1. Pension Accounting Chapter 17
Understand the nature/characteristics/accounting of employer pension plans:
Defined Benefit Plans.
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2. Fundamental differences between:
CHAPTER 17: PENSION
Objectives:
Pension Overview
Fundamental differences between:
Defined contribution plans
Defined benefit plans*
Accounting for Pension:
Key components: Pension expense
Disclosure/presentation
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3. Overview of Pension Plan
A pension plan:
An agreement between an employer/employee
Government plans: social security
Individual plans (IRA)
Employer Plans* 
Emphasis: Pension Plan: for Corporation:
Company set aside funds for employees’ service!
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4. Pensions: SFAS 158 132R: Disclosures
SFAS 158 Reporting pension items in the balance sheet and AOCI
132R: Disclosures
IAS 19 (detail information provided –end of the lecture)
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5. PENSION PLAN: Overview
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PENSION PLAN: Overview
Employer
Sponsors the plan
Benefits
Plan Administrator
Pension Recipients
The plan administrator receives the contributions from the employer, invests the pension assets, and makes the benefit payments.
Contributions
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6. TYPES OF PENSION PLANS TWO TYPES1
DEFINED
CONTRIBUTION
PLAN $ 2
Pension fund
DEFINED
BENEFIT
PLAN
promise FIXED ANNUAL CONTRIBUTIONS
promise FIXED RETIREMENT BENEFITS
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7. Defined contribution plans
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Defined Contribution
A plan that provides benefits based solely on what has been contributed and the earnings thereon
Amounts to be funded are determined by the plan
No promise for specific future benefits.
Independent third party holds assets
Risk borne by employee
Accounting relatively straightforward
Employer makes no guarantee to the amount of benefits
Employees’ retirement benefits based on the amount of funds in the plan
Independent third party holds assets.
Size of pension trust depends on amounts contributed to trust, earnings on the trust, withdrawals from the trust and treatment of terminations.
Sometimes these plans are purely optional and grow only from payroll deductions authorized by employee. However, most of the time, the employer matches all or part of the employee’s contribution to the 401k plan.
For government and nonprofit employees, the plans are 403(b) and there’s another kind available with a different number and slightly different rules. Federal law specifies maximum contributions and when you can first withdraw money and when you have to start withdrawing your money
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8. Defined Benefit Pension Plans
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DEFINED BENEFIT PLAN
Plan Characteristics
Employer is committed to specified retirement benefits.
Employer bears all risk of pension fund performance.
Retirement benefits are based on a formula that considers years of service, compensation level, and age.
In a defined benefit pension plan, the employer is committed to a specified retirement benefit for employees. Retirement benefits are based upon actuarially sound computations. The employer bears all the risks of pension fund performance. Our Social Security system is a defined benefit pension plan.
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9. Accounting for Defined Benefit Plans
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Defined benefit plans
Employer’s contribution is based on the expected future benefits
Affected by many variables:
Years of service
Annual salary at retirement
Retirement years
Etc.
Future Obligation for retirement benefits is based on many estimates/assumptions
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10. Pension calculations involve actuarial assumptions.
Actuaries and Pension Accounting
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Pension calculations involve actuarial assumptions.
These are estimates.
Assumptions involve:
mortality rates, employee turnover, future salaries, rates of return, etc.
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11. Measures of Pension Liability: Defined Benefit Plan
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Pension calculations involve actuarial assumptions.
Benefits for vested and nonvested employees at future salaries
(GAAP)
Projected
Benefit
Obligation
(PBO)
Benefits for vested/ non-
vested employees at current salaries
Accumulated
Benefit
Obligation
(AB0)
Go back to PV example and have students compute ABO instead of the PBO
Vested Benefit Obligation (VBO)
The actuarial present value, using current salary levels, of vested benefits only.
Accumulated Benefit Obligation (ABO)
The actuarial present value of benefits, vested and non-vested, attributed to the pension formula to employee service rendered to a particular date.
Calculations are done without
assumptions about future changes
in the level of compensation.
Projected Benefit Obligation (PBO)
The actuarial present value of vested and non-vested benefits attributed to the plan through the pension benefit formula for service rendered to that date based on employees’ future salary levels
Future years of service are not forecasted in computing either PBO or ABO
PBO assumes future pay increases, ABO does not
PBO = ABO: Flat benefit or non-pay-related benefit formulas
PBO <> ABO: Final pay or career average pay benefit formulas
To do the PVs: Discount rate is the rate required to currently settle benefits and generally based on rates published by the Pension Benefit Guarantee Corp (PBGC).
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12. OVERVIEW: PENSION COMPONENTS
Based On Actuarial Assumptions:
How much to contribute annually for the service provided by employees
1. SERVICE PROVIDED
Benefit Period
Employee
Retired
Employee
hired
SERVICE COST
PENSION EXPENSE
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13. PENSION EXPENSE: INTEREST COST
Interest cost : (PENSION EXPENSE)
– the increase in the pension obligation (PBO) due to the accrual of an additional year of interest.
PV of liability increases as you get closer to the due date
Interest cost = discount rate * beginning balance in PBO
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14. INTEREST COST:PENSION EXPENSE
PV of pension Obligation is increased by the interest cost on the beginning of PBO
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15. OVERVIEW: TIMELINE COMPONENTS PRIOR (PAST) SERVICE COST
Benefit Period
Employee
Retired
Employee
Hired
Plan
Initiation
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16. PENSION EXPENSE: Prior Service Cost
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PENSION EXPENSE: Prior Service Cost
Establishing (or modifying/amended) a plan
Cost of benefits granted for service rendered prior to the inception of the plan
Increases PBO at date of amendment/
The entire amount of Past Service Cost is NOT recognized as expense in the current year
Instead , Past Service Cost is recognized in the current period in Other Comprehensive Income (OCI)
Prior Service Cost (PSC)
Arises from amendments to the plan that grants increased benefits to employees based on services already rendered.
From FAS87 para 25 as amended
A plan amendment that retroactively increases benefits (including benefits that are granted to retirees) increases the projected benefit obligation. The cost of the benefit improvement shall be recognized as a charge to other comprehensive income at the date of the amendment. Except as specified in paragraphs 26 and 27, that prior service cost shall be amortized as a component of net periodic pension cost by assigning an equal amount to each future period of service of each employee active at the date of the amendment who is expected to receive benefits under the plan. If all or almost all of a plan’s participants are inactive, the cost of retroactive plan amendments affecting benefits of inactive participants shall be amortized based on the remaining life expectancy of those participants instead of based on the remaining service period. Other comprehensive income is adjusted each period as prior service cost is amortized.
Paragraph 26 as amended
To reduce the complexity and detail of the computations required, consistent use of an alternative approach that more rapidly amortizes the cost of retroactive amendments is acceptable. For example, a straight-line amortization of the cost over the average remaining service period of employees expected to receive benefits under the plan is acceptable. The alternative method used shall be disclosed.
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17. Issues in Accounting: Defined Benefit Plans
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Periodic expense (Pension Expense) of having a pension plan
Plan Assets Resources set aside by the employer from which to pay the retirement in the future (invested by Trustee)
3. Employer’s Obligation to pay retirement benefits in the future
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18. Pension Plan Assets
Resources with which the obligation will Satisfy: PLAN ASSETS
Employee contribution in the Pension Fund (held by Trustee)
Plan Assets are invested -in income producing assets.
Accumulated balance: Contribution + return on investment
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19. Return on Plan Asset Expected return on plan assets (FASB)
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Return on Plan Asset
Expected return on plan assets (FASB)
*Expected rate of return:
Based on long-term rate of return anticipated given investment of plan assets
Expected return on plan asset decreases the pension cost and increases plan asset
FAS87 Paragraph 20: - as amended by FAS158
The following components shall be included in the net pension cost recognized for a period by an employer sponsoring a defined benefit pension plan:
a. Service cost
b. Interest cost
c. Actual return on plan assets, if any [expected return here makes computations easier]
d. Amortization of any prior service cost or credit included in accumulated other comprehensive income.
e. Gain or loss (including the effects of changes in assumptions) to the extent recognized (paragraph 34) – [includes difference between expected and actual return if you do it this way]
f. Amortization of any net transition asset or obligation existing at the date of initial application of this FAS87 and remaining in accumulated other comprehensive income (paragraph 77).
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20. Actuarial Gains and Losses
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Actuarial Gains and Losses
Actuarial assumptions are subject to inaccuracies as time goes by and circumstances change
The estimate of the PBO also require revision
Inc/Dec in PBO is referred to gain/loss
Reasons for G/L
Gains and losses may arise from variations in assumed and actual asset rates of return and asset values themselves.
Gains and losses may arise from changes in the assumed variables used to determine the PBO required balance.
Amortization is required as a component of pension expense if, at the beginning of the year, the absolute value of the net unrecognized gain or loss exceeds 10% of the greater of:
The PBO or
The plan assets This 10% is referred to as the “corridor”:
If accumulated gains and losses are not greater than 10%, do not include their amortization in current pension cost.
Amortized gains reduce pension cost; losses increase it.
We’ll return to the details after we learn how to use the workpaper
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21. NET GAINS/LOSSES NET GAINS/LOSSES:
1. Gains/Losses from the return on Assets
2. Gains/Losses from changing assumptions (PBO)
= NET GAINS/LOSSES
Deferred and reported as OCI
Amortized using Corridor rule*
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22. The corridor amount is 10% of the greater of . . .
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Corridor Amount
STEPS
1: GREATER OF PBO & PLAN ASSETS
2: 10% OF STEP 1
3…. Next slide…
PBO at the beginning of the period.
The corridor amount is 10% of the greater of . . . Or
Fair value of plan assets at the beginning of the period.
The corridor amount is defined as 10% of the greater of the beginning projected benefit obligation or the beginning fair value of the plan assets. Before a gain or loss would be amortized, it must exceed the corridor amount. The existence of the corridor amount is an effort by the FASB to permit companies to smooth income. Only very large gains or losses exceed the corridor amount and are subject to amortization over an extended period of time.
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23. Gains and Losses EXAMPLE 2013 2013 Apply steps:
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EXAMPLE
2013
2013
For Global Communications, we are assuming a net loss—AOCI of $55 million at the beginning of Also recall that the PBO and plan assets are $400 million and $300 million, respectively, at that time. The amount to amortize to 2009 pension expense is $1 million. This is calculated by taking the net loss of $55 million and subtracting the corridor amount of $40 million ($400 million time 10% is used as the corridor since $400 million is greater than $300 million). This provides the excess at the beginning of the year of $15 million which is divided by the average service life of 15 years to arrive at the amortization of $1 million for 2009.
Apply steps:
Greater of PBO & Plan Assets = PBO $400
10% of PBO i.e. 400 x 10% = $40
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24. Gains and Losses $15,000,000 ÷ 15 years = $1,000,000
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STEP 3: FIND THE EXCESS TO BE AMORTIZED
For Global Communications, we are assuming a net loss—AOCI of $55 million at the beginning of Also recall that the PBO and plan assets are $400 million and $300 million, respectively, at that time. The amount to amortize to 2009 pension expense is $1 million. This is calculated by taking the net loss of $55 million and subtracting the corridor amount of $40 million ($400 million time 10% is used as the corridor since $400 million is greater than $300 million). This provides the excess at the beginning of the year of $15 million which is divided by the average service life of 15 years to arrive at the amortization of $1 million for 2009.
AMORTIZATION:
$15,000,000 ÷ 15 years = $1,000,000
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25. Defined Benefit Plan: Net Periodic Pension Cost
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So far…..
PENSION EXPENSE=
Service Cost
+ Interest Cost
- expected return on plan Asset
+Amortization (if any) of Prior service cost
+/- Amortization (net) Gains/Losses
FAS87 Paragraph 20: - as amended by FAS158
The following components shall be included in the net pension cost recognized for a period by an employer sponsoring a defined benefit pension plan:
a. Service cost
b. Interest cost
c. Actual return on plan assets, if any [expected return here makes computations easier]
d. Amortization of any prior service cost or credit included in accumulated other comprehensive income.
e. Gain or loss (including the effects of changes in assumptions) to the extent recognized (paragraph 34) – [includes difference between expected and actual return if you do it this way]
f. Amortization of any net transition asset or obligation existing at the date of initial application of this FAS87 and remaining in accumulated other comprehensive income (paragraph 77).
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26. REPORTING: Employer’s Obligation & Plan Asset
The employer’s obligation and plan assets are not individually reported in a company’s primary financial statements:
the difference between the two, the funded status, is reported as:
a pension liability if underfunded or
a pension asset if overfunded.
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27. Funded Status of Pension Plan
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Funded Status of Pension Plan
Projected Benefit Obligation (PBO)
- Plan Assets at Fair Value
Underfunded / Overfunded Status
This amount is reported in the balance sheet as a Pension Liability or Pension Asset.
The amount of the underfunding or overfunding of the pension plan is reported in the current period balance sheet as either a pension liability in the case of underfunding or a pension asset in the case of overfunding.
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28. Pension Disclosures The details for net periodic pension cost
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The details for net periodic pension cost
the service cost component.
the interest cost component.
the expected return on plan assets the amortization of PSC, transition amount and unrecognized gain/loss (separately)
Gain or loss from settlement or curtailment of plan
FASB 132 revised expanded the pension disclosures required – add summary statement here?
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29. Pension Disclosures Amount and types of assets held
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Pension Disclosures
Amount and types of assets held
Assumptions related to discount rate, rate of increase in compensation, expected return on plan assets
Alternative amortization policies
Past practice or history of regular benefit increases
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30. Pension Disclosures Employers with multiple plans
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Employers with multiple plans
Information can be combined but the computations are made for each individual plan
Net position for over-funded plans would be reported in noncurrent assets
Net position for under-funded plans would be reported in liabilities
Part may be reported as a current liability
See next slide
FAS 87 Paragraph 36 as amended
The employer shall aggregate the statuses of all overfunded plans and recognize that amount as an asset in its statement of financial position. It also shall aggregate the statuses of all underfunded plans and recognize that amount as a liability in its statement of financial position. An employer that
presents a classified statement of financial position shall classify the liability for an underfunded plan as a current liability, a noncurrent liability, or a combination of both. The current portion (determined on a plan-by-plan basis) is the amount by which the actuarial present value of benefits included in the benefit obligation payable in the next 12 months, or operating cycle if longer, exceeds the fair value of plan assets. The asset for an overfunded plan shall be classified as a noncurrent asset in a classified statement of financial position.
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31. Disclosure of Pension Plans FASB 132
A reconciliation between the beginning and ending balances for the projected benefit obligation
A reconciliation between the beginning and ending balances in the fair value of the pension fund
The fair value of plan assets (changes between BOY and EOY)
PBO Obligation (changes between BOY and EOY)
EoY = end of year BoY = beginning of year
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32. continues
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33. (continues)
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34. (concluded)
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35. (concluded)
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36. IAS 19: INFORMATION
The standard covers all employee benefits - not just pensions. This note focuses on pensions but a later section considers other employee benefits. The key pension points are:
Assets are taken at market value 
Liabilities are calculated using an interest rate based on the yield on high quality corporate bonds at the valuation date (usually taken as AA-rated) 
There is a limit to the amount that can be recognized as a prepayment (surplus) in the company balance sheet
Actuarial gains and losses may be:
recognized in the P&L immediately
recognized in the P&L on a smoothed basis
recognized immediately in the statement of recognized income and expense
The cost of past service benefit increases is recognized immediately to the extent that the increases are vested immediately
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