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Pensions

ACCTG 5120David Plumlee

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Important fact… Accounting we are talking about is for the

company!

The pension fund is actually managed and accounted for separately legal and accounting entity of its own…..

We focus on the impact of an asset/liability/expense for payment of the pension obligation from the company’s perspective

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Pensions: The Big Picture

EmployerPension Fund Trustee

Invests funds to earn a return and payout cash to retiree

Funding

Payments

RetireeBenefit Payments

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Basic questions

What is employer’s liability/asset (how should this be reported on the balance sheet)?

What is the current year’s expense associated with the plan?

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Defined Contribution Plan Employer contracts for an amount to

be contributed

Example Plan The company will make a contribution under the

plan equal to a stated percentage of the employee’s current annual salary. The percentages applied vary according to age (see attached table). All employees are required to make a 5% minimum contribution. Ownership of all contributions is fully vested in the participant.

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Defined Contribution Plan

Employee Employees Company%

Wages< age 45 7.0% $150,00045 to 49 8.5% $350,00050 to retirement 11.5% $200,000

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Company contribution

=$1,500,000* .07 + $3,500,000*.085 + $2,000,000*.115

=$335,000

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Defined Contribution Example

Total Employment Period Benefit period

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Defined Benefit Plan

Employer contracts for future payouts

Example Plan The company agrees to provide to all employees

at age 65, an annual pension benefit computed in accordance with the “benefit formula.” Ownership of all benefits becomes fully vested following three years of continuos employment with the company.

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Defined Benefit Example

Total Employment Period Benefit period

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Determining Employer Contribution

What does the employer need to do?

What is the amount of that liability?

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Actuarial Assumptions

Assume for an employee who works for this company: Benefits are $4,000 per year in retirement for every year

worked Expected # of years at company = 20 yrs Employee will live 15 years beyond retirement Settlement rate is 6%. (The interest rate implicit in the

annuity contract at retirement.) Expected rate of return 8%. ( The amount that funding

will earn.)

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Actuaries Determine Benefits

Current period Retirement

Total Employment Period

Actuarial Estimate of Retirement Benefits

= PV of Benefits @ Settlement Rate

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Actuaries Determine Benefits

Current period Retirement = 15 years

Remaining Employment Period = 20 years

Retirement Benefits =

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Actuaries Determine Funding

So, how much should the company fund this year?

What is that amount in this example?

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Actuaries Determine Funding

Current period Retirement = 15 years

Remaining Employment Period = 20 years

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Defined contribution vs. benefit plans

Benefit Employer’s

contribution is based on expected payout

Contract is for payments to retired employees employer bears risk associated with plan performance

Great uncertainty regarding annual pension expense

Contribution Employer’s

contribution to the plan is defined

No promises regarding ultimate pension benefit

Employees bear risk associated with plan performance

No uncertainty regarding annual pension expense

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Accounting for Defined Contribution Plans

Assume required contribution under terms of plan for 2003 is $335,000

Employer FundingContribution Status

Case A: $335,000 fully fundedCase B: $300,000 under fundedCase C: $600,000 over funded

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Accounting for Defined Contribution Plans

Case A:

Case B:

Case C:

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Defined BENEFIT Options

Cash basis accounting wait until employees retire expense actual payments to retired

employees

Modified cash basis accounting fund plan prior to retirement expense funding payments

Accrual basis accounting (FAS 87) expense pension related cost of services

provided in current year by employees

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What is the ‘obligation’?

Accumulated benefit obligation (ABO)Estimate of total retirement benefits based on

current salary levels

Vested benefit obligationPortion of ABO that is vested

Projected benefit obligation (PBO)Estimate of total retirement benefits based on

future salary levels

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Major Components of a Pension Plan

PBOactuarial present value of future pension benefits

earned to date to be paid to employees in the future

Pension plan assetsvalue of assets set aside to satisfy obligation

**net pension obligation (asset) =PBO-pension assets**

Pension expenseamount charged to income for the period

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Important Terms

Benefit payments pension payments to participants

Funding payments payments made to the trustee to fund

the plan

Transition adjustment “catch-up” adjustment that arose

when firms first adopted FAS 87

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Important Terms

Current service cost (CSC) present value of benefits earned

during the current period

Actual return on plan assets includes dividends, interest income

and capital gains and losses

Expected return on plan assets anticipated return on plan assets

based on the expected long-term rate of return on plan assets

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Important TermsExperience gain or loss

difference between actual and expected return on plan assets

Actuarial gain or loss a change in the value of the PBO

resulting from a change in actuarial assumptions

Prior service cost (PSC) cost of retroactive benefits granted in

a plan amendment

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Pension Assets

opening balance+ actual return on plan assets+ funding payments- benefit payments to retireesclosing balance

Pension Fund Trustee

Invests funds to earn a return and payout cash to retiree

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Projected Benefit Obligationopening balance+ current service cost+ prior service cost+ interest on obligation- benefit payments to

retirees+/- changes in assumptions (i.e. actuarial gains/losses)

closing balance

Employer

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Pension Expense

+ current service cost+ interest on pension obligation- actual return on plan assets+/- deferral of experience gain/loss+/- amortization of unrecognized gain/loss(including experience and actuarial gains/losses)

+ amortization of unrecognized prior service cost

+/- amortization of transition adjustmentpension expense

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Current Service Cost

Actuarial present value of new benefits earned by employees during current period

Current period Retirement

Total Employment Period

PV of additional retirement benefits

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Effect of Service Cost

PBO Service cost is

starting point Current service

cost will increase PBO on an annual basis

Expense Current service

cost increases in first year of plan,

same as for PBO

Beg Bal. $1,300,000Current SC 500,000 $ 500,000

Assume a $500,000 increase of PBO due to additional year of service

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Prior Service Cost Credit given to employees for past service

Initiate or amend a plan Retroactive benefits

really retroactive? Expectation of future service….

Increases PBO Amortize PSC for pension expense

Years of service method

prior service cost = $100,000, 5 year amortization

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Prior Service Cost

Current period Retirement

Total Employment Period

Plan Amendment

PV of benefits due to plan amendment or adoption for past periods

Prior service period

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Effect of PSC

PBO Increases by total

amount in year of change

Expense amortized into

over estimated life of employees effected, beginning with year of changeBeg Bal. $1,300,000

Current SC 500,000 $ 500,000PSC 100,000 20,000

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Interest on Pension Obligation

Employee is one year closer to retirement, which increase present value of benefits due to the time value of future benefits

Interest on the pension obligation (i.e. projected benefit obligation) outstanding during the period= beginning-of-year balance x settlement rate

Assume settlement rate = 10%

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Effect of Interest

Increases PBO Increases expense

Beg Bal $1,300,000Current SC 500,000 $ 500,000PSC 100,000 20,000Interest 130,000 130,000

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Payments and changes in assumptions

Benefit payments reduce PBO Payments have NO EFFECT on pension

expense Assume $30,000 funding payment Changes in actuarial assumptions

Increase or decrease PBO Amortized in pension expense (when too big!)

Assume actuarial assumptions change amount is increase in PBO of $40,000

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Effect of payments and changes in assumptions Payments decrease

PBO Changes in

actuarial assumptions change PBO

No effect Changes in actuarial

assumptions are amortized into expense using corridor approach

Beg Bal $1,300,000Current SC 500,000 $ 500,000PSC 100,000 20,000Interest 130,000 130,000Benefit pmt ( 30,000) 00Actuarial loss 40,000 00*

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Return on Plan Assets

Actual return = interest + dividends + cap. gains - cap.

losses

Expected return = actuary’s expected rate of return x plan assets

Difference is the ‘experience gain or loss’

Pension Fund Trustee

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Details of expected return Actual return reduces pension

expense with ‘experience’ gains/losses deferred

Net result is EXPECTED return reduces pension expense

Amortize experience gains/losses when they gets too large

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Return on plan assets

Plan assets = $1,000,000 Actual return at 25%= $250,000 Expected return at 11% = $110,000

unexpected gain (i.e. experience gain) = 250,000-110,000=140,000

Reduce pension expense by $250,000 Defer experience gain of $140,00

(incr. Pension exp.)

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Effect of return on plan assets No effect Reduces expense by

expected return Actual return less the

deferred ‘experience gain/loss’

Beg Bal $1,300,000Current SC 500,000 $ 500,000PSC 100,000 20,000Interest 130,000 130,000Benefit pmt ( 30,000) 00Actuarial loss 40,000 00*Actual return 000 (250,000)Deferred exp gain 000 140,000

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Delayed Recognition Under FAS 87

Impact of following items not fully recognized when they occur

experience gains and losses actuarial gains and losses (i.e. impact

of changes in assumptions) prior service cost transition adjustment (IGNORE!!)

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With Full Recognition:expense PBO plan assets

balance balance+ csc + csc+ psc + psc+ interest exp. + interest exp.- actual return + actual return

- benefits - benefits+ contributions

+/- actuarialgains and losses

+/- actuarialgains and losses

total expense balance balance

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Effect of Delayed RecognitionPrepaid (accrued) pension reported

on balance sheet may not equal net pension asset (obligation) i.e. frequently companies have

significant off-balance sheet pension liabilities or pension assets

Total pension expense does not equal the change in the PBO

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The Corridor ApproachMinimum amortization

allow gains less losses to accumulate until net amount deferred exceeds a defined threshold

amortization required when beginning-of-year net gain or loss exceeds 10% of maximum opening (PBO or fair value of plan assets)

amortization period is Estimated Average Remaining Service Life of the active employees expected to receive benefits

amount amortized is the EXCESS over the corridor amount.

(beginning net deferred gain/loss - threshold)/EARSL

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Corridor Example Beginning fair value of plan assets =

$1,000,000

Beginning of year PBO = $ 1,300,000

Beginning of year deferred gain/loss = $180,000

End of year deferred gain = $320,000

EARSL = 10 years

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Corridor Solution Determine 10% threshold

10% of beginning PBO = $130,000 10% of beginning FV plan assets = $100,000

Amortization amount Beginning deferred gain/loss = $180,000Corridor (10% of PBO) 130,000

Total amort. Amount $50,000(This year’s portion $50,000/10=$5,000)

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Effect of amortization No effect Increases expense

Beg Bal $1,300,000Current SC 500,000 $ 500,000PSC 100,000 20,000Interest 130,000 130,000Benefit pmt ( 30,000) 00Actuarial loss 40,000 00*Actual return 000 (250,000)Deferred exp gain 000 140,000Amortization 000 5,000

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What do we record? Journal entry to record pension

expense as calculated above

Entry to record funding payment

Balance to pension asset/liability

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What is not on the balance sheet?

Unrecognized experience gains/losses Plan assets include actual return not

expected return Unrecognized prior service cost

PBO includes entire prior service cost not amortized

Unrecognized actuarial gains/losses PBO includes all actuarial gains/loss

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Minimum liability Concerns over underfunded plans

with no balance sheet recognition Requires reporting of ‘minimum

liability’ Difference between fair value of plan

assets and ABO Can only report in a liability, not

additional asset…. (when ABO is less than FV of plan assets)

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Recording Compare minimum liability to balance

sheet and adjust for difference Debit contra equity account for amount

related to PSC Debit balance to Intangible Asset-Deferred

Pension Cost Credit additional pension liability for amount

minimum liability exceeds reported liability/asset

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Minimum Liability ExampleAssume no minimum liability attributable to PSC.

Intangible Asset - Deferred Pension Cost $XXXX

Minimum Liability $XXXX

Assume $ 100,000 attributable to PSC.

Intangible Asset - Deferred Pension Cost $(XXXX-$100k)

Contra Equity Account $100K

Minimum Liability $XXXX