Download Chapter 17

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
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
17-2
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.
17-3
Nature of Pension Plans
17-4
Defined Contribution Pension Plans
Plan Characteristics
Contributions
are defined
by
agreement.
Employer
deposits an
agreed-upon
amount into
an employeedirected
investment
fund.
Employee
bears all risk
of pension
fund
performance.
17-5
Defined Contribution Pension Plans
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:
Pension expense
Cash
3,300
3,300
The employee’s retirement benefits are totally
dependent upon how well investments perform.
17-6
Defined Benefit Pension Plans
Plan Characteristics
Employer is
committed to
specified
retirement
benefits.
Retirement
benefits are
based on a
formula that
considers
years of
service,
compensation
level, and age.
Employer
bears all risk
of pension
fund
performance.
17-7
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
Defined Benefit Pension Plan
An actuary assesses the various uncertainties
(employee turnover, salary levels, mortality, etc.) and
estimates the company’s obligation to employees in
connection with its pension plan.
The key elements of a defined benefit
pension plan are:
1. The employer’s 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.
17-9
Pension Expense—An Overview
The annual pension expense reflects
changes in both the pension obligation and
the plan assets.
17-10
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.)
17-11
The Pension Obligation
17-12
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%
Annual retirement benefits
Farrow is expected to retire in 2041 after 40 years of service. Her
retirement period is expected to be 20 years. At the end of 2011,
10 years after being hired, her salary is $100,000. The interest
rate is 6%. The company’s actuary projects Farrow’s salary to be
$400,000 at retirement.
17-13
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).
Step 3. Find the present value of the retirement benefits as of the
current date.
The present value (n=30, i=6%) of the retirement benefits at
2011 is $119,822 ($688,195 × .17411). This is the PBO.
17-14
Projected Benefit Obligation
If the actuary’s estimate of the final salary hasn’t 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
the retirement date is $757,015 ($66,000 × 11.46992).
Step 3. Find the present value of the retirement benefits as of the
current date.
The present value (n=29, i=6%) of the retirement benefits at
2012 is $139,715 ($757,015 × .18456). This is the PBO.
17-15
Projected Benefit Obligation
17-16
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.
17-17
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.
17-18
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 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:
Reporting the Funded Status of Pension
Plan
Projected Benefit Obligation (PBO)
- Plan Assets at Fair Value
Underfunded / Overfunded Status
This amount is reported in the
balance sheet as a Pension
Liability or Pension Asset.
17-19
17-20
Service Cost
Actuaries have determined that Global
Communications has service cost of
$41 million in 2013.
Global's 2013 Pension Expense
Service cost
Interest cost
Expected return on the plan assets
Amortization of prior service cost
Amortization of net loss
Pension expense
($ in millions)
$ 41
17-21
Interest Cost
Interest cost is calculated as:
PBOBeg × Discount rate
Global had PBO of $400 million on 1/1/13. The actuary
uses a discount rate of 6%.
Global's 2013 Pension Expense
Service cost
Interest cost
Expected return on the plan assets
Amortization of prior service cost
Amortization of net loss
Pension expense
($ in millions)
$ 41
24
2013 Interest Cost
PBO 1/1/13 $400,000,000 × 6% = $24,000,000
17-22
Return on Plan Assets
The plan trustee reports that plan assets were $300 million on
1/1/13. The trustee uses an expected return of 9% and the
actual return is 10%.
Global's 2013 Pension Expense
Service cost
Interest cost
Expected return on the plan assets
Amortization of prior service cost
Amortization of net loss
Pension expense
($ in millions)
$ 41
24
(27)
17-23
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 = $4 million per year
Global's 2013 Pension Expense
Service cost
Interest cost
Expected return on the plan assets
Amortization of prior service cost
Amortization of net loss
Pension expense
($ in millions)
$ 41
24
(27)
4
17-24
Gains and Losses
Projected Benefits Return on Plan
Obligation
Assets
Higher than
Expected
Low er than
Expected
Loss
Gain
Gain
Loss
Only if a net gain or net loss exceeds the
“corridor” is a charge to pension
expense allowed.
17-25
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.
17-26
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
17-27
Gains and Losses
2013 Net Loss Amortization ($ in millions)
PBO
$
Fair value of plan assets
Net loss for 2013
Average service life
Net loss
Corridor amount ($400 x 10%)
Excess at the beginning of the year
$
$
$15 million ÷ 15 years = $1 million
400
300
55
15
55
40
15
17-28
Determining Pension Expense
Global's 2013 Pension Expense
Service cost
Interest cost
Expected return on the plan assets
Amortization of prior service cost
Amortization of net loss
Pension expense
($ in millions)
$ 41
24
(27)
4
1
$ 43
17-29
Recording Gains and Losses
For 2013, the actual return on plan assets exceeded the
expected return by $3 million. In addition, there was a $23
million loss from changes made by the actuary when it
revised its estimate of future salary levels causing its PBO
estimate to increase. Global would make the following
journal entry to record the gain and loss:
Loss—OCI
PBO
Plan assets
Gain—OCI
($ in millions)
23
23
3
OCI = Other comprehensive income
3
17-30
Record Pension Expense
($ in millions)
Pension expense (calculated below)
Plan assets ($27 expected return on assets)
PBO ($41 service cost + $24 interest cost)
Prior service cost–AOCI
Net loss–AOCI
43
27
65
4
1
OCI = Other comprehensive income
 Service cost and interest cost add to Global’s PBO.


The return on plan assets adds to the plan assets.
Amortization of prior service and net loss reduce each account.
Global's Pension Expense
Service cost
Interest cost
Expected return on the plan assets
Amortization of prior service cost
Amortization of net loss
Pension expense
($ in millions)
$
41
24
(27)
4
1
$
43
17-31
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
It’s not unusual for the cash contribution to differ
from that year’s pension expense. After all,
determining the periodic pension expense and the
funding of the pension plan are two separate
processes.
17-32
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
17-33
Comprehensive Income
Comprehensive income is a more expansive view of
income than traditional net income.
17-34
Comprehensive Income
17-35
Pension Spreadsheet
Postretirement Benefits Other Than
Pensions
Net Cost of Benefits
Estimated medical
costs in each
year of retirement
Less:
Equals:
Retiree
share of
cost
Medicare
payments
Estimated net
cost of benefits
Many companies
also furnish other
postretirement
benefits to their
retired employees.
17-36
17-37
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.
17-38
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
$10,842
x
EPBO
x
2012
1.06
$11,493
EPBO
10/
35
=
fraction
attributed
$3,098
APBO
Assume the obligation increases by the 6%.
x
11/
35
=
fraction
attributed
She now has worked 11 of her estimated 35 years
$3,612
APBO
17-39
How the APBO Changed
The two elements of the increase in 2012 can be separated as follows:
17-40
End of Chapter 17