right to receive benefits not contingent upon continued employment. contributory: employees pay part...
TRANSCRIPT
• Right to receive benefits NOT contingent uponcontinued employment.
CONTRIBUTORY: Employees pay part of funding.
NONCONTRIBUTORY: Employees DON’T pay.
To record PENSION EXPENSE is simple:
Pension expense……….. $XX.XXCash……………..$XX.XXLiability for underpayments…. $XX.XX
Prepaid asset for overpayments……………….$XX.XX
Pension expense is MUCH MORE COMPLEX
And not all that popular in private industry anymore:
18% of private sector workers have Defined Benefit Planwhile80% of government workers have them(USA Today February 21, 2007).
Scenario: Lone Pine Corporation is a SOFTWARE development Co. in Central Oregon.We focus on ONE employee; Nicole Whitney.
• Pension Plan: Noncontributory defined benefit plan.• Inception date: January 1, 2008.• Co. start date: January 1, 2008.• Starting salary: $45,000/year.• Age on 1/1/08: 40• Expected retirement
date: December 31, 2032 (after 25 years of service).• Expected salary at
retirement: $150,000/yr• PENSION BENEFIT FORMULA:
Annual retirement payment = 2%(1 year of service)(final salary)
• Lone Pine vests 10% of benefits after the first year, 15% after the secondyear, then conforms to present ERISA schedule (20% of totalbenefits vested after the third year, and so forth.
• Settlement/Discount rate and expected long-term rate of return on pension planassets (expected equals actual return) is 10%.
• Nicole’s expected retirement period is 10 years; payments made at endof each calendar year during retirement.
• Contributions are made to the pension plan (funding) at the END ofthe service years.•First contribution- 12/31/08•Last contribution- 12/31/32
• Retirement benefit payments are made at the END ofthe retirement years:•First payment 12/31/33•Last payment 12/31/42
1. SERVICE COST.
2. INTEREST COST.
3. ACTUAL RETURN ON PLAN ASSETS.
4. AMORTIZATION OF PRIOR SERVICE COST.
5. GAIN OR LOSS RECOGNIZED.
SERVICE COST.-Is the actuarial present value of the pension benefits attributed to employee service based on the pension benefitformula.
In this example the formula is:
Benefit payment = 2%(1 year of service)(Final salary)
2%(1)($150,000)$3,000 =
This is the actual amount of money that Nicole will earnin each year of retirement based on this ONE year she justworked.
Graphically it looks like this:
1/1/08
Start
12/31/08
Time Zero
12/31/33
First retirementcheck
12/31/42
Last retirementcheck
Service Cost is the PRESENT VALUE of this $3,000 annuitystream at time zero.
12/31/32 makes it an ORDINARY annuity$3,000(6.14457)T 6-4, 10%, 10 per = $18,433.71
$18,433.71 x .10153 = $1,872T 6-2, 10%, 24 years
All those $3,000 annuity payments shrink down and become$1,872 in total as a charge against 2008 income.
• If this was all we had to worry about for 2008 the pensionexpense entry would look like this if $1500 werecontributed:
Pension expense………. $1,872
Cash………………………$1,500Pension Asset/ Liability….. $372
Is a LIABILITY which represents the amount the pensionfund is under-funded.
If instead, the company had decided to pay in $1900 to fundthe pension in 08 then the entry would have looked like this:
Pension expense………. $1,872Pension Asset/Liability $ 28
Cash………………………$1,900
Is an ASSET.
In 2008 (first year) this is the ONLY piece ofPENSION EXPENSE.
But a company would also need to be compiling lots ofinformation for the footnotes and for comprehensive incomeregarding the liability which is building….
Is the estimate of pension obligation based on EXPECTEDFUTURE values.
In our example, the PBO so far would be the PV of theservice cost we just calculated or $1,872.
Lone would need to currently invest $1872 in order to beable to pay out $3,000 a year when its needed in the retirement years.
Is the estimate of pension obligation based on CURRENTsalaries.
Going back to the formula:.02 (1 yr) ($45,000 current salary) = $900
Then we’d have to find the PV of a $900 annuity streamwhich would be $900(6.14457)(.10153) = $561
Is the estimate of pension obligation based on VESTEDsalaries.
Going back to the formula:.02 (1 yr) ($45,000 current salary)(.10 vested) = $90
Then we’d have to find the PV of a $90 annuity streamwhich would be $90(6.14457)(.10153) = $56
Represent what the firm does with money contributed to thepension plan. It is probably investments like stocks, bonds, etc..
• The plan assets ARE NOT recorded on the books of the firm.• They are instead recorded on the books of the TRUSTEE
FIRM. The employing firm shows this information intheir footnotes.
• We usually need to obtain the FMV of the plan assets at least once a year.
Remember Pension Expense is made up of multiplecomponents:
1. Service Cost2. Interest cost3. Return on Plan Assets4. Amortization of Prior Service Cost5. Gain or loss component.
So as we go into year two we’d have to calculate ANOTHERservice cost but the way things work we’d first be figuringout the interest cost….
Represents the cost of not paying the pension. Even tho itsnot due yet, you still have to calculate an interest charge.
Interest cost = Beginning PBO x Settlement Rate
$1,872 x .10$187 =
This is the interest charge for the SECOND year of operation.In the first year the only charge was service cost of $1,872.
Now for the second year, so far we know the Pension Expense has an interest cost of $187. But in the second yearwe can also analyze how the Return on the Plan Assets impactsthe pension expense.
1. Service Cost2. Interest cost $1873. Return on Plan Assets4. Amortization of Prior Service Cost5. Gain or loss component.
• If there is a positive return on plan assets, thatREDUCES the pension expense.
• Makes sense; if the investment for the pension is makingmoney, then that should reduce the cost of thepension expense.
• Suppose in 2009 the actual return on plan assets = $150.
You can find the actual return by using this formula:
Beginning fund balance…………………… $XX.XX+ Actual return on plan assets during period.. $XX.XX+ Employer contributions……………………. $XX.XX- Benefit payments…………………………… $XX.XX-----------------------------------------------------------------------Ending fund balance……………………….. $XX.XX
Now pension expense looks like this:
1. Service Cost2. Interest cost $1873. Return on Plan Assets ($150)4. Amortization of Prior Service Cost5. Gain or loss component.
Now its time to figure out 2009 Service Cost.
1/1/08
Start
12/31/08
Old Time Zero
12/31/33
First retirementcheck
12/31/42
Last retirementcheck
Service cost for 2009 is the PV of another 10 year annuity streamearned in 09 to be given in retirement. So basically it’s the sameas last time only when the PV of the lump sum is calculated itsfor one year less than before. 12/31/32 makes it an ORDINARY annuity
$3,000(6.14457)T 6-4, 10%, 10 per = $18,433.71
$18,433.71 x .11168 = $2,059T 6-2, 10%, 23 not 24 years
New Time Zero
12/31/09
Now pension expense looks like this:
1. Service Cost $2,0592. Interest cost $1873. Return on Plan Assets ($150)-----------------------------------------------Pension expense $2, 096
4. Amortization of Prior Service Cost5. Gain or loss component.
If in 2009, $2,000was funded….
Pension expense…….. $2,096Pension Asset/Liability…….. $96Cash…………….…………$2,000
Pension Worksheets bring together reports of the ACTUARYand the TRUSTEE.
• FORMAL RECORDS: Are actually in the ledger and appearon the left-hand side of the work-sheet.
• INFORMAL RECORDS: Do not appear on the balance sheetand are on the right-hand side of theworksheet.
Formal records Informal records
Items
DrPensionExpense
CrPension Asset/Liability Cash
Projected Benefit Obligation
Plan Assets
Items
DrPensionExpense
CrPension Asset/Liab Cash PBO Plan Assets
Beg Bal at 1/1/09
Pension Expense……. $1,872Pension Asset/Liability…….…. $372Cash………………………….. $1,500
Closed out
$372 $1,872 $1,500
RECONCILIATION:
PBO $1,872-PlanAssets $1,500----------------------Pension AssetLiab $372
Items
DrPensionExpense
CrPpd/AccdPension Cost
CrCash PBO Plan Assets
Beg Bal at 1/1/09 $372 $1,872 $1,500
Service Cost
$+2,059 $+2,059
Interest Cost
$+187 $+187
Actual Return
($150) +150
Contributions $+2,000 $+2,000
$2,096 $2,000$96 $4,118 $3,650
Pension expense…. $2,096Cash……………..…… $2,000Pension Asset/Liability $96
JournalEntry 12/31/09
Items
DrPensionExpense
CrPpd/AccdPension Cost
CrCash PBO Plan Assets
Beg Bal at 1/1/09 $372 $1,872 $1,500
Service Cost
$+2,059 $+2,059
Interest Cost
$+187 $+187
Actual Return
($150) +150
Contributions $+2,000 $+2,000
$2,096 $2,000$96 $4,118 $3,650RECONCILIATION:
PBO $4,118-PlanAssets $3,650----------------------Pension Asset/Liab $468
JournalEntry 12/31/09
Balance12/31/09
$468
Now we can deal with the 4th component of pensions:
1. Service Cost $2,0592. Interest cost $1873. Return on Plan Assets ($150)
4. Amortization of Prior Service Cost5. Gain or loss component.
Amortization of Prior Service Cost
• Comes from granting pension benefits for service rendered BEFORE the pension plan beganor from plan amendments.
• Its creation results in an INCREASE IN PBO
• Assume on 1/1/09 Lone Pine Co. AMENDS its plan to award Nicole an additional annual $500 retirementbenefit for service rendered in 2008.• At this time Nicole has 24 years remaining and is
expected to draw 10 retirement payments.
1/1/08
Start
1/1/09
Time Zero
12/31/33
First retirementcheck
12/31/42
Last retirementcheck
12/31/32 makes it an ORDINARY annuity
$500(6.14457)T 6-4, 10%, 10 per = $3,072
$3,072 x .10153 = $312T 6-2, 10%, 24 years
Putting this into the worksheet would look like as follows:
Items
DrPensionExpense
CrPensionAsset/Liab
CrCash PBO Plan Assets
Beg Bal at 1/1/09 $372 $1,872 $1,500
Service Cost $+2,059 $+2,059
Interest Cost
$+187 $+187
Actual Return ($150) +150
Contributions $+2,000 $+2,000
$2,096 $2,000$96 $4,118 $3,650
$+312 $+312 Unamortized PSC
OCIPSC
JournalEntry 12/31/09
Items
DrPensionExpense
CrPensionAsset/Liab
CrCash PBO Plan Assets
Beg Bal at 1/1/09 $372 $1,872 $1,500
Service Cost $+2,059 $+2,059
Interest Cost
$+187 $+187
Actual Return ($150) +150
Contributions $+2,000 $+2,000
$2,096 $2,000$96 $4,118 $3,650
$+312 $+312 Unamortized PSC
OCIPSC
JournalEntry 12/31/09
It is a worksheet entry torecord its creation.
Items
DrPensionExpense
CrPensionAsset/Liab
CrCash PBO Plan Assets
Beg Bal at 1/1/09 $372 $1,872 $1,500
Service Cost $+2,059 $+2,059
Interest Cost
$+187 $+187
Actual Return ($150) +150
Contributions $+2,000 $+2,000
$2,096 $2,000$96 $4,118 $3,650
$+312 $+312 Unamortized PSC
OCIPSC
JournalEntry 12/31/09 $+312
Then during 2009 part of the PSC would need to be amortized. Say 1/10
PSC Amortz +31 -31
$2,127 $281
Items
DrPensionExpense
CrPensionAsset/Liab
CrCash PBO Plan Assets
Beg Bal at 1/1/09 $372 $1,872 $1,500
Service Cost $+2,059 $+2,059
Interest Cost
$+187 $+187
Actual Return ($150) +150
Contributions $+2,000 $+2,000
$2,096 $2,000$96 $4,118 $3,650
$+312 $+312 Unamortized PSC
OCIPSC
JournalEntry 12/31/09 $+312
PSC Amortz +31 -31
$2,127 $281
Pension expense…. $2,127OCI (PSC)………... 281
Cash……………….…… $2,000Pension Asset/Liability… $408
AOCI 1/1/09 $0
Bal 12/31/09 $281
$408 $4,430
RECONCILIATION:
PBO $4,430-PlanAssets $3,650----------------------Pension Asset/Liab $780
$780
• Is made up of TWO PARTS.
Also calledASSET GAINS/LOSSES
There are (2) kinds of OCI (G/L) pension gains/losses:
1. LIABILITY GAINS/LOSSES
Actual PBO does not equal Actuary PBO
2. UNEXPECTED GAINS/LOSSES
Actual Return on Plan Assets does not equalExpected Return on Plan Assets
1. LIABILITY GAINS/LOSSESActual PBO does not equal Actuary PBO
2. UNEXPECTED GAINS/LOSSESActual Return on Plan Assets does not equal
Expected Return on Plan Assets
These two together form ONE CLASSIFICATION ofpension expense known as OCI (G/L)
+
OTHER COMPREHENSIVE INCOME GAINS/LOSSES
They are put in comprehensive income because they are not charged to Pension Expense right away. Instead they are storedand amortized over a period of years (if ever).
If they ever do get recognized they have to be bigger thansomething known as the CORRIDOR.
That’s because the FASB is trying to cut the volatility ofsuch increases/decreases.
Going back to our example, remember that on 12/31/09our PBO had grown to $4,118 (rounded) (before considering the‘what if’ PSC change).
• Suppose that on 1/1/10 the discount rate is changedfrom 10% to 8% resulting in an INCREASE inthe PBO to $6,857.
• Thus:•We thought our obligation was $4,118 •But its actually now…………… 6,857
LIABILITY LOSS………….. $2,739
• Assume no unexpected gain occurs (ARPA = ERPA)
• THUS this liability is the total OCI (G/L).
THE FIRST RULE IS, THAT THIS OCI (G/L)MUST SIT FOR AN ENTIRE YEAR BEFORE IT CAN EVENBE CONSIDERED AS A POSSIBLE PART OF PENSIONEXPENSE.
It would get logged into the pension worksheet as follows:
Little OCI loss waiting a year
Items
DrPensionExpense
CrPensionAsset/Liab
CrCash PBO Plan Assets
Beg Bal at 1/1/09 $372 $1,872 $1,500
Service Cost $+2,059 $+2,059
Interest Cost
$+187 $+187
Actual Return ($150) +150
Contributions $+2,000 $+2,000
$2,096 $2,000$96 $4,118 $3,650
OCIG(/L)
JournalEntry 12/31/09
Liab increase +$2,739($2,739)
At the end of the 2009, NONE of that liability loss(OCI (G/L) would be eligible to go into pension expense.
THE BALANCE MUST EXIST IN OCI (G/L)AT THE START OF THE YEAR IN ORDERTO BE CONSIDERED ELIGIBLE.
Is the BARRIER that keeps unexpected gains/losses frombeing recognized EVEN AFTER they’ve waited for a wholeyear.
THE CORRIDOR EQUALS THE GREATER OF:
10% x Beginning value of PBO
OR 10% x Beginning Market Related Value of Plan Assets
Thus $2,000 corridor > $1,800 OCI loss and NONEis recognized for current year.
Suppose at the BEGINNING ofa year there existed an $1,800OCI (L). Also beginningPBO was $20,000 and beginning MRVPA was $15,000.
THE CORRIDOR EQUALS THE GREATER OF:
10% x $20,000 = 2,000
OR 10% x $15,000 = $1,500
Suppose instead that beginning OCI loss was $100,000.Also, as before beginning PBO was $20,000 and beginning MRVPA was $15,000.
THE CORRIDOR EQUALS THE GREATER OF:
10% x $20,000 = 2,000
OR 10% x $15,000 = $1,500
$2000 is still thecorridor
Thus $2,000 corridor < $100,000 OCI loss so $98,000is ELIGIBLE for amortization in current year.
However, it may be spread out for years based on service yrs(e.g., $98,000/20 = $4,900 is added to pension expense.
Suppose instead that beginning OCI loss was $100,000.Also, as before beginning PBO was $20,000 and beginning MRVPA was $15,000.
THE CORRIDOR EQUALS THE GREATER OF:
10% x $20,000 = 2,000
OR 10% x $15,000 = $1,500
$2000 is still thecorridor
Thus $2,000 corridor < $100,000 OCI loss so $98,000is ELIGIBLE for amortization in current year.
However, it may be spread out for years based on service yrs(e.g., $98,000/20 = $4,900 is added to pension expense.
Suppose instead that beginning OCI loss was $100,000.Also, as before beginning PBO was $20,000 and beginning MRVPA was $15,000.
THE CORRIDOR EQUALS THE GREATER OF:
10% x $20,000 = 2,000
OR 10% x $15,000 = $1,500
$2000 is still thecorridor
Thus $2,000 corridor < $100,000 OCI loss so $98,000is ELIGIBLE for amortization in current year.
However, it may be spread out for years based on service yrs(e.g., $98,000/20 = $4,900 is added to pension expense.
$4900
Suppose instead that beginning unrecognized loss was $100,000.Also, as before beginning PBO was $20,000 and beginning MRVPA was $15,000.
THE CORRIDOR EQUALS THE GREATER OF:
10% x $20,000 = 2,000
OR 10% x $15,000 = $1,500
$2000 is still thecorridor
Thus $2,000 corridor < $100,000 unrecognized loss so $98,000is ELIGIBLE for amortization in current year.
However, it may be spread out for years based on service yrs(e.g., $98,000/20 = $4,900 is added to pension expense.
sits andwaits foranother year
This much gets through into pension expense!
$4900
Items
DrPensionExpense
CrPensionAsset/Liab
CrCash PBO Plan Assets
Beg Bal at 1/1/09 $372 $1,872 $1,500
Service Cost $+2,059 $+2,059
Interest Cost
$+187 $+187
Actual Return ($150) +150
Contributions $+2,000 $+2,000
$2,096 $2,000$96 $4,118 $3,650
OCIG/(L)
JournalEntry 12/31/09
OCI (L) amtz +4,900 (this would reduce the existingOCI (L) of $100K (just made up)+$4,900
It would look like this in the worksheet.
The rest of him forms back together, he’s JUST FINE, and he getsTHROWN BACK OVER THE CORRIDOR TO WAIT ANOTHER!
Remember tho, pension expense is made up of TWOCOMPONENTS:
Is the second component of pension expense each year.
But unexpected gains/losses IS ALSO one of the two pieces ofOCI gains/losses!
Doesn’t it seem that if we count it here again, we aredouble counting????
We aren’t.
Adjusting for unexpected gains/losses as a separate componentof pension expense is another smoothing technique.
When the FASB allows the ACTUAL RETURN on plan assetsto be subtracted from pension expense, what it “really” wantsto allow to be subtracted is EXPECTED RETURN on planassets.
Thus, adjusting for “unexpected G/L” results in the expectedreturn on plan assets being subtracted from pension expenseinstead of actual returns.
Suppose in a given year a firm had the following components ofpension expense:
Service Cost……………...…. $20+ Interest expense………….. 10- Actual Return on P.A……. (10)---------------------------------------------Pension Expense is…………. $20
But the FASB actually wants us to subtract only the expectedreturn on P.A. (in case there is something volatile that raised/lowered the actual return in a given year).
Thus we have to find out how much EXPECTED RETURN onP.A. is:
Plan assets value……………. $100x expected ROR…………… 8%----------------------------------------------Expected return on P.A. $8
Now, we can rewrite the pension expense calculation using“expected return on P.A.” instead.
Service Cost……………...…. $20+ Interest expense………….. 10- Expected Return on P.A……. (8)---------------------------------------------Pension Expense is…………. $22
Remember the pension expense with actual returnof $10 subtracted is $20. We need to make it comeout to $22.
Actual return on plan assets ……………… $10
- Expected return on plan assets………….. $8
Unexpected gain on plan assets…………… $2
Pension expense as it would really appear:
Service Cost……………...…. $20+ Interest expense………….. 10- Actual return on P.A. …… (10)+ Unexpected Gain………… 2---------------------------------------------Pension Expense is…………. $22
The unexpected gain DID NOT reduce the cost of the pensionexpense. All it did was result in only $8 being subtracted fromthe cost (expected return) instead of the actual return of $10.
Items
DrPensionExpense
CrPensionAsset/Liab
CrCash PBO Plan Assets
Beg Bal at 1/1/09 $372 $1,872 $1,500
Service Cost $+2,059 $+2,059
Interest Cost
$+187 $+187
Actual Return ($150) +150
Contributions $+2,000 $+2,000
$2,096 $2,000$96 $4,118 $3,650
OCIG(/L)
JournalEntry 12/31/09
Liab increase +$2,739($2,739)
Now this +2 unexpected gain and the $2,739 liability loss will go together to become a $2,737 OCI loss that will waituntil next year to see if it can clear the corridor.
unexpectedgain
+2 +2
2,737