Download FA3 Lesson 7. Pension costs and obligations

FA3
Lesson 7. Pension costs and obligations
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Pensions
Defined contribution vs. defined benefit
Accounting for pensions
Pension worksheet
1. Pensions
A pension plan consists of segregated assets
(managed by a trustee) and an actuarially
determined, long-term liability to employees for
pension entitlements earned.
Matching principle: cost of pension benefits
should be recorded in the year in which they are
earned (when the employees provide the labour
services)
Vocabulary
Contributory: employees makes contributions to
the pension plan (usually, along with employer)
Vested: pension benefits become vested at the
moment when the employee retains right to
receive benefits, even if employee leaves firm
Trusteed: independent trustee manages plan
assets and pays out benefits – pension assets and
liabilities do not appear on company balance
sheet
2. Defined contribution vs. defined benefit
Defined contribution: employer (and perhaps
employee) make defined cash contributions each
year to pension fund; employee receives annuity
at retirement, based on the market value of
pension contributions at retirement
Accounting: usually, current employer
contributions = pension expense
2. Defined contribution vs. defined benefit
Defined benefit plan
A certain level of retirement benefits are
guaranteed to the employee, usually as function
of employee earnings and years of service. To
ensure there are sufficient pension benefits to
meet this obligation, company must consider:
-investment earnings
-future salary increases
-employee turnover
-mortality rates and life expectancy
Defined benefit pension plan:
Accrued pension obligation and plan assets
-
Accrued obligation
+
Payment to pensioners Current service cost
Experience/actuarial gains Past service cost
Interest cost
Experience/actuarial losses
+
Pension plan assets
Employer contributions Payments to pensioners
Employee contributions
Investment income
Funding a defined benefit plan
Basic methods:
1. Accumulated benefit: annual cash
contribution is based on years of service to
date and current salary
2. Projected benefit: annual cash contribution is
based on years of service to date and
projected estimate of salary at retirement date
3. Level contribution: projects final salary and
years of service, and allocates cost evenly
over years of service
Defined benefit: Funding vs. accounting
Companies can use any of these three methods
(or variants thereof) to fund the pension plan.
For accounting purposes (determining annual
pension expense), the CICA says that the
projected benefit method provides the best
matching of pension benefits to periods in which
employee provides labour services.
Funding method could be different, though,
leading to pension asset/liability on balance sheet
(which will disappear when all employees
retire).
3. Calculating pension expense
Pension expense is composed of:
1. Current service cost: present value of pension
benefits earned by virtue of labour services
provided by employees in current period
2. Interest on (opening) accrued benefit
obligation: interest rate is long-term debt rate
at balance sheet date.
3. Expected earnings on (opening) plan assets
(negative): rate based on long-term market
rates of return
3. Calculating pension expense (cont’d)
Pension expense is composed of:
4. Past service cost from plan initiation: value of
pension benefits granted when plan instituted,
usually amortized straight-line over expected
period to full eligibility (EPFE)
5. Past service cost from plan amendment:
amortized over EPFE or period until next
expected amendment
6. Amortization of actuarial or experience gains
and losses
Actuarial/experience gains and losses
These are gains and losses caused by experience
(e. g., actual rates of return) or changes in
actuarial assumptions (e. g., discount rate,
employee longevity). Gains and losses are
netted out and:
1. Amortized using 10% corridor method
(amortize excess of G/L over 10% of opening
fund assets or accrued obligation, whichever is
greater, over average remaining service period
(ARSP). This is minimum permitted.
2. Some amount greater than (1) can be included
in pension expense.
Examples
• A20-9
• A20-13
4. Pension worksheet
A convenient way to put together all of the
pension variables.
EXAMPLES
A20-16
A20-26