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Pensions and Other

Postretirement Benefits
Chapter 17

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA

Copyright2013byTheMcGrawHillCompanies,Inc.Allrightsreserved.

17-2

Nature of Pension Plans


1. Pension plans provide income to

individuals during their retirement


years.
2. This is accomplished by setting aside
funds during an employees working
years so that at retirement, the
accumulated funds plus earnings from
investing those funds are available to
replace wages.

17-3

Nature of Pension Plans


For a pension plan to qualify for special tax
treatment it must meet the following
requirements:
1.Cover at least 70% of employees.
2.Cannot discriminate in favor of highly
compensated employees.
3.Must be funded in advance of retirement
through an irrevocable trust fund.
4.Benefits must vest after a specified period of
service.
5.Complies with timing and amount of
contributions.

17-4

Nature of Pension Plans

17-5

Defined Contribution Pension Plans


Plan
Plan Characteristics
Characteristics

Contributions
Contributions
are
are defined
defined
by
by
agreement.
agreement.

Employer
Employer
deposits
deposits an
an
agreed-upon
agreed-upon
amount
amount into
into
an
an employeeemployeedirected
directed
investment
investment
fund.
fund.

Employee
Employee
bears
bears all
all risk
risk
of
of pension
pension
fund
fund
performance.
performance.

17-6

Defined Contribution Pension Plans


Lets assume that the annual contribution is to
be 3% of an employees salary. If an employee
earned $110,000 during the year, the company
would make the following entry:
Pension expense
Cash

3,300
3,300

The employees retirement benefits are totally


dependent upon how well investments perform.

17-7

Defined Benefit Pension Plans


Plan
Plan Characteristics
Characteristics

Employer
Employer is
is
committed
committed to
to
specified
specified
retirement
retirement
benefits
benefits..

Retirement
Retirement
benefits
benefits are
are
based
based on
on aa
formula
formula that
that
considers
considers
years
years of
of
service,
service,
compensation
compensation
level,
level, and
and age.
age.

Employer
Employer
bears
bears all
all risk
risk
of
of pension
pension
fund
fund
performance.
performance.

17-8

Defined Benefit Pension Plan


A pension formula might define annual retirement
benefits as:
1 1/2 % x Years of service x Final years salary
By this formula, the annual benefits to an employee
who retires after 30 years of service, with a final salary
of $100,000, would be:
1 1/2 % x 30 years x $100,000 = $45,000

17-9

Defined Benefit Pension Plan


An actuary assesses the various uncertainties
(employee turnover, salary levels, mortality, etc.) and
estimates the companys obligation to employees in
connection with its pension plan.
The key elements of a defined benefit
pension plan are:
1.The employers obligation to pay
retirement benefits in the future.
2.The plan assets set aside by the
employer from which to pay the
retirement benefits in the future.
3.The periodic expense of having a
pension plan.

1710

Pension ExpenseAn Overview


The annual pension expense reflects
changes in both the pension obligation and
the plan assets.

1711

The Pension Obligation


1. Accumulated benefit obligation (ABO) The actuarys
estimate of the total retirement benefits (at their discounted
present value) earned so far by employees, applying the
pension formula using existing compensation levels.
2. Vested benefit obligation (VBO) The portion of the
accumulated benefit obligation that plan participants are
entitled to receive regardless of their continued employment.
3. Projected benefit obligation (PBO) The actuarys estimate
of the total retirement benefit (at their discounted present
value) earned so far by employees, applying the pension
formula using estimated future compensation levels. (If the
pension formula does not include future compensation
levels, the PBO and the ABO are the same.)

1712

The Pension Obligation

1713

Projected Benefit Obligation


The PBO is a more meaningful measurement
because it includes a projection of what the salary
might be at retirement.
Jessica Farrow was hired by Global Communications in 2002. She
is 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%

1714

Projected Benefit Obligation


Step 1. Use the pension formula to determine the retirement
benefits earned to date.
$400,000

10
1.5%
$ 60,000 per year

Step 2. Find the present value of the retirement benefits as of the


retirement date.
The present value (n=20, i=6%) of the retirement annuity at
the retirement date is $688,195 ($60,000 11.46992).

1715

Projected Benefit Obligation


If the actuarys estimate of the final salary hasnt changed,
the PBO a year later at the end of 2012 would be $139,715.
Step 1. Use the pension formula to determine the retirement
benefits earned to date.
$400,000

11
1.5%
$ 66,000 per year

Step 2. Find the present value of the retirement benefits as of the


retirement date.
The present value (n=20, i=6%) of the retirement annuity at

1716

Projected Benefit Obligation

1717

Projected Benefit Obligation

Service cost is the increase in the PBO


attributable to employee service performed
during the period.

1718

Projected Benefit Obligation

Interest cost is the interest on the PBO


during the period.

1719

Projected Benefit Obligation

Prior service cost is the increase in the PBO


due to a plan change that provides credit for
employee service rendered in prior years.

1720

Projected Benefit Obligation

Loss or gain on PBO results from revising


estimates used to determine the PBO.

1721

Projected Benefit Obligation

Retiree benefits paid reduce the PBO.

1722

Projected Benefit Obligation

*Of course, these expanded amounts are not simply the amounts for Jessica Farrow
multiplied by 2,000 employees because her years of service, expected retirement date, and
salary are not necessarily representative of other employees. Also, the expanded amounts
take into account expected employee turnover and current retirees.

Includes the prior service cost that increased the PBO when the plan was amended in 2012.

1723

Pension Plan Assets


The pension plan assets are not reported separately in
the balance sheet but are netted together with the PBO
to report either a net pension asset (debit balance) or a
net pension liability (credit balance).
The higher the expected
return on plan assets, the less
the employer must actually
contribute. On the other hand,
a relatively low expected
return means the difference
must be made up by higher
contributions.

1724

Pension Plan Assets


Global Communications funds its defined benefit pension
plan by contributing the years service cost plus a portion of
the prior service cost each year. 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 expected rate of return on the investment of
those assets was 9%, but the actual return in 2011 was
10%. Retirement benefits of $38 million were paid at the
end of 2013 to retired employees. The plan assets at the
end of 2013 will be:

1725

Funded Status of the Pension Plan


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

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

Reporting the Funded Status of Pension


Plan
Projected
Projected Benefit
Benefit Obligation
Obligation (PBO)
(PBO)
-- Plan
Plan Assets
Assets at
at Fair
Fair Value
Value
Underfunded
Underfunded // Overfunded
Overfunded Status
Status

1726

The Relationship Between Pension Expense


and Changes in the PBO and Plan Assets

1727

1728

Service Cost
Actuaries have determined that Global
Communications has service cost of
$41 million in 2013.

1729

Interest Cost
Interest cost is calculated as:
PBOBeg Discount rate
Global had PBO of $400 million on 1/1/13. The actuary
uses a discount rate of 6%.

2013 Interest Cost


PBO 1/1/13 $400,000,000 6% = $24,000,000

1730

Return on Plan Assets


The plan trustee reports that plan assets were $300 million on
1/1/13. The trustee uses an expected return of 9% and the
actual return is 10%.

1731

Amortization of Prior Service Cost


In 2012, Global Communications amended the
pension plan, increasing the PBO at that time.
For all plan participants, the prior service cost
was $60 million at 1/1/12. The average
remaining service life of the active employee
group is 15 years.

$60 million PSC 15 = $4 million per year

1732

Gains and Losses

Only if a net gain or net loss exceeds the


corridor is a charge to pension
expense allowed.

1733

Corridor Amount

The corridor
amount is 10% of
the greater of

PBO at the
beginning of the
period.
Or
Fair value of plan
assets at the
beginning of the
period.

1734

Gains and Losses


If the beginning net
unrecognized gain or loss
exceeds the corridor
amount, amortization is
recognized using the
following formula . . .
Net unrecognized gain or loss
Corridor

at beginning of year
amount
Average remaining service period of active
employees expected to receive benefits under the plan

1735

Gains and Losses


2013 Net Loss Amortization ($ in millions)
PBO
$
Fair value of plan assets
Net loss for 2013
Average service life

$15 million 15 years = $1 million

400
300
55
15

1736

Determining Pension Expense

1737

Recording Gains and Losses


For 2013, the actual return on plan assets exceeded the
expected return by $3 million. In addition, there was a $23
million loss from changes made by the actuary when it
revised its estimate of future salary levels causing its PBO
estimate to increase. Global would make the following
journal entry to record the gain and loss:

LossOCI
PBO
Plan assets
GainOCI

($ in millions)
23
23
3

OCI = Other comprehensive income

1738

Record Pension Expense


($ in millions)

Pension expense (calculated below)


Plan assets ($27 expected return on assets)
PBO ($41 service cost + $24 interest cost)
Prior service costAOCI
Net lossAOCI
OCI = Other comprehensive income
Service cost and interest cost add to Globals PBO.

The return on plan assets adds to the plan assets.


Amortization of prior service and net loss reduce each account.

43
27
65
4
1

1739

Recording the Funding of Plan Assets


When Global adds its annual cash investment of $48
million to its plan assets, the value of those plan
assets increases by $48 million.

($ in millions)
Plan assets
48
Cash (contribution to plan assets)
48
Its not unusual for the cash contribution to differ
from that years pension expense. After all,
determining the periodic pension expense and the
funding of the pension plan are two separate
processes.

1740

Recording the Funding of Plan Assets

Global pays $38 million in retirement


pension benefits.
($ in millions)
PBO
38
Plan assets (payments to retired employees)
38

1741

U. S. GAAP vs. IFRS


Important differences in accounting for actuarial
gains and losses using U.S. GAAP and IFRS.

Gains and losses are the


difference between the
actual and expected
returns, where the
expected return is different
from company to company
and usually different from
the interest rate used to
determine the interest cost.

Requires that we use the


same rate (the rate for
high -grade corporate
bonds) for both the
interest cost on the defined
benefit obligation (called
projected benefit obligation
or PBO under GAAP) and
the interest revenue on the
plan assets.

1742

U. S. GAAP vs. IFRS


Important differences in accounting for actuarial
gains and losses using U.S. GAAP and IFRS.

Requires that gains and


losses are to be (a)
included among OCI items
in the statement of
comprehensive income
when they first arise and
then (b) gradually
amortized or recycled out
of OCI and into expense
(when the accumulated net
gain or net loss exceeds the

Gains and losses are


included in OCI when they
first arise, but unlike U.S.
GAAP those amounts are
not subsequently amortized
out of OCI and into
expense. Instead, under
IFRS those amounts remain
in the balance sheet as
accumulated other
comprehensive income.

1743

Comprehensive Income
Comprehensive income is a more expansive view of
income than traditional net income.

1744

Comprehensive Income

1745

Pension Spreadsheet

1746

U. S. GAAP vs. IFRS


Under IFRS we separately report (a) the service
cost component (including past service cost) and (b)
the net interest cost/income component in the
income statement and (c) remeasurement gains and
losses as other comprehensive income.

Postretirement Benefits Other Than


Pensions
Net Cost of Benefits
Estimated
Estimated medical
medical
costs
costs in
in each
each
year
year of
of retirement
retirement

Less:

Equals:

Retiree
Retiree
share
share of
of
cost
cost

Medicare
Medicare
payments
payments

Estimated
Estimated net
net
cost
cost of
of benefits
benefits

Many companies
also furnish other
postretirement
benefits to their
retired employees.

1747

1748

Postretirement Benefit Obligation


1. Expected Postretirement Benefit Obligation

(EPBO) The actuary's estimate of the total


postretirement benefits (at their discounted
present value) expected to be received by plan
participants.
2. Accumulated Postretirement Benefit
Obligation (APBO) The portion of the EPBO
attributed to employee service to date.

1749

Postretirement Benefit Obligation


Assume the actuary estimates the net cost of providing health care
benefits to Jessica Farrow during her retirement years to have a
present value of $10,842 as of the end of 2011. This is the EPBO. If
the benefits (and therefore the costs) relate to an estimated 35 years
of service and 10 of those years have been completed, the APBO
would be:
2011

x
2012

$10,842
EPBO

1.06
$11,493
EPBO

10

/35

fraction
attributed

$3,098
APBO

Assume the obligation increases by the 6%.

/35

11

fraction
attributed

She now has worked 11 of her estimated 35 years

$3,612
APBO

1750

How the APBO Changed


The two elements of the increase in 2012 can be separated as follows:

1751

Attribution

The process of assigning the cost of


benefits to the years during which
those benefits are assumed to be
earned by employees.

Accounting for Postretirement Benefit


Plans Other Than Pensions
Attribute a portion of the accumulated
postretirement benefit obligation to each year
as the service cost for that year.

Measuring Service Cost

1752

Appendix 17: Service Method of


Allocating Prior Service Cost
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 Global Communications has 2,000 employees and
the companys actuary determined that the total number of
service years of these employees is 30,000. We would
calculate the following amortization fraction:
30,000
2,000

= 15 average service years

1753

1754

End of Chapter 17