1. CHAPTER 17
Pensions 2

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

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

4. 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.

5. 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

6. 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

7. 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

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

9. 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

10. Pension Expense – An Overview16

11. 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

12. Projected Benefit Obligation21

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

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

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

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

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

18. 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

19. 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

20. 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

21. Defined Benefit Plan 1.5% x Service Years x Final year’s salary
Jessica Farrow was hired by Global Communications in 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?

22. 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.

23. 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 = $668,195
(n=20, i=6%)
Step 3 – Calculate the present value of the retirement annuity today
$ x = $119,822
(n=30, i=6%)

24. 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

25. 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.

26. 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 = $757,015
(n=20, i=6%)
Step 3 – Calculate the present value of the retirement annuity today
$757,015 x = $139,715
(n=29, i=6%)

27. 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

28. Service Cost 25

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

30. 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

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

32. 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

33. 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

34. 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

35. 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

36. 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

37. 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

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

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

40. 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.

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

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

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

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

45. 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.

46. 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

47. 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.

48. 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

49. 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.

50. 64

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

52. $ 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

53. 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

54. 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

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

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

57. 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

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

59. 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

60. 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

61. 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

62. 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

63. Interest Cost 25

64. 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

65. 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

66. 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

67. 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)

68. Actuarial Gains and Losses44

69. 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.

70. Corridor Amortization of Net Actuarial Gains and Losses25

71. 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

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

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

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

75. 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

76. 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

77. 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

78. 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

79. 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

80. 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

81. 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

82. End of Chapter 17