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Pensions
RCJ Chapter 14
Paul Zarowin 2
Key Issues1. Types of pension plans: defined benefit vs. defined contribution2. Pension liability: PBO, ABO, VBO3. Assumptions: discount rate%, salary growth rate%, E(ROA)%,
actuarial4. PENSION assets5. Primary (ongoing) factors6. Journal entries7. Smoothing of transitory gains and losses8. Types of transitory gains and losses9. Additional factors10. Funded status reconciliation11. Minimum liability
12. Corridor amortization
13. Pension worksheet14. Footnote disclosures15. Correction JE 16. OPEB’s
Paul Zarowin 3
Structure of Pension Plan
firm or employee pension fund retiree Cash Pay benefits
Paul Zarowin 4
Types of Pension Plans1.Defined contribution:
employee bears risk, no firm liability
2.Defined benefit: firm bears risk and has liability (our focus)
Paul Zarowin 5
Ex. Defined Benefit Plan worker’s age = 60 service = 30 yrs so far retire @ 65 (5 more years) current salary = $50,000Pension contract:
X% per year * final salary (X = # of years of service @ retirement)Example: 35% x $50,000 = $17,500
Paul Zarowin 6
Pension LiabilitiesPension liability: discounted PV of expected future cash payments - like any other non-current liability (effective interest method).
compare to other non-current liabilities: r% E(CF)
Bonds known knownLeases known? known Pensions ? ?
Both discount rate and expected cash flows are subjective
Paul Zarowin 7
3 Definitions of Liabilities PBO = PV of expected payments, given expected future salaries ABO= PV of expected payments, given current salaries VBO =PV of vested portion of expected payments, given current
salaries
PBO ABO VBO
Which definition is appropriate for which case?
1. valuing a going concern
2. Takeover
3. Firm in bankruptcy
We’ll use PBO, unless otherwise stated.
Paul Zarowin 8
Key Assumptions discount rate = r%
salary growth rate = g% (for PBO)
actuarial (life span, tenure, turnover, etc.)
EROA% (expected rate of return on pension assets), see below
Q: Is liability bigger for older or younger workers?
What are management’s incentives?
Paul Zarowin 9
Ex. Defined Benefit Plan, Continued
Assumptions Expected salary growth rate = 5% Discount rate = 10% Life expectancy = 80 years (15 years in retirement)
Expected final salary = 50,000 * (1.05)5 = 63,814 30% * 63,814 = 19,144 = amount he’ll receive per year in
retirement (based on service so far) PV of annuity factor, 10%, 15 yrs = 7.606 19,144 * 7.606 = 145,611 = PV @ retirement
PBO = 145,611/(1.10)5 = 90,413 = PV of annuity nowABO = (30% * 50,000 * 7.606)/1.105 = 70,841PBO > ABO due to expected salary growth
Paul Zarowin 10
Primary (Ongoing) Factors Affecting PBO
PBO - +
DR CR pay benefits Interest cost
Service cost
def: interest cost = r% * PBO @ beginning of year(remember: effective interest method)[debt accretion, like zero coupon bond]
def: service cost = PV of future benefits earned this year
Ex. E14-1, E14-13
Paul Zarowin 11
Ex. Defined Benefit Plan, Continued
Interest cost = 90413*.10 = 9041Service cost = (1% * 63,814 * 7.606)/1.105 =
3014
Q: how does a higher or lower r% affect interest cost?
Q: how does an employee’s age affect his service cost?
E14-1,13
Paul Zarowin 12
Pension Assets Pension assets: FMV of assets (stocks, bonds, etc.)
Funded status (true, economic position): Pension assets – PBO
Overfunded: assets > PBO Underfunded: assets < PBO Severely underfunded: assets < ABO
Paul Zarowin 13
Primary (Ongoing) Factors Affecting Pensions Assets
Assets+ -
DR CR Funding (contribution) Pay benefits (ROA)Return on assets#
# note: this is actual ROA; ROA is shown as +, but could be –
Ex. E14-6, E14-13
Paul Zarowin 14
Primary Journal Entries
* note: actual ROA is shown as +, but could be –
UNL = unexpected net loss (if actual ROA < expected ROA)UNG = unexpected net gain (if actual ROA > expected
ROA)
DR CR
service, interest
Pension expense PBO
Funding(contributions)
Assets Cash
benefits PBO Assets
ROA Assets(actual ROA)*
Pension Expense(expected ROA= EROA%*beginning assets)
UNL or UNG
Paul Zarowin 15
Ex. Defined Benefit Plan, Continued
Assume: pension assets = 100,000 E(ROA)% = 10% actual ROA = 15,000
DR assets 15,000 CR Pension expense 10,000CR UNGain 5,000
Q: How does assumed EROA% affect FMV of assets?
Paul Zarowin 16
Primary Factors Affecting Pension Expense
Pension Expense+ -
DR CRService E(ROA)
Interest
Q: What is the effect of funding on expense?
Paul Zarowin 17
Ex. Defined Benefit Plan, Continued
Service 3,014 Interest 9,041 E(ROA) (10,000)pension expense 2,055
Ex. E14-12 without amortization and unexpected lossP 14-1, Parts 1-3 in Summary So Far
Paul Zarowin 18
Smoothing of Transitory Gains and Losses def: unrecognized = deferred (in footnotes)def: recognized = amortized (into pension expense
on I/S)
Transitory gains, losses are CR’d (gains) or DR’d (losses) to unrecognized (footnote) accounts, rather than recognized as gain or loss on I/S. The unrecognized balances are amortized onto I/S. This smooths NI and keeps assets and PBO off of B/S.
Full Exp For E14-13
Paul Zarowin 19
Smoothing (cont’d): Intuition
Loss in DR, Gain in CRDR CR
Loss: Unrecognized loss Asset or liab.
Amort’n: Exp.(recorded) Unrecognized loss
Gain: Asset or liab. Unrecognized gain
Amort’n: Unrecognized gain Exp.(recorded)
20
Types of Transitory Gains, Losses
DR CR
asset gain: actual ROA > expected ROA Assets Pension expense
UNG
asset loss: actual ROA < expected ROA AssetsUNL
Pension expense
* assets are DR’d (or CR’d) for actual ROA; pension expense is CR’d for expected ROA; difference is UNG or UNL (see slide #15)
liability loss (due to assumption r%, g%, etc.)
UNL PBO
liability gain (due to assumption r%, g%, etc.)
PBO UNG
note: asset and liability gains and losses are all aggregated into one UNG/L account note: liability gains and losses are also called actuarial gains and losses
Q: What happens if EROA% is set too high (higher than true average ROA%)?
Paul Zarowin 21
2 Types of Liability Gain/Loss
1. Change in assumptions
2. Change in contracts
Intuition: What affects r% and E(CF)’s
Paul Zarowin 22
Types of Transitory Gains, Losses (cont’d)
DR CR
Change in pension contract: sweetening
UPSC PBO
Change in pension contract: souring PBO UPSC
def: UPSC = unrecognized prior service cost (retroactive benefits)
Paul Zarowin 23
Ex. Defined Benefit Plan, Continued
1. assume benefits are sweetened to pay 1.1% * final salary per year (increased by 10%)increase in PBO = 10% * 90,413 = 9041 DR UPSC 9041
CR PBO 9041
2. assume salary growth rate is increased to 6% (final salary = 66,912), so PBO = 94,802 and increase in PBO = 4389 (94,802 – 90,413)
DR UNLoss 4389CR PBO 4389
Paul Zarowin 24
Additional Factors Affecting PBO
PBODR (+) CR (-)
Primary factors
Pay benefits Interest cost
Service cost
Additional factors
Liability gain
Liability loss
Souring Sweetening
( assumptions)( contracts)
Paul Zarowin 25
Additional Factors Affecting Pension Expense
ExpenseDR (+) CR (-)
Primary factors Interest cost E(ROA)
Service cost
Additional factors
loss amortization
Gain amortization
Paul Zarowin 26
Additional Factors Affecting Pension Expense (cont’d)
Loss amortization:DR Pension expense
CR UPSC or UNL or UTL Gain amortization:
DR UPSC or UNG or UTACR Pension expense
UTA, UTL = unrecognized transition asset, liability = net position (assets - PBO) @ adoption of SFAS #87
remember: amortization = recognized into expense amortization is generally SL over average remaining
service life of employees
Paul Zarowin 27
Ex. Defined Benefit Plan, Continued
Amortize UPSC over 5 years: 9041/5 = 1808DR pension expense 1808
CR UPSC 1808
service 3,014
interest 9,041
E(ROA) (10,000)
UPSC Amort. 1,808
pension expense 3,863
Ex. E14-13 GM disclosure E 14-12 w/o Loss
Paul Zarowin 28
Funded Status Reconciliation Reconcile true vs. recognized position
assets- PBO funded status (can be net asset or net liability): ‘true position’+ UNL (or - UNG)+ UPSC+ UTL (or - UTA) recognized (on B/S) position: prepaid pension cost (asset) or deferred pension cost (liab)
note: funded status (true economic position) vs. recognized position unrecognized losses & liab’s make the recognized position better than the
true position unrecognized gains & assets make the recognized position worse than the
true position
Ex. E14-14, 19
Unrecognized Gains/Losses
Paul Zarowin 29
Minimum Liability if ABO > assets the pension plan is considered
‘severely underfunded’ and a liab. (ABO - assets) must be recognized.
if recognized position is asset (prepaid cost) or liab (accrued cost) < (ABO-assets), additional entry is needed to bring recognized position to minimum level:
DR Intangible asset*
CR Additional liability* should be DR to a loss account
additional liab can be shown separately or aggregated with accrued pension cost on B/S
Ex. E14-2, E14-5
30
Corridor (Minimum) Amortization UNL or UNG must be amortized only if it > “corridor” corridor = 10% of bigger (PBO, assets) @BOY amortization is down to corridor, not zero if amort’n is required one year, it might or might not be
the next year, and vice versa
UNG/L DR CR
*BOY net loss *BOY net gain (* for current year amort’n test)
Current year loss Current year gain
gain amort’n loss amort’n (amort’n only if required)
#EOY net loss #EOY net gain (# for next year’s amort’n test)Ex. P14-1, sec 1-6 E14-18
Pension Worksheet - put it all together - relate to funded status
reconciliation Recognized (on FS) bal. Unrecognized (footnote)
balances
Pen. exp
Cash
pp’d/acc cost
Pen Ass
Pen Liab
UNGL
UPSC
Service cost DR CR
Interest cost DR CR
ROA CR DR plug
Funding (contribution)
CR DR
Benefits CR DR
liability loss6 CR DR
Sweetening7 CR DR
Amortization UNL8 DR CR
Amortization of UPSC (from sweetening)9 DR CR
Summary JE; only recognized (on FS) JE
DR CR CR or DR6. reverse DR and CR for a liability gain 8. reverse DR and CR for amort’n of unrecognized gain 7. reverse DR and CR for souring 9. reverse DR and CR for amort’n from souringNote: recognized asset/liab (prepaid/accrued pension cost) is net of all unrecognized accounts
Paul Zarowin 32
Exercise problems
E14-3, E14-4, E14-7 E14-17, 20 P14-2, P14-3 P14-13
Paul Zarowin 33
Footnote Disclosures The pension footnote includes:
1. total pension expense and its components
2. reconciliation of BOY vs EOY PBO and asset accounts (like t-accounts)
3. funded status reconciliation
4. assumptions (r%, g%, EROA%)
C 14-2,3
Paul Zarowin 34
Correction JE (to put assets and liabs on B/S) using information in pension footnote, put pension assets and
liab on B/S; replace recognized position with true position
DR CR pension assets PBO accrued pension cost or Prepaid pension cost R/E or R/E
1. put pension assets and PBO on B/S2. remove accrued or prepaid pension cost from B/S3. plug: DR or CR R/E = cumulative unrecognized gains/losses
(sum of UNGL, UPSC, UTAL)note: DR or CR to R/E rather than current year gain or loss
Paul Zarowin 35
Other Post-Employment Benefits (OPEB’s) Same accounting as pensions, with minor differences1. ABO instead of PBO (OPEB’s not tied to salary)
2. significance of (TL) transition liability (no incentive to fund, so ABO > assets) firms can: amortize TL over <= 20 years
DR OPEB expense CR Accrued OPEB cost
or take loss as change in accounting principle (below the line):DR loss due to change in acct principle
CR Accrued OPEB cost most firms chose latter: why?
3. service cost is accrued (earned) over short (vesting) period, since benefits don’t increase with tenure