14. Pensions

Question 1

What are the elements that go into a pension expense?

Answer 1

A-SPIDER

+ Service cost

+/- Prior service cost amortization

+ Interest cost

• Actual Return on plan assets

+ Deferred gain (or - deferred loss)

• Excess amortization of deferred gain (or + deferred loss)

+/- Amortization of existing net obligation or net asset at implementation

A +

S +

P +

I +

D +

E -

R -

Question 2

What is PBO?

Answer 2

PBO (projected benefit obligation) is a balance sheet item. It represents the amount of money an employer needs to contribute to its pension plan in order to pay out estimated pension benefits in the future. The amount changes each year. An increase in PBO is a PBO loss, and a decrease is a PBO gain.

Question 3

What is service cost (S in A-SPIDER)?

Answer 3

Service cost is the main component of pension expense. It represents the present value of benefits that employees earned during the current year. That is, it is the amount by which PBO increased during the year. Therefore, it is added to pension expense.

Question 4

What is prior service cost amortization (P in A-SPIDER)?

Answer 4

Prior service cost amortization is a component of pension expense. Prior service cost represents benefits granted to employees for their service before the benefits plan was implemented. When a plan is implemented, prior service cost is initially recorded:

Dr. OCI

Cr. PBO liability

The amount in OCI is amortized over the average remaining service time of employees. The amortized amount is added to pension expense.

Question 5

What is interest cost (I in A-SPIDER)?

Answer 5

Interest cost is a component of pension expense. It’s the increase in PBO that results from the passage of time. It’s equal to beginning PBO times the discount rate, which is the rate at which future benefits are discounted to present value. Interest cost is added to pension expense.

Question 6

What is actual return on plan assets (R in A-SPIDER)

Answer 6

Actual return on plan assets is a component of pension expense. It represents the earnings (losses) of the plan’s investments during the period after adjusting for contributions to, and withdrawals from, the investment fund. The earnings are subtracted from pension expense since the income offsets other expense components. Losses are added to pension expense.

Question 7

What is deferred pension gain (loss) (D in A-SPIDER)?

Answer 7

Deferred pension gain (loss) is a component of pension expense. It represents the difference between actual returns on plan assets during the year and the long-term expected rate of return on plan assets. The deferred gains (losses) are accumulated in OCI and added to (subtracted from) pension expense.

To include deferred pension gain (loss) in pension expense:

1. Calculate expected return by multiplying beginning plan assets by expected rate of return
2. If actual return on plan assets is greater (less) than expected return, add (subtract) the difference to (from) pension expense.
3. The net effect is pension expense includes the expected, rather than actual, rate of return

Question 8

What is excess amortization of deferred gain (loss) (E in A-SPIDER)?

Answer 8

Excess amortization of deferred pension gain (loss) is a component of pension expense. It is subtracted from (added to) pension expense when the balance of deferred gains/losses in OCI gets too large.

To determine whether the balance is too large, use the corridor approach:

1. Compare the beginning balance of deferred gain (loss) in OCI to 10% of the greater of
   
   1. beginning PBO balance, or
   2. beginning plan assets (at fair value)
2. If the balance of deferred gain (loss) is larger than what it is compared to, amortize the excess amount
3. To calculate one year of amortization, divide the excess amount by average remaining service time of employees (in years)
4. If amortizing a net gain (loss), subtract (add) the amount to pension expense

Question 9

What is amortization of existing net obligation or net asset at implementation (A in A-SPIDER)?

Answer 9

Amortization of existing net obligation or net asset at implementation is a component of pension expense. It amortizes any difference between PBO and fair value of plan assets that existed at implementation of the plan.

To add the component to pension expense:

1. If PBO > FV of PA, the difference is a net obligation.
2. If FV of PA > PBO, the difference is a net asset.
3. The net obligation or asset should be amortized over the greater of 15 years or average remaining service time.
4. If the amortized amount is an obligation (asset), it is added to (subtracted from) pension expense.