PENSIONS

PENSION PLAN CHARACTERISTICS

Contributory Plan– Employer and employee contribute.– Employees keep their contributions.– Vesting determines employee right to employer

contributions. Defined CONTRIBUTION Plan – Villanova faculty

– Specific contributions are promised by the employer. (“Match” $2 for $1 up to 5%)

– Specific benefits are NOT promised.– Benefits are a function of the management of the plan

assets. Risk/Reward borne by Employee– Pension expense = Cash contributions by employer.

PENSION PLAN CHARACTERISTICS

Defined BENEFIT PLAN (Hydromaint)– Specific benefit payments are promised by the employer.

(e.g., at retirement get $2,000 per mo.)– Much More complex accounting.

Funded Pension Plan– Fully funded: Plan Assets = PV of “ABO” (Accumulated

Benefit Obligation—using EXISTING compensation levels)

– Partially funded: Plan Assets < PV of ABO» Need not be fully funded; plan only needs to have enough assets to

meet current payment obligations.

» ERISA, tax laws, cash flow impact determines “funding’

– Pension Expense = GAAP (FASB #87)

DEFINED BENEFIT PLANSPension Expense on Income Statement composed of:

1) Service Cost – “earned” by employees this period (present value of increase in amount paid at retirement for work done this period)

2) Interest cost accrued on Beg. of Year Pension Liability -- the “PBO” (Projected Benefit Obligation—using EXPECTED future compensation levels)

3) “PSC” (Prior Service Cost) amortization – attributed to employee service before plan amendment

4) Plan Asset return – “expected” return on plan assets5) Gain/loss amortization – adjust expected plan asset

return for difference between expected and actual AND for other gains and losses due to changes in estimate that affect PBO (e.g., life expectancy, discount rate, actual age of employees at retirement, employee turnover). These gains and losses are only amortized IF net gain or loss > 10% of plan assets or PBO whichever is larger.

EXAMPLE PLAN ASSUMPTIONS Employee Data

– Hired on 1/1/20x1, Expected to retire on 12/31/20x5, and expected to die on 12/31/20x7.

– Earns $10,000 per year from 20x1 to 20x3 and expected to earn $20,000 per year from 20x4 to 20x5.

Plan Data (adopted 1/1/20x3)– Benefits = number of years worked x 1% x highest salary– Discount rate is 5%. (Use present value because will not

be paying out money until the future)– Current service cost is fully funded at the end of each year.– Expected rate of return to be earned on plan assets is 10%.– PSC (Prior Service Cost) -- Pension credit given for work

years prior to plan adoption date. This PSC is given at time plan adopted on 1/1/20X3.

– 1/10th of PSC “voluntarily” funded 1/1/20x3;– 3 year amortization of PSC to Pension Expense.

Calculate Prior Service Cost at Plan Adoption Date (1/1/20X3)

20x1 20x2 20x4 20x5 20x6 20x720x3

1/1/x1 1/1/x3 12/31/x3 12/31/x5 12/31/x7

Hire Employee

Adopt Plan

Balance Sheet Date

Employee Retires

Employee Dies

Number of service years (20x1 & 20x2) 2 Highest salary level expected $20,000 Pension Benefit annually at retirement $400 (Begins on 1/1/x6 when employee retires) 1st $400 paid to retiree on 1/1/20x6.Calculate PBO:

Compute PV of employee's pension benefit Years = 2 (20x6 and 20x7) until death, at the date of retirement discount rate= 5.00%

pmt = $400 Solve for PV at retirement date PV = $780.95 (Annuity Due)

Compute PV of retirement benefits at Years = 3 (20x3 through 20x5) date granted by the plan discount rate= 5.00%

FV $780.95 Solve for PV at plan adoption date PV $674.62 (Regular PV, no annuity due) This is the PBO. It also happens to be the prior service cost (PSC) at the plan adoption date.

Projected Benefit Obligation (PBO) is the present value of benefits for employee service prior to a particular date based on expected future salary levels.

Calculate Service Cost for 20x3(First Year of the Plan)

Number of service years 1 Highest salary level expected $20,000 Pension Benefit @ 1% $200

20x4 20x5 20x6 20x7

12/31/x5 12/31/x7

Employee Retires

Employee Dies

20x1 20x2 20x3

12/31/x3

Balance Sheet Date

1/1/x1 1/1/x3

Hire Employee

Adopt Plan

PSC is $674.62

Compute PV of increase in pension benefit Years = 2 (20x6 and 20x7) at the date of retirement discount rate= 5.00%

pmt = $200 Solve for PV at retirement date PV = $390.48 (Annuity Due)

Compute PV of the increase in retirement Years = 2 (x4 and x5) benefit for additional service year discount rate= 5.00%

FV = $390.48 Solve for PV of increase in benefit PV = $354.17 (Regular PV, no annuity due)

Service Cost is the increase in PBO due to work performed in the current year (20x3).

Calculate Pension Benefit Obligation (PBO) at 12/31/x3 (Current Year End)

20x4 20x5 20x6 20x7

12/31/x5 12/31/x7

Employee Retires

Employee Dies

20x1 20x2 20x3

12/31/x3

Balance Sheet Date

1/1/x1 1/1/x3

Hire Employee

Adopt Plan

PSC is $674.61

Service Cost is $354.17

Total Number of service years earned by 12/31/20x3 3 years Highest salary level $20,000 Pension Benefit @1% $600

Compute PV of retirement benefit Years 2 (20x6 and 20x7) at 12/31/20x3 discount rate= 5.00%

pmt = $600 Solve for PV at retirement date PV = $1,171.43 (Annuity Due)

Compute PV of retirement benefits Years = 2 (20x4 and 20x5) at 12/31/20x3 discount rate = 5.00%

FV = $1,171.43 Solve for PV of total retirement benefits PV = $1,062.52 (Regular PV, no annuity due) This is the PBO at 12/31/20x3.

Prior Service Cost (PBO @ 1/1/20x3) 674.62Interest on PBO at 5% discount rate 33.73Current year (20x3) Service Cost 354.17 "Proof" of 12/31/20x3 PBO 1,062.52

PBO vs. ABO

Projected Benefit Obligation (PBO)– PV of benefits, based on expected future salary

levels

Accumulated Benefit Obligation (AB0)– PV of benefits, based on existing compensation

levels (Need ABO vs. Plan Assets at end of year to determine IF need an entry to show “Minimum Liability” on Balance Sheet)

Financial Statement Effects

Pension Plan FUNDING to Trustee by Employer

1/10 Prior service cost funded 1/1/X3 $67.46Service cost funded on 12/31/x3 $354.17

Trustee Account Record (No Direct Entry on Employer's "Books")Initial funding at 1/1/x3 by employer 67.46Annual return on assets held by trustee 6.75Funding by employer at 12/31/x3 354.17 Funds held by trustee at 12/31/x3 428.38

Pension Expense Calculation for 20x3Service Cost for 20x3 354.17Interest on PBO: $674.62 PBO 1/1/x3 x 5% 33.73Amortization of Prior Service Cost: $674.62 PSC / 3 years 224.87Less: 10% Return on plan assets (6.75) Total pension expense 606.03

Employer Journal Entries

Accrued Pension Liability 67.46 Cash 67.46To record funding of plan on 1/1/x3.

Accrued Pension Liability 354.17 Cash 354.17To record funding of plan on 12/31/20x3

Pension Expense 606.03 Accrued Pension Liability 606.03To record pension expense for x3.

Accrued Pension Liability

67.46354.17

606.03184.40

Still would need to check for “Minimum Liability”

RECENT DEVELOPMENTS

SFAS No. 132 --Employers’ Disclosures about Pensions and Other Postretirement Benefits.– Standardizes disclosures for pensions and

other post-retirement benefit plans.– Required disclosures:

» Change in PBO.» Change in Plan Assets.» Assumptions for discount rate, expected return

on plan assets, and compensation increases.» Components of pension expense (net periodic

pension cost).

Recent additional pension disclosures

– Investment strategies & targets– Plan asset allocations—equities, fixed assets,

real estate, and other– Expected pension benefits to be paid out to

retirees – each of next 5 years and total estimate for next 10 years

– Estimated cash contribution to plan trustee for next year

Pension Note Disclosures for 20x3

Change in benefit obligation Benefit obligation at beginning of year $-0- Service cost 354.17 Interest cost 33.73 Adopton of plan 674.62 Benefit obligation at end of year 1,062.52

Change in plan assets Fair value of plan assets at beginning of year $-0- Actual return on plan assets 6.75 Employer contributions 421.63 Fair value of plan assets at end of year 428.38

Underfunded status (FMV of Plan Assets < PBO) (634.14)Unrecognized prior service cost 449.74Accrued Pension Liab. (184.40)

Weighted-average assumptions as of 12/31/20x3 Discount rate 5.00% Expected return on plan assets 10.00%

Components of net periodic benefit cost Service cost 354.17 Interest cost 33.73 Expected return on plan assets (6.75) Amortization of prior service costs 224.87 Net periodic benefit cost 606.03