1. Pensions and Other Postretirement Benefits Chapter 15 Robinson, Munter and Grant

2. Robinson, Munter & Grant Chapter 152 Learning Objectives Retirement plans –Defined benefit –Defined contribution Pension liability Pension expense Actuarial assumptions Health care and other benefits

3. Robinson, Munter & Grant Chapter 153 Types of Retirement Benefits 1.Defined Contribution Plans Company promises to contribute a certain amount to a plan each period 2.Defined Benefit Plans Employer promises that the employees will receive a certain pension amount at retirement

4. Robinson, Munter & Grant Chapter 154 Defined Contribution Plans Firm’s periodic contribution is defined and can take many forms –Percentage of employee’s salary –Percentage of firm profits Plan assets may be controlled by employee –Stock mutual funds –Employee bears the risk associated with returns

5. Robinson, Munter & Grant Chapter 155 Defined Benefit Plans Employee will receive a certain amount at retirement –Non-Pay-Related –Pay-Related Employer bears risk of plan performance Complex accounting

6. Robinson, Munter & Grant Chapter 156 Accounting for Defined Benefit Plans Company must report the funding status of the plan Liability if the present value of future benefits exceeds the value of the plan’s assets Asset if the present value of the future benefits is less than the value of the plan’s assets

7. Robinson, Munter & Grant Chapter 157 Accounting for Defined Benefit Plans Some terms Service cost: Change in pension obligation due to current period service Projected benefit obligation: liability based on projected salary increases Accumulated benefit obligation: liability excluding salary increases Vested benefit obligation: portion of liability that employee is entitled to

8. Robinson, Munter & Grant Chapter 158 Example Current salary: $100,000 Total employment = 20 years Annual compensation increase: 3% –Final salary: $175,351 (100,000*1.03 19 ) Discount rate: 7% Pension: 2% per year of service –40% of final salary

9. Robinson, Munter & Grant Chapter 159 Example After One Year Projected annual pension: 2% * $175,351 = $3,507 10-year pension is worth $25,356 at retirement 10-year pension is worth $7,288 currently Earn $100,000 with 3% annual increases 020 years30 years Receive $3,507 annual pension 1 year PV$7,288 $26,356

10. Robinson, Munter & Grant Chapter 1510 Example After One Year In this case, at the end of the first year, service cost = pension liability = pension expense = $7,288, the PBO ABO excludes all salary increases, $4,156 –Use $100,000 instead of $175,351 in calculations VBO is 20% of ABO, $831 –Pension vests over 5 years, 20% per year

11. Robinson, Munter & Grant Chapter 1511 Example After Two Years Projected annual pension: 2*2% * $175,351 = $7,014 10-year pension is worth $52,712 at retirement 10-year pension is worth $15,596 currently Earn $100,000 with 3% annual increases 020 years30 years Receive $7,014 annual pension 2 years PV $15,596 $52,712

12. Robinson, Munter & Grant Chapter 1512 Example After Two Years PBO = $15,596 –Pension expense = $15,596-$7,288 = $8,308 –Interest on previous year’s obligation = $510 $7,288*7% –Service cost = $8,308-$510 = $7,798 ABO = $9,161 Use $100,000 instead of $175,351 in calculations VBO = $3,664 Pension vests over 5 years, 20% per year

13. Robinson, Munter & Grant Chapter 1513 Assumptions Higher/Lower Discount rate Higher/Lower Compensation rate increase Higher/Lower Expected return on plan assets PBOLower/HigherHigher/LowerNo impact ABOLower/HigherNo impact/HigherNo impact VBOLower/HigherNo impact Pension expenseLower/HigherHigher/LowerLower/Higher

14. Robinson, Munter & Grant Chapter 1514 Components of Pension Expense Service Cost Interest Cost Return on Plan Assets Amortization of unrecognized prior service cost Amortization and deferral of gain or loss Amortization of the transition liability or asset

15. Robinson, Munter & Grant Chapter 1515 Service Cost The change in PBO during the period –Attributed to work performed during the period Recognized in pension expense in its entirety –Consistent with the matching principle

16. Robinson, Munter & Grant Chapter 1516 Interest Cost Interest accrued on the PBO for the period –PBO is computed at each balance sheet date Discount rate * PBO = Interest cost Small changes in the interest rate may result in substantial changes in pension expense

17. Robinson, Munter & Grant Chapter 1517 Return on Plan Assets Expected return = Beginning market-related value * Expected long-term rate of return Majority of companies use expected return on plan assets in calculating pension expense –Actual return may not = expected return Differences in actual vs. expected long-term rate of return Market-related value may not = actual value

18. Robinson, Munter & Grant Chapter 1518 Return on Plan Assets Market-related Value Beginning market-related value + Expected return on plan assets + Employer contributions - Benefits paid to retirees +/- % of deferred asset gains/losses (over 3 or 5 years) = Ending market-related value

19. Robinson, Munter & Grant Chapter 1519 Amortization of Prior Service Cost PBO after plan amendment – PBO before plan amendment = Prior service cost from plan amendment Amortized over average remaining service life of all active employees

20. Robinson, Munter & Grant Chapter 1520 Amortization and Deferral of Gain or Loss Gains/losses associated with differences between actual and expected PBO that arise as a result of changes in actuarial assumptions These gains/losses are deferred and amortized Net the liability and asset gain/loss to a single number –Liability item: change in life expectancy –Asset item: change in return on assets

21. Robinson, Munter & Grant Chapter 1521 Amortization and Deferral of Gain or Loss, Continued Amortize amount above corridor threshold –10% of the greater of the PBO or the market- related value at the beginning of the year Amortize over the average remaining service life of current employees Remember, if assumptions are reasonable, gain and losses should net out over time.

22. Robinson, Munter & Grant Chapter 1522 Amortization of the Transition Liability or Asset Asset or liability in place when current US standard was adopted –1987 Amortized over average remaining service life Most of this amount has already been amortized

23. Robinson, Munter & Grant Chapter 1523 Pension Liability PBO at the end of the period Value of ending plan assets Difference equals funded status Also include unrecognized net gains, prior service costs and transition asset Liability = Funded status ± 3 adjustments

24. Robinson, Munter & Grant Chapter 1524 Disclosure Requirements: US Standards 1.Reconciliation of the benefit obligation 2.Reconciliation of the fair value of plan assets 3.The funded status 4.Pension expense recognized 5.Key assumptions 6.Explain significant changes in the benefit obligation or plan assets

25. Robinson, Munter & Grant Chapter 1525 International Standards Retirement Plans Generally similar Differences related to: –Classification of defined benefit and defined contribution plans –Amortization of gains and losses under the corridor approach –Expensing of prior service costs –No recognition of minimum pension liability

26. Robinson, Munter & Grant Chapter 1526 International Standards Reporting Requirements Accounting policy for actuarial gains/losses Description of plan Reconciliation of assets and liabilities Components of fair value of plan assets Reconciliation of changes to the net liability Total expense Actual return on plan assets Principal actuarial assumptions

27. Robinson, Munter & Grant Chapter 1527 Other Postretirement Benefits Non-pensions are typically not pay-related. –Report Accumulated postretirement benefit obligation only No minimum liability to report

28. Robinson, Munter & Grant Chapter 1528 Other Postretirement Benefits Current Period Expense Service cost Interest cost Less: actual return on plan assets Plus (minus) loss (gain) recognized in excess of the corridor Plus (minus) gain (loss) deferred based on expected return on plan assets Amortization of prior service cost Amortization of transition liability

29. Robinson, Munter & Grant Chapter 1529 Retirement Benefit Disclosures Consider whether pension assets are invested in the company’s own stock Look for various types of plans –Regular, executive, supplemental Consider changes to actuarial assumptions Compare to similar firms Funded status

30. Robinson, Munter & Grant Chapter 1530 Summary Pension plans Pension expense and liability Disclosures required International standards Other postretirement benefits