paid

defined benefit pension plans component 1 service cost

Here’s the December 31, 2005 journal entry:

DRPension expense $8,734

CR Cash $8,734

Defined benefit pension plans:Component 1—Service cost
  • Service cost is the increase in the discounted present value of the pension benefits ultimately payable that is attributable to an additional year’s employment.

2005

2006

2007

$10,000

Benefit earned

Service cost

$8,734

defined benefit pension plans component 1 service cost for 2006
Defined benefit pension plans:Component 1—Service cost for 2006

2005

2006

2007

$10,000

Additional benefit earned

Service cost

$9,346

defined benefit pension plans component 2 interest cost for 2006
Defined benefit pension plans:Component 2—Interest cost for 2006
  • The interest cost component of pension expense arises from the passage of time.

$8,734 benefit liability

$9,346 benefit liability

2005

2006

2007

Interest cost

$611 = $8,734 x 0.07

Discount rate

Benefit liability

defined benefit pension plans component 3 expected return on plan assets
Defined benefit pension plans:Component 3—Expected return on plan assets
  • This component of pension expense reflects the long-term expected return earned on pension investments.

$8,734 cash contribution to trust

Increased value of plan assets

2005

2006

2007

Expected return on plan assets

$611 = $8,734 x 0.07

Expected rate of return

Plan assets

defined benefit pension plans pension expense for 2006
Defined benefit pension plans:Pension expense for 2006
  • The journal entry for 2006 is:

Component 1

Component 2

Component 3

DRPension expense $9,346

CR Cash $9,346

defined benefit pension plans relaxing the perfect certainty assumption
In our example, perfect certainty meant:

Date of retirement was known in advance

Amount of the pension was also known in advance

Discount rates and earnings rates were equal and could be perfectly forecast

Under these circumstances, pension expense is equal to service cost in every period.

Accounting complications arise when:

Higher or lower than anticipated employee turnover.

Higher or lower employee mortality before retirement.

Actual return on plan assets differs from the expected return.

Companies retroactively alter the level of benefits promised under the plan.

Defined benefit pension plans:Relaxing the perfect certainty assumption
defined benefit pension plans discount rate uncertainty
Defined benefit pension plans:Discount rate uncertainty
  • SFAS No. 87 requires that firms use a settlement rate as the assumed discount rate in their pension expense calculation.
defined benefit pension plans rates vary across firms
Defined benefit pension plans:Rates vary across firms

Settlement Rate

Expected Rate of Return

defined benefit pension plans compensation increase rates vary across firms
Defined benefit pension plans:Compensation increase rates vary across firms

Compensation Increase Rates 1997-2002

defined benefit pension plans component 4 recognized gains and losses
Defined benefit pension plans:Component 4—Recognized gains and losses
  • The actual return on plan assets can differ considerably from the expected return in any year.
  • This volatility in asset returns would—in the absence of SFAS No.87—translate directly into net income volatility.

Volatility in actual return

defined benefit pension plans sfas no 87 and component 4
Defined benefit pension plans:SFAS No. 87 and Component 4
  • To avert the net income volatility, SFAS No. 87 allows firms to reduce pension expense by the expected return on plan assets rather than by the actual return:
    • Firms first select a target return that they expect to earn on plan assets in the long run.
    • Any difference between this expected return and the actual return earned in a given year is assigned to an off-balance sheet device called unrecognized gain or loss.
defined benefit pension plans excerpts from ge s pension footnotes
Defined benefit pension plans:Excerpts from GE’s pension footnotes

Volatile actual returns

Smooth expected returns

defined benefit pension plans how component 4 is measured
Defined benefit pension plans:How Component 4 is measured
  • If gains and losses do not offset one another over time, the cumulative off-balance sheet deferred amounts will grow excessively large.
  • The role of Component 4 is to gradually reduce the cumulative deferred amounts.
  • Actual versus expected return on plan assets
  • Actuarial assumptions versus actual experience
  • Changes in assumptions (e.g., discount rate)

Cumulative

unrecognizedgains and losses

defined benefit pension plans computing component 4 step 1
Defined benefit pension plans:Computing Component 4—Step 1

Step 1 : Compute the 10% threshold

Threshold equals 10% of MRAV or PBO, whichever is larger. Here the threshold is $1 million.

defined benefit pension plans computing component 4 step 2
Defined benefit pension plans:Computing Component 4—Step 2

Step 2 : Determine whether the threshold is triggered

Because CUGOL exceeds the threshold amount, the threshold is triggered.

defined benefit pension plans computing component 4 step 3
Defined benefit pension plans:Computing Component 4—Step 3

Step 3 : Compute the current year component 4 amortization

So, pension expense will be reduced by $40,000 in the current year.

defined benefit pension plans component 5 transition amounts
Defined benefit pension plans:Component 5—Transition amounts
  • When firms first adopted SFAS No. 87, they were required to determine the transition funding status of the plan:
  • This transition asset or liability is then amortized over the remaining service period of employees who are expected to receive benefits under the plan.

Transition assets

Transition liability

$

$

$

$

Plan assets

Pension liability

Plan assets

Pension liability

defined benefit pension plans component 6 prior service cost
Defined benefit pension plans:Component 6—Prior service cost
  • Pension plans are frequently amended to provide increased benefits to employees.
  • When benefits are retroactively enhanced, it means prior pension expense was too low.
defined benefit pension plans journal entries illustrated

If Adess decides to fund $44,000 that year:

DRPension expense $50,000

CR Cash $44,000

CR Unfunded accrued pension cost 6,000

Defined benefit pension plans:Journal entries illustrated
  • Here are the pension expense components for Adess Corp.:
  • If the entire amount of pension expense is funded by payments to the plan trustee, the entry is:

DRPension expense $50,000

CR Cash $50,000

defined benefit pension plans the pension funding decision
Funding decisions are influenced by income tax laws, protective pension legislation, the availability of cash, and other incentives.Defined benefit pension plans:The pension funding decision

Income tax laws

ERISA

  • Firms with high marginal tax rates tend to overfund their pension plans.
  • Firms with less stringent capital constraints and larger union membership tend to have higher funding ratios.

Competing

cash needs

Contracting and

political cost incentives

  • Firms with more “precarious” debt/equity ratios tend to have lower funding ratios.
the pension footnote general electric part 1
The pension footnote:General Electric—Part 1

GE has pension income rather than pension expense.

Used in later journal entry

the pension footnote general electric part 3
The pension footnote:General Electric—Part 3

Pension assets are larger than GE’s pension obligation

Used in later journal entry

the pension footnote funded status disclosure plan assets
The pension footnote:Funded status disclosure—Plan assets

Causes of Increases and Decreases in Plan Assets

the pension footnote funded status disclosure pbo
The pension footnote:Funded status disclosure—PBO

Causes of Increases and Decreases in Projected Benefit Obligations (PBO)

the pension footnote ge s journal entry
The pension footnote:GE’s journal entry

Change in account balance from Ex 14.8

“Effect on operations” from Ex 14.8

Employer contribution

Change in account balance from Ex 14.8

the pension footnote extracting analytical insights
The pension footnote:Extracting analytical insights
  • The funded status reconciliation provides insights about future pension-related cash flows:
  • Firms are also now required to disclose anticipated pension benefit payouts for the next five years.

Slightly overfunded

$

  • Suppose the firm did not contribute cash to their pensions trust this year.
  • Will cash contributions be required in futures years?

$

Plan assets

Pension benefit obligation

the pension footnote extracting analytical insights concluded
The pension footnote:Extracting analytical insights (concluded)
  • Pension assets and liabilities are quite sensitive to changes in interest rates:
  • Changes in various pension rate assumptions also affect pension expense.

Assumed rate of

Compensation increase

Service cost

Spread between the

discount rate and rate of

Compensation increase

defined benefit plans cash balance plans
Defined benefit plans:Cash-balance plans
  • Many U.S. companies are replacing existing pension plans with a new cash-balance plan.
  • Cash balance plans are attractive to employers, but they are also controversial.

Contributes fixed amount per year, say 5% of salary

Interest earned at T-bond rate

Employer

Trustee

Pays annuity benefit to employee

Employee

defined benefit plans minimum balance sheet liability
Defined benefit plans:Minimum balance sheet liability
  • Firms are required to report a minimum balance sheet liability whenever the accumulated benefit obligation (ABO) exceeds the fair value of plan assets (FVPA).
  • The journal entry would be:

Minimum balance sheet liability

DRIntangible asset $2,000,000

CR Minimum pension liability $2,000,000

defined benefit plans minimum liability complication 1
Defined benefit plans:Minimum liability—complication 1
  • Suppose the company already had an “accrued pension liability” of $400,000 on its books. In this case, the computation is:
  • The journal entry would then be:

DRIntangible asset $1,600,000

CR Minimum pension liability $1,600,000

$2,000,000 - $400,000 =

defined benefit plans minimum liability complication 2
Defined benefit plans:Minimum liability—complication 2
  • Assume the unrecognized prior service cost is only $1.5 million:
  • The journal entry would be:

DRIntangible asset $1,500,000

DR Accumulated comprehensive loss 500,000

CR Minimum pension liability $2,000,000

Cannot exceed amount of UPSC

defined benefit plans amr s minimum balance sheet liability
Defined benefit plans:AMR’s minimum balance sheet liability

= ABO - FVPA

DRIntangible asset $330

DR Accumulated comprehensive loss 1,293

CR Minimum pension liability $1,623

UPSC = $330

other postretirement benefits
Other postretirement benefits
  • Many firms promise to provide healthcare and life insurance to employees (or their spouses) during retirement.
  • Under the matching principle, an expense should be recognized over the period of employment as employees qualify for these OPEBs.
  • Prior to SFAS No. 106 in 1992, most firms used “pay-as-you-go” accounting.
  • The dollar amount’s involved can be staggering:

$33.116

billion

GM’s 1992 adoption of SFAS No.106

$22.083

billion

OPEB liability

Initial OPEB expense

other postretirement benefits initial sfas no 106 adoption
Other postretirement benefits:Initial SFAS No. 106 adoption

The Two Permitted SFAS No.106 Alternative Adoption Methods

pension and opeb accounting reliability and valuation relevance
Pension and OPEB accounting:Reliability and valuation relevance
  • Pension asset and liability measures in the footnotes are more closely associated with stock prices than are the measures recognized on the balance sheet.
  • Both footnote liabilities (ABO for pensions and APBO for OPEBS) are negatively correlated with stock prices.
  • Investors price the APBO as though it is measured with less reliability.
summary
Summary
  • Under SFAS No. 87 and 132, pension expense consists of service cost, interest cost, expected return on plan assets and three other components.
  • The three other components are smoothing mechanisms that avoid year-to-year volatility in pension expense.
  • Because some pension items are “off-balance sheet,” the FASB requires firms to disclose the funded status of the plan and to reconcile funded status to reported balance sheet amounts.
  • An understanding of the funded status disclosure helps readers better forecast future operating cash flows.
summary continued
Summary continued
  • The reporting rules for postretirement benefit plans (OPEB) closely parallel the pension accounting rules.
  • Prior to SFAS No. 106, only a few companies funded OPEB obligations. Consequently, significant off-balance OPEB liabilities exist for many firms.
  • Research evidence suggests that the equity valuation impact of these estimated OPEB obligations is less than dollar-for-dollar due to the potential uncertainty and measurement error associated with the estimates.
summary concluded
Summary concluded
  • Statement readers should be alert for these warning signals of earnings management:
    • A significant divergence between any of the various pension and OPEB rates selected by a firm and the rates chosen by other firms in the industry.
    • A very large difference between the chosen expected rate of return on plan assets and the discount rate used.
    • An increase in the year-to-year expected rate of return on plan assets that seems unrelated to changes in market conditions.
    • A decrease in the assumed rate of increase in future compensation levels that cannot be explained by changing industry or labor market forces.