mcgraw-hill /irwin© 2009 the mcgraw-hill companies, inc. pensions and other postretirement benefits...

McGraw-Hill /Irwin © 2009 The McGraw-Hill Companies, Inc.

PENSIONS AND OTHER PENSIONS AND OTHER POSTRETIREMENT POSTRETIREMENT BENEFITSBENEFITS

Chapter 17

17-2

Nature of Pension PlansNature of Pension Plans

1.1. Pension plans provide income to Pension plans provide income to individuals during their retirement years. individuals during their retirement years.

2.2. This is accomplished by setting aside This is accomplished by setting aside funds during an employee’s working funds during an employee’s working years so that at retirement, the years so that at retirement, the accumulated funds plus earnings from accumulated funds plus earnings from investing those funds are available to investing those funds are available to replace wages. replace wages.

For a pension plan to qualify for special tax For a pension plan to qualify for special tax treatment it must meet the following treatment it must meet the following

requirements:requirements:

1.1. Cover at least 70% of employees.Cover at least 70% of employees.

2.2. Cannot discriminate in favor of highly Cannot discriminate in favor of highly compensated employees.compensated employees.

3.3. Must be funded in advance of retirement Must be funded in advance of retirement through an irrevocable trust fund.through an irrevocable trust fund.

4.4. Benefits must vest after a specified period of Benefits must vest after a specified period of service.service.

5.5. Complies with timing and amount of Complies with timing and amount of contributions.contributions.

17-3

Types of Pension PlansTypes of Pension Plans

Defined contribution pension plans promise fixed annual contributions to a pension fund (say, 10% of the employees' pay). The employee chooses (from designated options) where funds are invested – usually stocks or fixed-income securities. Retirement pay depends on the size of the fund at retirement.

17-4

Types of Pension PlansTypes of Pension Plans

Defined benefit pension plans promise fixed retirement benefits defined by a designated formula. Typically, the pension formula bases retirement pay on the employees' (a) years of service, (b) annual compensation [often final pay or an average for the last few years], and sometimes (c) age. Employers are responsible for ensuring that sufficient funds are available to provide promised benefits.

17-5

Contributions Contributions are defined by are defined by

agreement.agreement.

Contributions Contributions are defined by are defined by

agreement.agreement.

Employer Employer deposits an deposits an

agreed-upon agreed-upon amount into an amount into an

employee-employee-directed directed

investment investment fund.fund.

Employer Employer deposits an deposits an

agreed-upon agreed-upon amount into an amount into an

employee-employee-directed directed

investment investment fund.fund.

Employee Employee bears all risk bears all risk of pension of pension

fund fund performance.performance.

Employee Employee bears all risk bears all risk of pension of pension


Plan CharacteristicsPlan CharacteristicsPlan CharacteristicsPlan Characteristics

Defined Contribution Pension PlansDefined Contribution Pension Plans

17-6

Defined Contribution Pension PlansDefined Contribution Pension PlansAccounting for these plans is quite simple. 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:

17-7

Employer is Employer is committed to committed to

specified specified retirement retirement benefitsbenefits..

Employer is Employer is committed to committed to

specified specified retirement retirement benefitsbenefits..

Retirement Retirement benefits are benefits are based on a based on a formula that formula that

considers years considers years of service, of service,

compensation compensation level, and age.level, and age.

Retirement Retirement benefits are benefits are based on a based on a formula that formula that

considers years considers years of service, of service,

compensation compensation level, and age.level, and age.

Employer Employer bears all risk bears all risk of pension of pension


Employer Employer bears all risk bears all risk of pension of pension


Plan CharacteristicsPlan CharacteristicsPlan CharacteristicsPlan Characteristics

Defined Benefit Pension PlansDefined Benefit Pension Plans

17-8

Defined Benefit Pension PlanDefined 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

17-9

The Pension ObligationThe Pension Obligation

© 2008 The McGraw-Hill Companies, Inc.

1.1. Accumulated benefit obligation Accumulated benefit obligation (ABO) The actuary’s (ABO) The actuary’s estimate of the total retirement benefits (at their discounted estimate of the total retirement benefits (at their discounted present value) earned so far by employees, applying the present value) earned so far by employees, applying the pension formula using pension formula using existing compensation levelsexisting compensation levels..

2.2. Vested benefit obligation Vested benefit obligation (VBO) The portion of the (VBO) The portion of the accumulated benefit obligation that plan participants are accumulated benefit obligation that plan participants are entitled to receive entitled to receive regardless of their continued regardless of their continued employmentemployment..

3.3. Projected benefit obligation Projected benefit obligation (PBO) The actuary’s estimate (PBO) The actuary’s estimate of the total retirement benefit (at their discounted present of the total retirement benefit (at their discounted present value) earned so far by employees, applying the pension value) earned so far by employees, applying the pension formula using formula using estimated future compensation levelsestimated future compensation levels. (If . (If the pension formula does not include future compensation the pension formula does not include future compensation levels, the PBO and the ABO are the same.levels, the PBO and the ABO are the same.

17-10

Projected Benefit ObligationProjected Benefit Obligation

Jessica Farrow was hired by Global Communications in 1998. She Jessica Farrow was hired by Global Communications in 1998. She is eligible to participate in the company's defined benefit pension is eligible to participate in the company's defined benefit pension plan. The benefit formula is: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 2037 after 40 years of service. Her Farrow is expected to retire in 2037 after 40 years of service. Her retirement period is expected to be 20 years. At the end of 2007, retirement period is expected to be 20 years. At the end of 2007, 10 years after being hired, her salary is $100,000. The interest 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 rate is 6%. The company’s actuary projects Farrow’s salary to be $400,000 at retirement.$400,000 at retirement.

The PBO is a more meaningful measurement because it includes a projection of what the salary

might be at retirement.

17-11

Projected Benefit ObligationProjected Benefit ObligationStep 1. Step 1. Use the pension formula to determine the retirement Use the pension formula to determine the retirement benefits earned to date. benefits earned to date.

$400,000

× 10

× 1.5%

$ 60,000 per year

Step 2. Step 2. Find the present value of the retirement benefits as of the Find the present value of the retirement benefits as of the retirement date.retirement date.

The present value (n=20, The present value (n=20, ii=6%,) of the retirement annuity at =6%,) of the retirement annuity at the retirement date is $688,195 ($60,000 the retirement date is $688,195 ($60,000 × 11.46992).

Step 3. Step 3. Find the present value of the retirement benefits as of the Find the present value of the retirement benefits as of the current date.current date.

The present value (n=30, The present value (n=30, ii=6%,) of the retirement benefits at =6%,) of the retirement benefits at 2007 is $119,822 ($688,195 2007 is $119,822 ($688,195 × .17411). This is the PBO.

17-12

Projected Benefit ObligationProjected Benefit ObligationIf the actuary’s estimate of the final salary hasn’t changed, If the actuary’s estimate of the final salary hasn’t changed, the PBO a year later at the end of 2008 would be $139,715.the PBO a year later at the end of 2008 would be $139,715.

Step 1. Step 1. Use the pension formula to determine the retirement Use the pension formula to determine the retirement benefits earned to date. benefits earned to date.

$400,000

× 11

× 1.5%

$ 66,000 per year

Step 2. Step 2. Find the present value of the retirement benefits as of the Find the present value of the retirement benefits as of the retirement date.retirement date.

The present value (n=20, The present value (n=20, ii=6%,) of the retirement annuity at =6%,) of the retirement annuity at the retirement date is $757,015 ($66,000 the retirement date is $757,015 ($66,000 × 11.46992).

Step 3. Step 3. Find the present value of the retirement benefits as of the Find the present value of the retirement benefits as of the current date.current date.

The present value (n=The present value (n=2929, , ii=6%,) of the retirement benefits at =6%,) of the retirement benefits at 2008 is $139,715 ($757,015 2008 is $139,715 ($757,015 × .18456). This is the PBO.

17-13

The PBO changes as a result of:Cause Effect Frequency

Service Cost + Each period

Interest Cost +Each period (except the first period

of the plan)Prior Service

Cost+

Only if the plan is amended (or initiated) that period

Loss or Gain on PBO

+ or -Whenever revisions are made in the

pension liability estimateRetiree Benefits

Paid-

Each period (unless no employees have yet retired under the plan)





Cost+


Loss or Gain on PBO



Paid-


Changes in the PBOChanges in the PBO

17-14





Cost+


Loss or Gain on PBO



Paid-






Cost+


Loss or Gain on PBO



Paid-


Service cost Service cost is the increase in the PBO is the increase in the PBO attributable to employee service performed attributable to employee service performed

during the period.during the period.


17-15





Cost+


Loss or Gain on PBO



Paid-






Cost+


Loss or Gain on PBO



Paid-


Interest costInterest cost is the interest on the PBO during is the interest on the PBO during the period.the period.


17-16





Cost+


Loss or Gain on PBO



Paid-






Cost+


Loss or Gain on PBO



Paid-


Prior service costPrior service cost is the increase in the PBO from using is the increase in the PBO from using a new, more generous pension formula to determine the a new, more generous pension formula to determine the

pension obligation for prior years.pension obligation for prior years.


17-17





Cost+


Loss or Gain on PBO



Paid-






Cost+


Loss or Gain on PBO



Paid-


Loss or gain on PBOLoss or gain on PBO results from revising results from revising estimates used to determine the PBO.estimates used to determine the PBO.


17-18





Cost+


Loss or Gain on PBO



Paid-






Cost+


Loss or Gain on PBO



Paid-


Retiree benefits paid Retiree benefits paid are payments to are payments to retired employees.retired employees.


17-19

The changes in the PBO for Global Communications during 2009 were as follows:

PBO at the beginning of 2009+ (amount assumed) 400$ Service cost, 2009 (amount assumed) 41 Interest cost: $400 6% 24 Loss (gain) on PBO (amount assumed) 23 Less: Retiree benefits paid (amount assumed) (38)

PBO at the end of 2009 450$

($ in millions)*

*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 2008.


17-20

Pension Plan AssetsPension 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 2009.

Plan assets at the beginning of 2009 were valued at $300 million. The expected rate of return on the investment of those assets was 9%, but the actual return in 2009 was 10%. Retirement benefits of $38 million were paid at the end of 2009 to retired employees. The plan assets at the end of 2009 will be:

Plan assets at the beginning of 2009 $ 300,000,000 Return on plan assets (10% x $300 million) 30,000,000 Cash contributions 48,000,000 Less: Retiree benefits paid (38,000,000)Plan assets at the end of 2009 $ 340,000,000

17-21

Funded Status of the Pension PlanFunded Status of the Pension Plan

OVERFUNDED

Market value of plan Market value of plan assets exceeds the assets exceeds the

actuarial present value actuarial present value of all benefits earned by of all benefits earned by

participants.participants.

UNDERFUNDED

Market value of plan Market value of plan assets is below the assets is below the

actuarial present value actuarial present value of all benefits earned by of all benefits earned by

participants.participants.

17-22

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 balance sheet as a Pension Liability or Pension Asset.Liability or Pension Asset.

17-23

Pension Expense – An OverviewPension Expense – An Overview

Components of Pension Expense+ Service cost ascribed to employee service this period+ Interest accrued on pension liability - Expected return on the plan assets+ Amortized portion of prior service cost

+ or - Amortization of net loss or net gain= Pension expense

17-24

Pension ExpensePension Expense

Actuaries have determined that Global Actuaries have determined that Global Communications has service cost of Communications has service cost of

$41,000,000 in 2009.$41,000,000 in 2009.

Service cost 41$ Interest costExpected return on the plan assetsAmortization of prior service cost Amortization of net loss Pension expense 41$

Global's 2009 Pension Expense ($ in millions)

17-25

Service cost 41$ Interest cost 24 Expected return on the plan assetsAmortization of prior service cost Amortization of net loss Pension expense 65$


Interest CostInterest CostInterest cost is calculated as:Interest cost is calculated as:

PBOPBOBegBeg × Discount rate × Discount rate

Global had PBO of $400,000,000 on 1/1/09. The Global had PBO of $400,000,000 on 1/1/09. The actuary uses a discount rate of 6%.actuary uses a discount rate of 6%.

2009 Interest Cost: PBO 1/1/09 $400,000,000 × 6% = $24,000,000

17-26

Return on Plan AssetsReturn on Plan Assets

The plan trustee reports that plan assets were The plan trustee reports that plan assets were $300,000,000 on 1/1/09. The trustee uses an expected $300,000,000 on 1/1/09. The trustee uses an expected

return of 9% and the actual return is 10%.return of 9% and the actual return is 10%.

Beginning value of plan assets 300,000,000$ Rate of return 10%Return on plan assets 30,000,000 Beginning value of plan assets 300,000,000$ Adjustment (10% - 9%) 1%Adjusted for gain on plan assets 3,000,000 Expected return on plan assets 27,000,000$

Beginning value of plan assets 300,000,000$ Rate of return 10%Return on plan assets 30,000,000 Beginning value of plan assets 300,000,000$ Adjustment (10% - 9%) 1%Adjusted for gain on plan assets 3,000,000 Expected return on plan assets 27,000,000$

Service cost 41$ Interest cost 24 Expected return on the plan assets (27) Amortization of prior service cost Amortization of net lossPension expense 38$


17-27

Amortization of Prior Service Cost Amortization of Prior Service Cost

In 2008, Global Communications amended the pension plan, In 2008, Global Communications amended the pension plan, increasing the PBO at that time. For all plan participants, increasing the PBO at that time. For all plan participants,

the prior service cost was $60 million at 1/1/08. The the prior service cost was $60 million at 1/1/08. The average remaining service life of the active employee average remaining service life of the active employee

group is 15 years.group is 15 years.

$60,000,000 PSC $60,000,000 PSC ÷÷ 15 = $4,000,000 per year 15 = $4,000,000 per year

Service cost 41$ Interest cost 24 Expected return on the plan assets (27) Amortization of prior service cost 4Amortization of net loss Pension expense 42$


17-28

Gains and LossesGains and Losses

Projected Benefits Obligation

Return on Plan Assets

Higher than Expected Loss Gain

Low er than Expected Gain Loss

17-29

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 period.period.

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

OrOr

17-30

Gains and LossesGains and Losses

Net unrecognized gain or lossNet unrecognized gain or loss at beginning of yearat beginning of year

Average remaining service period of activeAverage remaining service period of activeemployees expected to receive benefits under the planemployees expected to receive benefits under the plan

Corridor Corridor amountamount

־־

If the beginning net unrecognized gain or loss If the beginning net unrecognized gain or loss exceeds the corridor amount, amortization is exceeds the corridor amount, amortization is recognized using the following formula . . .recognized using the following formula . . .

17-31

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

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

17-32

Recording Gains and LossesRecording Gains and LossesFor 2009, 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:

OCI = Other comprehensive income

17-33

Recording the Pension ExpenseRecording the Pension Expense

Service cost 41$ Interest cost 24 Expected return on the plan assets (27) Amortization of prior service cost (calculated later) 4Amortization of net loss (calculated later) 1Pension expense 43$


mcgraw-hill /irwin© 2009 the mcgraw-hill companies, inc. pensions and other postretirement benefits...

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benefit pension plans

pension obligation

defined benefit pension

types of pension plans

nature of pension plans

retirement years

annual retirement benefits

fixed retirement benefits