CHAPTER 17 Pensions 2

Nature of Pension Plans I agree to make payments into a fund for future retirement benefits for employee services. I am the employee for whom the pension plan provides benefits. Sponsor Participant 3

Nature of Pension Plans Registered Pension Plan (RPP) Qualify for special tax treatment Employer gets immediate tax deduction Employee is taxed when benefit is received Earnings in pension fund are not taxed Similar to Registered Retirement Savings Plans for employees

Nature of Pension Plans Contributory Pension Plan Employee and employer make contributions to the plan. Noncontributory Pension Plan Cost of the plan is borne entirely by employer.

Defined Contribution Plans Contributions are established by formula or contract. Employer deposits an agreed upon amount into an employee-directed investment fund. Employee bears all risk of pension fund performance. 5

Defined Benefit Pension Plans Employer is committed to specified retirement benefits. Retirement benefits are based on a formula that considers years of service, compensation level, and age. Employer bears all risk of pension fund performance. 6

Defined Contribution Pension Plans More popular since they require less administration Promise fixed periodic contributions Cash provided on retirement depends on size of the fund at retirement No further commitment made by employer regarding the benefits at retirement

Defined Contribution Pension Plans The entry to record pension expense is based on the amount of the contribution made by the employer. 62

Defined Benefit Plan Pension expense is measured by assigning pension benefits to periods of employee service as defined by the pension benefit formula. A typical benefit formula might be: 1.5% × Years of Service × Final year’s salary So, for 30 years of service and a final salary of $100,000, the employee would receive: 1.5% × 30 × $100,000 = $45,000 per year. 16

Pension Expense – An Overview 16

Pension Obligation Projected Benefit Obligation Present value of additional benefits related to projected pay increases. Accumulated Benefit Obligation Present value of nonvested benefits at present pay levels. Vested Benefit Obligation Present value of vested benefits at present pay levels. VBO ABO PBO 21

Projected Benefit Obligation 21

Pension Benefit Obligation Service cost is the increase in the PBO attributable to employee service performed during the period. 21

Pension Benefit Obligation Interest cost is the accrued interest on the PBO during the period. 21

Pension Benefit Obligation Past service cost effects result from changes in the pension benefit formula or plan terms. 21

Pension Benefit Obligation Loss or gain on PBO results from required revisions of estimates used to determine PBO. 21

Pension Benefit Obligation Retiree benefits paid are the result of paying benefits to retired employees. 21

A trustee manages the pension plan assets. Pension plan assets (like the PBO) are not formally recognized on the balance sheet. A trustee manages the pension plan assets. 18

Pension Plan Assets OVERFUNDED Market value of plan assets exceeds the actuarial present value of all benefits earned by participants. UNDERFUNDED Market value of plan assets is below the actuarial present value of all benefits earned by participants. 11

Pension Expense Pension expense is the net cost of: Service cost Interest cost Return on plan assets Amortization of past service costs Gain or loss recognized. 18

Defined Benefit Plan 1.5% x Service Years x Final year’s salary Jessica Farrow was hired by Global Communications in 1994. The company has defined benefit plan that specifies annual retirement benefits equal to: 1.5% x Service Years x Final year’s salary   Farrow is expected to retire in 2033 after 40 years of service. Her retirement is expected to be 20 years. At the end of 2003, 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 $400,000 at retirement. What is the company’s projected benefit obligation?

Defined Benefit Plan Steps to calculate the projected benefit obligation: Use the pension formula to determine the retirement benefits earned to date. Find the present value of the retirement benefits as of the retirement date. Find the present value of the retirement benefits as of the current date.

Defined Benefit Plan 1.5% x 10 years x $400,000 = $60,000 per year Step 1 – Calculate retirement benefits earned to date. 1.5% x 10 years x $400,000 = $60,000 per year Step 2 – Calculate present value of retirement annuity at retirement date $60,000 x 11.46992 = $668,195 (n=20, i=6%) Step 3 – Calculate the present value of the retirement annuity today $688195 x .174111 = $119,822 (n=30, i=6%)

Defined Benefit Plan Retirement expectancy is 20 years. 1994 2003 2033 2053 PV of retirement benefit of $688,195 in 2003 is $119,822. Starting on retirement date Jessica will receive $60,000 of retirement benefits per year. PV = $688,195

The Pension Benefit Obligation will increase since: Defined Benefit Plan One year later The Pension Benefit Obligation will increase since: One more service year is included in the pension formula calculation. The employee is one more year closer to retirement, causing the PV of the benefits to increase due to interest costs.

Defined Benefit Plan 1.5% x 11 years x $400,000 = $66,000 per year Step 1 – Calculate retirement benefits earned to date. 1.5% x 11 years x $400,000 = $66,000 per year Step 2 – Calculate present value of retirement annuity at retirement date $66,000 x 11.46992 = $757,015 (n=20, i=6%) Step 3 – Calculate the present value of the retirement annuity today $757,015 x .18456 = $139,715 (n=29, i=6%)

Defined Benefit Plan Retirement expectancy is 20 years. 1994 2004 2033 2053 PV of retirement benefit of $757,015 in 2004 is $139,715. Starting on retirement date Jessica will receive $66,000 of retirement benefits per year. PV = $757,015

Service Cost 25

Interest Cost Interest cost is the growth in PBO during a reporting period. Interest cost is calculated as: PBOBeg × Discount rate 26

Therefore the interest for 2004 is: Interest Cost The PBO related to Jessica Farrow at the beginning of 2004 is $119,822. The interest rate is 6%. Therefore the interest for 2004 is: $119,822 x 6% = $7,189. 29

Interest Cost 2004: PBO 1/1/04 $119,822 × 6% = $7,189 30

Past Service Cost Past service cost (PSC) results from the granting of pension benefits for service rendered before the pension plan began or from plan amendments granting increased pension benefits for service rendered before the amendment. PSC is the present value of the retroactive benefits and increases PBO. 35

Past Service Cost Benefits attributable to past service are assumed to benefit future periods by: Improving employee productivity. Improving employee morale. Reducing turnover. Reducing demands for pay raises. 36

Past Service Cost PSC is amortized over the remaining service period of those employees active at the date of the amendment who are expected to receive benefits under the plan. If most of a plan’s participants are inactive, then amortize PSC over the participants’ remaining life expectancy. 37

Two approaches to amortizing PSC: Past Service Cost Two approaches to amortizing PSC: Straight-line method Amortize PSC over the average remaining service period. Service method Amortize PSC by allocating equal amounts to each employee service year remaining. 38

Past Service Cost Effective 1/1/04, Jessica’s employer amends the retirement plan to provide increased benefits attributable to service performed before 1/1/04. The salary percentage was increased from 1.5% to 1.7%. 39

Past Service Cost PBO with Amendment 1.7% x 10yrs x $400,000 = $68,000 (PBO without amendment) Difference of $15,976 is past service cost. 41

Past Service Cost * (1.7% x 1yr x $400,000) x 11.46992 x .18456 = $14,395 ** ($135,798 x 6%) 43

Past Service Cost * (1.7% x 1yr x $400,000 x 11.46992 x .19563) 30

Actuarial Gain or loss on the PBO There are a number of estimates used to determine the PBO. Let’s modify our example so that the estimate of Jessica’s final salary would be increased by 5% to $420,000. The effect of this change in an estimate is accounted for in the current year and future years.

Actuarial Gain or loss on the PBO PBO with Revised Estimate 1.7% x 12yrs x $420,000 = $85,680 $85,680 x 11.46992 = $982,743 $982,743 x .19563 = $192,254 $935,945 x .19563 = $183,099 (PBO without revised estimate) Difference of $9,155 is loss on PBO. 41

Actuarial Gain or loss on the PBO If the revised estimate causes the PBO to be lower, an actuarial gain would be indicated. 43

Other Possible Estimate Changes Change in life expectancy Change in retirement date Change in the assumed discount rate

Payment of retirement benefits The PBO is reduced by the payment of retirement benefits to retirees. 29

Pension Plan Assets These are resources that will satisfy the pension obligation. They are not recognized on the balance sheet but are disclosed in the notes. Assets are held by a trustee, who accepts employer contributions, accumulates earnings on the investments and pays the benefits.

Pension Plan Assets Actual Return Expected Return The dividends, interest, and capital gains generated by the fund during the period. Actual Return Estimated each year to determine the amount of funds to set aside to pay retirement benefits as they become due. Expected Return 31

Return on Plan Assets The plan trustee reports that plan assets were $300 million at the beginning of 2005. The trustee uses an expected return of 9% and an actual return of 10%. Contributions of $48 million were made in 2005. Benefits of $38 million were paid in 2005.

Return on Plan Assets 2005 The income generated by the plan assets is reinvested in the plan to increase its value. The plan assets are less than the PBO. Therefore, the PBO is underfunded. 33

Determining Pension Expense There is a relationship between the pension expense and changes in the PBO and plan assets. Pension expense is part of overall compensation for employees. Accounting objective is to match the cost of providing compensation with the benefits of services being performed.

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Example Global Communications The next slide includes: information on the PBO as provided by the actuary. plan asset information as provided by the trustee.

$ millions PBO Plan Assets Beginning 2005 $400 $300 + Service Cost 41 + Expected return 30 + Interest Cost 24 + Cash contributions 48 +/- Actuarial Loss (Gain) 23 - benefits paid (38) Ending 2005 $450 $340

The Pension Spreadsheet This information is not part of the accounting records of the company. However, it is disclosed in the notes to the financial statements. These are accounts in the general ledger of the company. 40

Pension Expense Pension expense is the net cost of: Service cost Interest cost Expected return on plan assets Amortization of past service costs Amortization of net loss or net gain 18

Service Cost This is the increase in the PBO attributed to employee service during the year. 25

Interest Cost Interest cost is the growth in PBO during a reporting period. Interest cost is calculated as: PBOBeg × Discount rate 26

The actuary uses a discount rate of 6%. Interest Cost Actuaries determined that Global had PBO of $400 million on January 1, 2005. The actuary uses a discount rate of 6%. $400 million x 6% = $24 million 29

This is the interest on the PBO. Interest Cost This is the interest on the PBO. 25

Return on Plan Assets Actual return on plan assets is the dividends, interest, and capital gains generated by the fund during the period. Actual Return Expected Return 31

Return on Plan Assets Actual Return Expected Return Expected return on plan assets is estimated each year to determine the amount of funds to set aside to pay retirement benefits as they are due. Actual Return Expected Return 31

Return on Plan Assets Actual Return Expected Return The CICA concluded that the actual return must be adjusted to reflect the expected return as a component of pension expense. Actual Return Expected Return 31

Return on Plan Assets Expected Return: $300m x 9% = $27 This is the return expected over the life of the plan. Actual Return: $300m x 10% = $30m This is the actual return on the plan to date

Interest Cost 25

Amortization of Past Service Cost PSC is amortized over the remaining service period of those employees active at the date of the amendment who are expected to receive benefits under the plan. If most of a plan’s participants are inactive, then amortize PSC over the participants’ remaining life expectancy. 37

Amortization of Past Service Cost Two approaches to amortizing PSC: Straight-line method Amortize PSC over the average remaining service period. Service method Amortize PSC by allocating equal amounts to each employee service year remaining. 38

Amortization of Past Service Cost The PSC was $60 million in 2004 and the average remaining service life is 15 years. $60m / 15yrs = $4m. 25

Unamortized Past Service Cost The informal records would show that the unamortized past service cost is reduced by the 2005 amortization of $4 million. The balance in the memorandum “account” is not recognized in the financial statements. ($56m - $4 = $52)

Actuarial Gains and Losses 44

Corridor Amortization of Net Actuarial Gains and Losses The practical justification for delayed recognition is that over time the actuarial gains and losses might cancel each other out. The corridor approach is used for amortizing the unrecognized gain or loss.

Corridor Amortization of Net Actuarial Gains and Losses 25

Amortization of Net Loss or Net Gain The net excess at the beginning of the year is $15 and the remaining service life is 15 years $15m / 15yrs = $1m. * NAL = Net Actuarial Loss 25

Corridor Amortization of Net Actuarial Gains and Losses The balance in this memorandum account is not recognized in the financial statements. 25

Pension Expense Cotton contributed $48million to the plan trustee at the end of 2005. We determined that the pension expense for 2005 was $43million. 62

Reconciliation of Pension Amounts Four “off-balance sheet” accounts: PBO Plan Assets Unamortized PSC Unamortized Gain or Loss 68

Reconciliation of Pension Amounts These four amounts combine to account for the one pension account that is reported on the balance sheet: prepaid pension asset or pension liability. 68

Transition Cost Section 3461 came into effect in 2000 and the resulting transitional asset or transitional obligation would be accounted for either retroactively or prospectively. 68

Transition Cost If the transitional balance is accounted for retroactively, the restatement can be with or without restatement. If the prospective approach is adopted, the transitional balance is amortized in a rational and systematic manner over an appropriate period of time. 68

Pension Disclosures Description of the pension plan Pension expense, service cost, interest cost, return on plan assets (actual and expected), and net total of other components 73

Pension Disclosures Reconciliation of the funded status of the plan with (a) plan assets at fair value, (b) PBO, (c) unrecognized PSC, (d) unrecognized gain or loss, (e) unrecognized transition asset or liability, (f) net pension asset or liability 74

Pension Disclosures Discount rate, rate of compensation increase used to measure PBO, and the expected long-term rate of return on plan assets Amount and types of employer securities included in plan assets 75

Settlements and Curtailments Pension plan settlements Reduce PBO and are viewed as the realization of a portion of the net unrecognized gain or loss and a portion of the unrecognized transition asset. Pension plan curtailments Often reduce PBO, resulting in a gain, which reduces accrued pension cost. 71

End of Chapter 17