Pensions and Postretirement Benefits Revsine/Collins/Johnson/Mittelstaedt: Chapter 14 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning objectives 1.The rights and obligations in defined contribution and defined benefit plans. 2.The institutional features of pension plan arrangements. 3.The components of pension expense and their relation to pension assets and pension liabilities. 4.How GAAP smoothes the volatility inherent in pension estimates and forecasts. 5.The determinants of pension funding. 14-2

Learning objectives: Concluded 6.How to analyze and use the retirement benefit footnote disclosures. 7.Other postretirement benefits plan concepts and financial reporting rules. 8.What research tells us about the usefulness of the detailed pension and other postretirement benefits disclosures. 9.The key differences in defined benefit plan reporting among current U.S. GAAP, current IFRS requirements, and the 2010 IASB Exposure Draft. 14-3

Pension plans  A pension plan is an agreement by the firm to provide a series of payments (called a pension) to employees when they retire.  The firm makes periodic contributions to a pension trust.  The pension trust then makes periodic benefit payments to retired employees.  There are two types of pension plans: defined contribution plans and defined benefit plans. Firm (sponsor) Pension trust Retired employee Contributions Benefit payments 14-4

Defined benefit pension plans: Accounting complications  The plan specifies the benefit formula but not the benefit amount.  To determine the periodic pension expense, the following factors must be estimated: 1. The proportion of the workforce that will remain with the firm long enough to qualify for benefits under the plan (called vesting). 2. The rate at which employee salaries will rise until retirement. 3. The anticipated life expectancy of employees after retirement. 4. The rate of return that will be earned on pension investments. 5. The discount rate used to reflect the present value of future benefits earned by employees in the current period. 14-5

Defined benefit pension plans: Five components of pension expense Service cost (+) Interest cost (+) Expected return on pension assets (-) Recognized gains or losses (- or +) Recognized prior service cost (- or +) The increase in the discounted present value of the pension benefits due to an additional year’s employment. Measures the growth in the pension liability that arises from the passage of time. Dollar return management believes will be earned on pension investments. Smoothing device that adjusts for the difference between the expected and actual return on pension assets. Smoothing device that adjusts for the costs of retroactive changes in plan benefits. 14-6

Defined benefit pension plans: Determinants of Pension Funding  Funding decisions are influenced by income tax laws, protective pension legislation, the availability of cash, and other incentives. Income tax laws ERISA Competing cash needs Contracting and political cost incentives  Firms with high marginal tax rates tend to overfund their pension plans.  Firms with less stringent capital constraints and larger union membership tend to have higher funding ratios.  Firms with more “precarious” debt/equity ratios tend to have lower funding ratios. 14-7

The pension footnote: Extracting analytical insights  The funded status reconciliation provides insights about future pension-related cash flows:  Firms are also now required to disclose anticipated pension benefit payouts for the next five years. $ Slightly overfunded Plan assets Pension benefit obligation $ Suppose the firm did not contribute cash to their pensions trust this year. Will cash contributions be required in future years? 14-8

Defined benefit plans: Cash-balance plans  Many U.S. companies are replacing existing pension plans with a new cash-balance plan.  Cash balance plans are attractive to employers, but they are also controversial. Employer Employee Trustee Contributes fixed amount per year, say 5% of salary Pays annuity benefit to employee Interest earned at T-bond rate 14-9

Other postretirement benefits  Many firms promise to provide healthcare and life insurance to employees (or their spouses) during retirement.  Under the matching principle, an expense should be recognized over the period of employment as employees qualify for these OPEBs.  Pre-Codification SFAS No. 106, most firms used “pay-as-you-go” accounting.  The dollar amounts involved can be staggering: $ billion $ billion OPEB liabilityInitial OPEB expense GM’s 1992 adoption of SFAS No

Analytical Insights: Assessing OPEB Liability Similar to pensions, the OPEB liability is riskier than many traditional forms of debt. Risk measures are defined as follows: 14-11

Pension and OPEB accounting: Reliability and valuation relevance  Pension asset and liability measures in the footnotes are more closely associated with stock prices than are the measures recognized on the balance sheet.  Both footnote liabilities (ABO for pensions and APBO for OPEBS) are negatively correlated with stock prices.  Investors price the APBO as though it is measured with less reliability

Global Vantage Point Comparison of IFRS and GAAP Retirement Benefit Accounting DifferenceGAAPIFRS Actuarial Gains and LossesFollows FASB ASC Subtopic First approach – new gains and losses are not recognized in OCI. The second approach recognizes gains and losses immediately into OCI with no subsequent amortization Prior Service CostsRecognize new prior services costs as part of OCI and recycle them into pension expense over the shorter of the average remaining work life or the period covered under the collective bargaining agreement Called past service costs under IFRS. Under IAS – past service cost related to vested employees is recognized immediately where that related to nonvested employees is amortized over the average remaining vesting period Smoothed asset valuesNot allowed under IAS 19 – instead expected return and corridor calculations are based on pension asset fair values Balance sheet pension assetCan’t exceed the sum of the net plan assets, the unrecognized prior service cost and the unrecognized net actuarial losses 14-13

Summary  In pension plan contracts, employees exchange current service for payments to be received during retirement.  Defined contribution pension plans specify amounts to be invested for the employee during the employee’s career, and the employee’s pension will be based on the value of those investments at retirement.  In the U.S., most new pension plans are defined contribution plans.  The accounting for defined contribution plans is straightforward. Defined benefit plans specify amounts to be received during retirement, thereby complicating the underlying economics of the exchange and the accounting

Summary continued  Under ASC Topic 715, pension expense for defined benefit plans consists of service cost, interest cost, expected returns on plan assets, and two other “smoothing” components.  The two smoothing mechanisms avoid year-to-year volatility in pension expense but make pension accounting exceedingly complex, because many pension related items are in accumulated other comprehensive income.  Under pre-Codification SFAS 87, the balance sheet asset (liability) on the balance sheet differed from the actual funded status of the plan. Current GAAP, requires that the balance sheet asset (liability) equal the funded status of the plan

Summary continued  Employer funding of defined benefit pension plans is influenced by tax law, union membership, and the financial health of the employer.  The reporting rules for other postretirement benefit plans (OPEB) closely parallel pension accounting rules.  GAAP requires information about the expected future cash flows, future amortization amounts, and major classes of investments so that investors can make cash flow projections, assess risk, and evaluate return assumptions.  Academic research suggests that stock prices reflect pension and OPEB disclosures, but their impact may not be fully valued

Summary concluded  Statement readers should be alert for these warning signals of earnings management: 1. A significant divergence between any of the various pension and OPEB rates selected by a firm and the rates chosen by other firms in the industry. 2. A very large difference between the chosen expected rate of return on plan assets and the discount rate used. 3. An increase in the year-to-year expected rate of return on plan assets that seems unrelated to changes in market conditions. 4. A decrease in the assumed rate of increase in future compensation levels that cannot be explained by changing industry or labor market forces. 5. Rate of return assumptions that are inconsistent with prior investment experience or mix of equity and debt investments. 6. The concepts and calculations under IAS 19 are similar to U.S. GAAP. The IASB has issued an Exposure Draft that would make several significant changes to IAS