Pensions

RCJ Chapter 14

Paul Zarowin 2

Key Issues1. Types of pension plans: defined benefit vs. defined contribution2. Pension liability: PBO, ABO, VBO3. Assumptions: discount rate%, salary growth rate%, E(ROA)%,

actuarial4. PENSION assets5. Primary (ongoing) factors6. Journal entries7. Smoothing of transitory gains and losses8. Types of transitory gains and losses9. Additional factors10. Funded status reconciliation11. Minimum liability

12. Corridor amortization

13. Pension worksheet14. Footnote disclosures15. Correction JE 16. OPEB’s

Paul Zarowin 3

Structure of Pension Plan

firm or employee pension fund retiree Cash Pay benefits

Paul Zarowin 4

Types of Pension Plans1.Defined contribution:

employee bears risk, no firm liability

2.Defined benefit: firm bears risk and has liability (our focus)

Paul Zarowin 5

Ex. Defined Benefit Plan worker’s age = 60 service = 30 yrs so far retire @ 65 (5 more years) current salary = $50,000Pension contract:

X% per year * final salary (X = # of years of service @ retirement)Example: 35% x $50,000 = $17,500

Paul Zarowin 6

Pension LiabilitiesPension liability: discounted PV of expected future cash payments - like any other non-current liability (effective interest method).

compare to other non-current liabilities: r% E(CF)

Bonds known knownLeases known? known Pensions ? ?

Both discount rate and expected cash flows are subjective

Paul Zarowin 7

3 Definitions of Liabilities PBO = PV of expected payments, given expected future salaries ABO= PV of expected payments, given current salaries VBO =PV of vested portion of expected payments, given current

salaries

PBO ABO VBO

Which definition is appropriate for which case?

1. valuing a going concern

2. Takeover

3. Firm in bankruptcy

We’ll use PBO, unless otherwise stated. 

Paul Zarowin 8

Key Assumptions discount rate = r%

salary growth rate = g% (for PBO)

actuarial (life span, tenure, turnover, etc.)

EROA% (expected rate of return on pension assets), see below

Q: Is liability bigger for older or younger workers?

What are management’s incentives?

Paul Zarowin 9

Ex. Defined Benefit Plan, Continued

Assumptions Expected salary growth rate = 5% Discount rate = 10%  Life expectancy = 80 years (15 years in retirement)

Expected final salary = 50,000 * (1.05)5 = 63,814 30% * 63,814 = 19,144 = amount he’ll receive per year in

retirement (based on service so far) PV of annuity factor, 10%, 15 yrs = 7.606 19,144 * 7.606 = 145,611 = PV @ retirement

PBO = 145,611/(1.10)5 = 90,413 = PV of annuity nowABO = (30% * 50,000 * 7.606)/1.105 = 70,841PBO > ABO due to expected salary growth

Paul Zarowin 10

Primary (Ongoing) Factors Affecting PBO

PBO - +

DR CR pay benefits Interest cost

Service cost

def: interest cost = r% * PBO @ beginning of year(remember: effective interest method)[debt accretion, like zero coupon bond]

def: service cost = PV of future benefits earned this year

Ex. E14-1, E14-13

Paul Zarowin 11

Ex. Defined Benefit Plan, Continued

Interest cost = 90413*.10 = 9041Service cost = (1% * 63,814 * 7.606)/1.105 =

3014

Q: how does a higher or lower r% affect interest cost? 

Q: how does an employee’s age affect his service cost?

E14-1,13

Paul Zarowin 12

Pension Assets Pension assets: FMV of assets (stocks, bonds, etc.)

Funded status (true, economic position): Pension assets – PBO

Overfunded: assets > PBO Underfunded: assets < PBO Severely underfunded: assets < ABO

Paul Zarowin 13

Primary (Ongoing) Factors Affecting Pensions Assets

Assets+ -

DR CR Funding (contribution) Pay benefits (ROA)Return on assets#

# note: this is actual ROA; ROA is shown as +, but could be –

Ex. E14-6, E14-13

Paul Zarowin 14

Primary Journal Entries

* note: actual ROA is shown as +, but could be –

UNL = unexpected net loss (if actual ROA < expected ROA)UNG = unexpected net gain (if actual ROA > expected

ROA)

DR CR

service, interest

Pension expense PBO

Funding(contributions)

Assets Cash

benefits PBO Assets

ROA Assets(actual ROA)*

Pension Expense(expected ROA= EROA%*beginning assets)

UNL or UNG

Paul Zarowin 15

Ex. Defined Benefit Plan, Continued

Assume: pension assets = 100,000 E(ROA)% = 10% actual ROA = 15,000 

DR assets 15,000 CR Pension expense 10,000CR UNGain 5,000

Q: How does assumed EROA% affect FMV of assets?

Paul Zarowin 16

Primary Factors Affecting Pension Expense

Pension Expense+ -

DR CRService E(ROA)

Interest

Q: What is the effect of funding on expense?

Paul Zarowin 17

Ex. Defined Benefit Plan, Continued

Service 3,014 Interest 9,041 E(ROA) (10,000)pension expense 2,055

Ex. E14-12 without amortization and unexpected lossP 14-1, Parts 1-3 in Summary So Far

Paul Zarowin 18

Smoothing of Transitory Gains and Losses def: unrecognized = deferred (in footnotes)def: recognized = amortized (into pension expense

on I/S)

Transitory gains, losses are CR’d (gains) or DR’d (losses) to unrecognized (footnote) accounts, rather than recognized as gain or loss on I/S. The unrecognized balances are amortized onto I/S. This smooths NI and keeps assets and PBO off of B/S.

Full Exp For E14-13

Paul Zarowin 19

Smoothing (cont’d): Intuition

Loss in DR, Gain in CRDR CR

Loss: Unrecognized loss Asset or liab.

Amort’n: Exp.(recorded) Unrecognized loss

Gain: Asset or liab. Unrecognized gain

Amort’n: Unrecognized gain Exp.(recorded)

20

Types of Transitory Gains, Losses

DR CR

asset gain: actual ROA > expected ROA Assets Pension expense

UNG

asset loss: actual ROA < expected ROA AssetsUNL

Pension expense

* assets are DR’d (or CR’d) for actual ROA; pension expense is CR’d for expected ROA; difference is UNG or UNL (see slide #15)

liability loss (due to assumption r%, g%, etc.)

UNL PBO

liability gain (due to assumption r%, g%, etc.)

PBO UNG

note: asset and liability gains and losses are all aggregated into one UNG/L account note: liability gains and losses are also called actuarial gains and losses

Q: What happens if EROA% is set too high (higher than true average ROA%)?

Paul Zarowin 21

2 Types of Liability Gain/Loss

1. Change in assumptions

2. Change in contracts

Intuition: What affects r% and E(CF)’s

Paul Zarowin 22

Types of Transitory Gains, Losses (cont’d)

DR CR

Change in pension contract: sweetening

UPSC PBO

Change in pension contract: souring PBO UPSC

def: UPSC = unrecognized prior service cost (retroactive benefits)

Paul Zarowin 23

Ex. Defined Benefit Plan, Continued

1. assume benefits are sweetened to pay 1.1% * final salary per year (increased by 10%)increase in PBO = 10% * 90,413 = 9041 DR UPSC 9041

CR PBO 9041

2. assume salary growth rate is increased to 6% (final salary = 66,912), so PBO = 94,802 and increase in PBO = 4389 (94,802 – 90,413)

DR UNLoss 4389CR PBO 4389

Paul Zarowin 24

Additional Factors Affecting PBO

PBODR (+) CR (-)

Primary factors

Pay benefits Interest cost

Service cost

Additional factors

Liability gain

Liability loss

Souring Sweetening

( assumptions)( contracts)

Paul Zarowin 25

Additional Factors Affecting Pension Expense

ExpenseDR (+) CR (-)

Primary factors Interest cost E(ROA)

Service cost

Additional factors

loss amortization

Gain amortization

Paul Zarowin 26

Additional Factors Affecting Pension Expense (cont’d)

Loss amortization:DR Pension expense

CR UPSC or UNL or UTL Gain amortization:

DR UPSC or UNG or UTACR Pension expense

UTA, UTL = unrecognized transition asset, liability = net position (assets - PBO) @ adoption of SFAS #87

remember: amortization = recognized into expense amortization is generally SL over average remaining

service life of employees

Paul Zarowin 27

Ex. Defined Benefit Plan, Continued

Amortize UPSC over 5 years: 9041/5 = 1808DR pension expense 1808

CR UPSC 1808

service 3,014

interest 9,041

E(ROA) (10,000)

UPSC Amort. 1,808

pension expense 3,863

Ex. E14-13 GM disclosure E 14-12 w/o Loss

Paul Zarowin 28

Funded Status Reconciliation Reconcile true vs. recognized position

assets- PBO funded status (can be net asset or net liability): ‘true position’+ UNL (or - UNG)+ UPSC+ UTL (or - UTA) recognized (on B/S) position: prepaid pension cost (asset) or deferred pension cost (liab)

note: funded status (true economic position) vs. recognized position unrecognized losses & liab’s make the recognized position better than the

true position unrecognized gains & assets make the recognized position worse than the

true position

Ex. E14-14, 19

Unrecognized Gains/Losses

Paul Zarowin 29

Minimum Liability if ABO > assets the pension plan is considered

‘severely underfunded’ and a liab. (ABO - assets) must be recognized.

if recognized position is asset (prepaid cost) or liab (accrued cost) < (ABO-assets), additional entry is needed to bring recognized position to minimum level:

DR Intangible asset*

CR Additional liability* should be DR to a loss account

additional liab can be shown separately or aggregated with accrued pension cost on B/S

Ex. E14-2, E14-5

30

Corridor (Minimum) Amortization UNL or UNG must be amortized only if it > “corridor” corridor = 10% of bigger (PBO, assets) @BOY amortization is down to corridor, not zero  if amort’n is required one year, it might or might not be

the next year, and vice versa

UNG/L DR CR

*BOY net loss *BOY net gain (* for current year amort’n test)

Current year loss Current year gain

gain amort’n loss amort’n (amort’n only if required)

#EOY net loss #EOY net gain (# for next year’s amort’n test)Ex. P14-1, sec 1-6 E14-18

Pension Worksheet - put it all together - relate to funded status

reconciliation Recognized (on FS) bal. Unrecognized (footnote)

balances

Pen. exp

Cash

pp’d/acc cost

Pen Ass

Pen Liab

UNGL

UPSC

Service cost DR CR

Interest cost DR CR

ROA CR DR plug

Funding (contribution)

CR DR

Benefits CR DR

liability loss6 CR DR

Sweetening7 CR DR

Amortization UNL8 DR CR

Amortization of UPSC (from sweetening)9 DR CR

Summary JE; only recognized (on FS) JE

DR CR CR or DR6. reverse DR and CR for a liability gain 8. reverse DR and CR for amort’n of unrecognized gain 7. reverse DR and CR for souring 9. reverse DR and CR for amort’n from souringNote: recognized asset/liab (prepaid/accrued pension cost) is net of all unrecognized accounts

Paul Zarowin 32

Exercise problems

E14-3, E14-4, E14-7 E14-17, 20 P14-2, P14-3 P14-13

Paul Zarowin 33

Footnote Disclosures The pension footnote includes:

1. total pension expense and its components

2. reconciliation of BOY vs EOY PBO and asset accounts (like t-accounts)

3. funded status reconciliation

4. assumptions (r%, g%, EROA%)

C 14-2,3

Paul Zarowin 34

Correction JE (to put assets and liabs on B/S) using information in pension footnote, put pension assets and

liab on B/S; replace recognized position with true position

DR CR pension assets PBO accrued pension cost or Prepaid pension cost R/E or R/E

1. put pension assets and PBO on B/S2. remove accrued or prepaid pension cost from B/S3. plug: DR or CR R/E = cumulative unrecognized gains/losses

(sum of UNGL, UPSC, UTAL)note: DR or CR to R/E rather than current year gain or loss

Paul Zarowin 35

Other Post-Employment Benefits (OPEB’s) Same accounting as pensions, with minor differences1. ABO instead of PBO (OPEB’s not tied to salary)

2. significance of (TL) transition liability (no incentive to fund, so ABO > assets) firms can: amortize TL over <= 20 years

DR OPEB expense CR Accrued OPEB cost

or take loss as change in accounting principle (below the line):DR loss due to change in acct principle

CR Accrued OPEB cost most firms chose latter: why? 

3. service cost is accrued (earned) over short (vesting) period, since benefits don’t increase with tenure