Pension AccountingPension AccountingChapter 17Chapter 17

Understand the nature/characteristics/accounting of employer

pension plans:

Defined Benefit Plans.

Professor Vedd

Objectives:Pension OverviewFundamental differences between:

– Defined contribution plans– Defined benefit plans*

Accounting for Pension:– Key components: Pension expense

Disclosure/presentation

Professor Vedd

CHAPTER 17: PENSIONCHAPTER 17: PENSION

A pension plan:An agreement between an employer/employee

• Government plans: social security• Individual plans (IRA)• Employer Plans*

Emphasis: Pension Plan: for Corporation: Company set aside funds for employees’ service!

Professor Vedd

OverviewOverview of Pension Planof Pension Plan

SFAS 158 Reporting pension items in the balance sheet and AOCI

132R: Disclosures

IAS 19 (detail information provided –end of the lecture)

Professor Vedd

Pensions: SFAS 158Pensions: SFAS 158

Professor Vedd

PENSION PLAN: OverviewPENSION PLAN: Overview

EmployerSponsors the plan

Plan Administrator

Pension Recipients

Contributions

Benefits

The plan administrator receives the contributions from the employer, invests the pension assets, and makes the benefit payments.

TYPES OF PENSION PLANSTYPES OF PENSION PLANSTWO TYPESTWO TYPES

$

DEFINED CONTRIBUTION PLAN

1

2DEFINED BENEFIT PLAN

promise FIXED ANNUAL CONTRIBUTIONS

promise FIXED RETIREMENT BENEFITS

Pension fund

Professor Vedd

Defined Contribution A plan that provides benefits based solely on what has been contributed and the earnings thereon

Amounts to be funded are determined by the plan – No promise for specific future benefits. – Independent third party holds assets – Risk borne by employee – Accounting relatively straightforward

• Employer makes no guarantee to the amount of benefits

• Employees’ retirement benefits based on the amount of funds in the plan

Professor Vedd

Defined Defined contributioncontribution plans plans

Professor Vedd

Defined Defined Benefit Benefit Pension PlansPension Plans

Employer is committed to

specified retirement benefits.

Employer is committed to

specified retirement benefits.

Retirement benefits are based on a formula that considers years of

service, compensation level, and age..

Retirement benefits are based on a formula that considers years of

service, compensation level, and age..

Employer bears all risk of

pension fund performance.

Employer bears all risk of

pension fund performance.

Plan CharacteristicsPlan Characteristics

DEFINED BENEFIT PLAN

Defined benefit plans – Employer’s contribution is based on the expected

future benefits – Affected by many variables:

Years of service Annual salary at retirement Retirement years

– Etc.

Future Obligation for retirement benefits is based on many estimates/assumptions

Professor Vedd

Accounting for Accounting for DefinedDefined Benefit Plans Benefit Plans

Professor Vedd

Pension calculations involve actuarial assumptions.

Assumptions involve:

mortality rates, employee turnover, future salaries, rates of return, etc.

These are estimates.

Actuaries and Pension Accounting

Professor Vedd

Measures of Pension Liability:Measures of Pension Liability:Defined Benefit PlanDefined Benefit Plan

AccumulatedBenefit

Obligation

(AB0)

ProjectedBenefit

Obligation

(PBO)

Benefits for vested/ non-vested employees at current salaries

Benefits for vested and nonvested employees at future salaries (GAAP)

Pension calculations involve actuarial assumptions.

Professor Vedd

OVERVIEW: PENSION OVERVIEW: PENSION COMPONENTSCOMPONENTS

Employeehired

EmployeeRetired

1. SERVICE PROVIDED Benefit Period

Based On Actuarial Assumptions:How much to contribute annually for the service provided by employees

SERVICE COST

PENSION EXPENSE

Interest cost : (PENSION EXPENSE)

– the increase in the pension obligation (PBO) due to the accrual of an additional year of interest.

PV of liability increases as you get closer to the due date– Interest cost = discount rate * beginning

balance in PBO

Professor Vedd

PENSION EXPENSE: INTEREST COSTPENSION EXPENSE: INTEREST COST

INTEREST COST:PENSION INTEREST COST:PENSION EXPENSEEXPENSE

PV of pension Obligation is increased by the interest cost on the beginning of PBO

Professor Vedd

Professor Vedd

OVERVIEW: TIMELINEOVERVIEW: TIMELINECOMPONENTSCOMPONENTS

PRIOR (PAST) SERVICE COSTPRIOR (PAST) SERVICE COST

PlanInitiation

EmployeeHired

EmployeeRetired

Past Service Cost SERVICE COST

Benefit Period

Establishing (or modifying/amended) a plan

Cost of benefits granted for service rendered prior to the inception of the plan

Increases PBO at date of amendment/The entire amount of Past Service Cost is NOT

recognized as expense in the current yearInstead , Past Service Cost is recognized in the

current period in Other Comprehensive Income (OCI)

Professor Vedd

PENSION EXPENSE: Prior Service CostPENSION EXPENSE: Prior Service Cost

1. Periodic expense (Pension Expense) of having a pension plan

2. Plan Assets Resources set aside by the employer from which to pay the retirement in the future (invested by Trustee)

3. Employer’s Obligation to pay retirement benefits in the future

Professor Vedd

Issues in Accounting:Issues in Accounting:Defined Benefit PlansDefined Benefit Plans

Resources with which the obligation will Satisfy: PLAN ASSETS

Employee contribution in the Pension Fund (held by Trustee)

Plan Assets are invested -in income producing assets.

Accumulated balance: Contribution + return on investment Professor Vedd

Pension Plan AssetsPension Plan Assets

– Expected return on plan assets (FASB)– *Expected rate of return:

Based on long-term rate of return anticipated given investment of plan assets

– Expected return on plan asset decreases the pension cost and increases plan asset

Professor Vedd

Return on Plan AssetReturn on Plan Asset

Actuarial assumptions are subject to inaccuracies as time goes by and circumstances change

The estimate of the PBO also require revision

Inc/Dec in PBO is referred to gain/loss

Professor Vedd

Actuarial Gains and LossesActuarial Gains and Losses

NET GAINS/LOSSES:1. Gains/Losses from the return on Assets

2. Gains/Losses from changing assumptions (PBO)

= NET GAINS/LOSSES • Deferred and reported as OCI • Amortized using Corridor rule*

NET GAINS/LOSSESNET GAINS/LOSSES

Professor Vedd

Professor Vedd

Corridor AmountCorridor Amount

The corridor The corridor amount is 10% of amount is 10% of the greater of . the greater of . . .. .

PBO at the PBO at the beginning of the beginning of the periodperiod..

Fair value of plan Fair value of plan assets at the assets at the beginning of the beginning of the periodperiod..

OrOr

STEPS 1: GREATER OF PBO & PLAN ASSETS2: 10% OF STEP 13…. Next slide…

Professor Vedd

Gains and Losses 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

EXAMPLE

Apply steps: 1.Greater of PBO & Plan Assets = PBO $4002.10% of PBO i.e. 400 x 10% = $40

2013

2013

Professor Vedd

Gains and Losses Gains and Losses

Net loss 55$

Corridor amount ($400 x 10%) 40

Excess at the beginning of the year 15$

$15,000,000 $15,000,000 ÷ 15 years = $1,000,000÷ 15 years = $1,000,000

STEP 3: FIND THE EXCESS TO BE AMORTIZED

AMORTIZATION:

So far…..PENSION EXPENSE=

Service Cost + Interest Cost

- expected return on plan Asset+Amortization (if any) of Prior service

cost +/- Amortization (net) Gains/Losses

Professor Vedd

Defined Benefit Plan:Defined Benefit Plan:Net Periodic Pension CostNet Periodic Pension Cost

The employer’s obligation and plan assets are not individually reported in a company’s primary financial statements:

the difference between the two, the funded status, is reported as:

a pension liability if underfunded or a pension asset if overfunded.

Professor Vedd

REPORTING: REPORTING: EmployerEmployer’’s Obligation & Plan Assets Obligation & Plan Asset

Professor Vedd

Funded Status of Pension PlanFunded Status of Pension Plan

Projected Benefit Obligation (PBO)

- Plan Assets at Fair Value

Underfunded / Overfunded Status

Projected Benefit Obligation (PBO)

- Plan Assets at Fair Value

Underfunded / Overfunded Status

This amount is reported in the This amount is reported in the balance sheet as a Pension Liability balance sheet as a Pension Liability or Pension Asset.or Pension Asset.

The details for net periodic pension cost– the service cost component. – the interest cost component. – the expected return on plan assets the

amortization of PSC, transition amount and unrecognized gain/loss (separately)

– Gain or loss from settlement or curtailment of plan

Professor Vedd

Pension DisclosuresPension Disclosures

– Amount and types of assets held– Assumptions related to discount

rate, rate of increase in compensation, expected return on plan assets

– Alternative amortization policies– Past practice or history of regular

benefit increases

Professor Vedd

Pension DisclosuresPension Disclosures

Employers with multiple plans– Information can be combined but the

computations are made for each individual plan

Net position for over-funded plans would be reported in noncurrent assets

Net position for under-funded plans would be reported in liabilities

– Part may be reported as a current liability

– See next slide

Professor Vedd

Pension DisclosuresPension Disclosures

Disclosure of Pension PlansDisclosure of Pension PlansFASB 132FASB 132

1. A reconciliation between the beginning and ending balances for the projected benefit obligation

2. A reconciliation between the beginning and ending balances in the fair value of the pension fund

The fair value of plan assets (changes between BOY and EOY)

PBO Obligation (changes between BOY and EOY)

EoY = end of yearBoY = beginning of year

Professor Vedd

continues

Professor Vedd

(continues)Professor Vedd

(concluded)Professor Vedd

(concluded)Professor Vedd

IAS 19: INFORMATIONIAS 19: INFORMATION

The standard covers all employee benefits - not just pensions. This note focuses on pensions but a later section considers other employee benefits. The key pension points are:

Assets are taken at market value 

Liabilities are calculated using an interest rate based on the yield on high quality corporate bonds at the valuation date (usually taken as AA-rated) 

There is a limit to the amount that can be recognized as a prepayment (surplus) in the company balance sheet

Actuarial gains and losses may be:

– recognized in the P&L immediately– recognized in the P&L on a smoothed basis– recognized immediately in the statement of recognized income and expense

The cost of past service benefit increases is recognized immediately to the extent that the increases are vested immediately

Professor Vedd