Chapter 17

PENSIONS AND OTHER

POSTRETIREMENT
BENEFITS

McGraw-Hill /Irwin © 2009 The McGraw-Hill Companies, Inc.

 Slide 2

Nature of Pension Plans

For a pension plan to qualify for special tax
treatment
1. Pension plans itprovide
must meet the to
income following
individuals during requirements:
their retirement years.
1. 2.Cover
Thisatis least 70% of employees.
accomplished by setting aside
fundsdiscriminate
2. Cannot during an employee’s
in favor of working
highly
years so thatemployees.
compensated at retirement, the
3. Mustaccumulated
be funded funds plus earnings
in advance from
of retirement
investing
through those fundstrust
an irrevocable are available
fund. to
replacemust
4. Benefits wages.
vest after a specified period of
service.
5. Complies with timing and amount of
contributions.
17-2
 Slide 3

Types of Pension Plans

Defined contribution pension plans promise fixed
annual contributions to a pension fund (say, 10% of
the employees' pay). The employee chooses (from
designated options) where funds are invested –
usually stocks or fixed-income securities. Retirement
pay depends on the size of the fund at retirement.

17-3
 Slide 4

Types of Pension Plans

Defined benefit pension plans promise fixed retirement
benefits defined by a designated formula. Typically,
the pension formula bases retirement pay on the
employees' (a) years of service, (b) annual
compensation [often final pay or an average for the
last few years], and sometimes (c) age. Employers
are responsible for ensuring that sufficient funds are
available to provide promised benefits.

17-4
 Slide 5

Defined Contribution Pension Plans

Plan
Plan Characteristics
Characteristics

Contributions
Contributions Employer
Employer Employee
Employee
are
are defined
defined by
by deposits
deposits anan bears
bears all
all risk
risk
agreement.
agreement. agreed-upon
agreed-upon of
of pension
pension
amount
amount into
into an
an fund
fund
employee-
employee- performance.
performance.
directed
directed
investment
investment
fund.
fund.
17-5
 Slide 6

Defined Contribution Pension Plans

Accounting for these plans is quite simple. Let’s assume
that the annual contribution is to be 3% of an employee’s
salary. If an employee earned $110,000 during the year,
the company would make the following entry:

17-6
 Slide 7

Defined Benefit Pension Plans

Plan
Plan Characteristics
Characteristics

Employer
Employer is is Retirement Employer
Employer
Retirement
committed
committed to to benefits bears
bears all
all risk
risk
benefits are
are
specified
specified based of
of pension
pension
based onon aa
retirement
retirement formula fund
fund
formula that
that
benefits
benefits.. considers performance.
performance.
considers years
years
of
of service,
service,
compensation
compensation
level,
level, and
and age.
age.
17-7
 Slide 8

Defined Benefit Pension Plan

A pension formula might define annual retirement
benefits as:

1 1/2 % x Years of service x Final year’s 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

17-8
 Slide 9

The Pension Obligation

1. Accumulated benefit obligation (ABO) The actuary’s
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 actuary’s 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.© 2008 The McGraw-Hill Companies, Inc.
17-9
 Slide 10

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 1998. 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%

17-10
 Slide 11

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).
17-11
 Slide 12

Projected Benefit Obligation

If the actuary’s estimate of the final salary hasn’t changed,
the PBO a year later at the end of 2008 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 17-12

 Slide 13

Changes in the PBO

The
The PBO
PBO changes
changes as
as aa result
result of:
of:
Cause
Cause Effect
Effect Frequency
Frequency
Service
Service Cost
Cost ++ Each
Each period
period
Each
Each period
period (except
(except thethe first
first period
period
Interest
Interest Cost
Cost ++
of
of the
the plan)
plan)
Prior
Prior Service
Service Only
Only ifif the
the plan
plan isis amended
amended (or (or
++
Cost
Cost initiated)
initiated) that
that period
period
Loss
Loss or
or Gain
Gain on
on Whenever
Whenever revisions
revisions areare made
made in in the
the
++ or
or --
PBO
PBO pension
pension liability
liability estimate
estimate
Retiree
Retiree Benefits
Benefits Each
Each period
period (unless
(unless no no employees
employees
--
Paid
Paid have
have yet
yet retired
retired under
under the
the plan)
plan)

17-13
 Slide 14

Changes in the PBO

The
The PBO
PBO changes
changes as
as aa result
result of:
of:
Cause
Cause Effect
Effect Frequency
Frequency
Service
Service Cost
Cost ++ Each
Each period
period
Each
Each period
period (except
(except the first
first period
thePBO period
Service
Interest Cost
Interest Cost cost++ is the increase in the
of
of the
the plan)
plan)
attributable
Prior
Prior Service
Service
to employee Only
Only ififservice
the
the plan
plan isperformed
is amended
amended (or (or
++
Cost
Cost during the period.
initiated)
initiated) that
that period
period
Loss
Loss or
or Gain
Gain on
on + or - Whenever
Whenever revisions
revisions are are made
made in in the
the
+ or -
PBO
PBO pension
pension liability
liability estimate
estimate
Retiree
Retiree Benefits
Benefits Each
Each period
period (unless
(unless no
no employees
employees
--
Paid
Paid have
have yet
yet retired
retired under
under the
the plan)
plan)

17-14
 Slide 15

Changes in the PBO

The
The PBO
PBO changes
changes as
as aa result
result of:
of:
Cause
Cause Effect
Effect Frequency
Frequency
Service
Service Cost
Cost ++ Each
Each period
period
Each
Each period
period (except
(except thethe first
first period
period
Interest
Interest Cost
Cost ++
of
of the
the plan)
plan)
Prior
Prior Service
Interest cost
Service Only
Only ifif the
is++the interest onplan
the theisisPBO
plan amended
amended (or
during(or
Cost
Cost initiated)
initiated) that
that period
period
Loss
the period.
Loss or
or Gain
Gain on
on ++ or -
Whenever
Whenever revisions
revisions areare made
made in in the
the
or -
PBO
PBO pension
pension liability
liability estimate
estimate
Retiree
Retiree Benefits
Benefits Each
Each period
period (unless
(unless no
no employees
employees
--
Paid
Paid have
have yet
yet retired
retired under
under thethe plan)
plan)

17-15
 Slide 16

Changes in the PBO

The
The PBO
PBO changes
changes as
as aa result
result of:
of:
Cause
Cause Effect
Effect Frequency
Frequency
Service
Service Cost
Cost ++ Each
Each period
period
Each
Each period
period (except
(except the the first
first period
period
Interest Cost
Interest Cost ++
of
of the
the plan)
plan)
Prior
Prior Service
Service Only
Only ifif the
the plan
plan is is amended
amended (or (or
++
Cost
Cost initiated)
initiated) thatthat period
period
Loss
Prioror
Loss Gain
Gain on
orservice
oncost is theWhenever
Whenever
increase revisions
revisions
in the PBO are made
arefrom in
in the
madeusing the
++ or -
or -
a new,PBO
PBO
more generous pension pension
pension
formula liability
liability estimate
estimate the
to determine
Retiree
Retiree Benefits
Benefits Each
Each period
period (unless
(unless no
no employees
employees
pension-- obligation for prior years.
Paid
Paid have
have yet
yet retired
retired under
under the
the plan)
plan)

17-16
 Slide 17

Changes in the PBO

The
The PBO
PBO changes
changes as
as aa result
result of:
of:
Cause
Cause Effect
Effect Frequency
Frequency
Service
Service Cost
Cost ++ Each
Each period
period
Each
Each period
period (except
(except thethe first
first period
period
Interest Cost
Interest Cost ++
of
of the
the plan)
plan)
Prior
Prior Service
Service Only
Only ifif the
the plan
plan isis amended
amended (or (or
++
Cost
Cost initiated)
initiated) that
that period
period
Loss
Loss or
or Gain
Gain on
on + or - Whenever
Whenever revisions
revisions areare made
made in in the
the
+ or -
PBO
PBO pension
pension liability
liability estimate
estimate
Retiree Benefits Each period
period (unless
Retiree
LossBenefits Eachresults
or gain --on PBO from no
(unless no employees
employees
revising
Paid
Paid have
have yet
yet retired
retired under
under the
the plan)
plan)
estimates used to determine the PBO.

17-17
 Slide 18

Changes in the PBO

The
The PBO
PBO changes
changes as
as aa result
result of:
of:
Cause
Cause Effect
Effect Frequency
Frequency
Service
Service Cost
Cost ++ Each
Each period
period
Each
Each period
period (except
(except thethe first
first period
period
Interest
Interest Cost
Cost ++
of
of the
the plan)
plan)
Prior
Prior Service
Service Only
Only ifif the
the plan
plan isis amended
amended (or (or
++
Cost
Cost initiated)
initiated) that
that period
period
Loss
Loss or
or Gain
Gain on
on Whenever
Whenever revisions
revisions areare made
made in in the
the
++ or
or --
PBO
PBO pension
pension liability
liability estimate
estimate
Retiree
Retiree Benefits
Benefits Each
Each period
period (unless
(unless no no employees
employees
--
Paid
Paid have
have yet
yet retired
retired under
under the
the plan)
plan)

Retiree benefits paid are payments to

retired employees.
17-18
 Slide 19

Changes in the PBO

The changes in the PBO for Global Communications during 2009 were as follows:
($ in millions)*
PBO at the beginning of 2009+ (amount assumed) $ 400
Service cost, 2009 (amount assumed) 41
Interest cost: $400  6% 24
Loss (gain) on PBO (amount assumed) 23
Less: Retiree benefits paid (amount assumed) (38)
PBO at the end of 2009 $ 450
*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
2008.

17-19
 Slide 20

Pension Plan Assets

Global Communications funds its defined benefit pension
plan by contributing the year’s service cost plus a portion of
the prior service cost each year. Cash of $48 million was
contributed to the pension fund in 2009.

Plan assets at the beginning of 2009 were valued at $300

million. The expected rate of return on the investment of
those assets was 9%, but the actual return in 2009 was
10%. Retirement benefits of $38 million were paid at the
end of 2009 to retired employees. The plan assets at the
end of 2009 will be:
Plan assets at the beginning of 2009 $ 300,000,000
Return on plan assets (10% x $300 million) 30,000,000
Cash contributions 48,000,000
Less: Retiree benefits paid (38,000,000)
Plan assets at the end of 2009 $ 340,000,000
   

17-20
 Slide 21

Funded Status of the Pension Plan

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

17-21
 Slide 22

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

This amount is reported in the

balance sheet as a Pension
Liability or Pension Asset.
17-22
 Slide 23

Pension Expense – An Overview

Components of Pension Expense

+ Service cost ascribed to employee service this period
+ Interest accrued on pension liability
- Expected return on the plan assets
+ Amortized portion of prior service cost
+ or - Amortization of net loss or net gain
= Pension expense

17-23
 Slide 24

Pension Expense

Actuaries have determined that Global

Communications has service cost of
$41,000,000 in 2009.
Global's 2009 Pension Expense ($ in millions)
Service cost $ 41
Interest cost
Expected return on the plan assets
Amortization of prior service cost
Amortization of net loss
Pension expense $ 41

17-24
 Slide 25

Interest Cost
Interest cost is calculated as:
PBOBeg × Discount rate
Global had PBO of $400,000,000 on 1/1/09. The
actuary uses a discount rate of 6%.
Global's 2009 Pension Expense ($ in millions)
Service cost $ 41
Interest cost 24
Expected return on the plan assets
Amortization of prior service cost
Amortization of net loss
Pension expense $ 65

2009 Interest Cost: PBO 1/1/09 $400,000,000 × 6% = $24,000,000

17-25
 Slide 26

Return on Plan Assets

The plan trustee reports that plan assets were
$300,000,000 on 1/1/09. The trustee uses an expected
return of 9% and the actual return is 10%.
Beginning value of plan assets $ 300,000,000
Rate of return 10%
Return on plan assets 30,000,000
Beginning value of plan assets $ 300,000,000
Adjustment (10% - 9%) 1%
Adjusted for gain on plan assets 3,000,000
Expected return on plan assets $ 27,000,000

Global's 2009 Pension Expense ($ in millions)

Service cost $ 41
Interest cost 24
Expected return on the plan assets (27)
Amortization of prior service cost
Amortization of net loss
Pension expense $ 38
17-26
 Slide 27

Amortization of Prior Service Cost

In 2008, Global Communications amended the pension plan,
increasing the PBO at that time. For all plan participants,
the prior service cost was $60 million at 1/1/08. The
average remaining service life of the active employee
group is 15 years.

$60,000,000 PSC ÷ 15 = $4,000,000 per year

Global's 2009 Pension Expense ($ in millions)

Service cost $ 41
Interest cost 24
Expected return on the plan assets (27)
Amortization of prior service cost 4
Amortization of net loss
Pension expense $ 42
17-27
 Slide 28

Gains and Losses

Projected Benefits Return on Plan

Obligation Assets
Higher than
Loss Gain
Expected
Low er than
Gain Loss
Expected

17-28
 Slide 29

Corridor Amount

PBO at the
beginning of the
The corridor period.
amount is 10% of Or
the greater of . . . Fair value of plan
assets at the
beginning of the
period.

17-29
 Slide 30

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

17-30
 Slide 31

Gains and Losses

2009 Net Loss Amortization ($ in millions)
PBO $ 400
Fair value of plan assets 300
Net loss for 2009 55
Average service life 15
Net loss $ 55
Corridor amount ($400 x 10%) 40
Excess at the beginning of the year $ 15

$15,000,000 ÷ 15 years = $1,000,000

17-31
 Slide 32

Recording Gains and Losses

For 2009, 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:

OCI = Other comprehensive income

17-32
 Slide 33

Recording the Pension Expense

Global's 2009 Pension Expense ($ in millions)
Service cost $ 41
Interest cost 24
Expected return on the plan assets (27)
Amortization of prior service cost (calculated later) 4
Amortization of net loss (calculated later) 1
Pension expense $ 43

17-33
 Slide 34

Pension Expense Spreadsheet

17-34
 Slide 35

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

Retiree
Retiree
Less: Medicare
Medicare
share
share of
of payments
payments
cost
cost

Equals: Estimated
Estimated net
net
cost
cost of
of benefits
benefits
17-35
 Slide 36

Other Postretirement Benefits

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.

17-36
 Slide 37

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

17-37
 Slide 38

Postretirement Benefit Expense

17-38
 Slide 39

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 company’s 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

17-39
 End of Chapter 17

McGraw-Hill /Irwin © 2009 The McGraw-Hill Companies, Inc.