Chapter 17: Pensions & Other Post-Retirement Benefits Flashcards
Pension Plans
Designed to provide income to individuals in retirement. Plans often enhance productivity, reduce turnover, satisfy union demands, and allow employers to compete in the labor market.
Defined Contribution Pension Plans
Promise fixed annual contributions to a pension fund (say, 5% of employee pay, or more often, to match contributions by workers). Employees choose (from designated options) where funds are invested - usually stocks or fixed income securities. Retirement pay depends on the size of the fund at retirement.
Defined Benefit Pension Plans
Promise fixed retirement benefits defined by a designated formula. Typically, the pension formula bases retirement pay on the employees’ (a) years of service, (b) annual compensation (often final pay or an average for the last few years), and sometimes (c) age. Employers are responsible for ensuring that sufficient funds are available to provide promised benefits.
Very few new pensions are of the defined benefit variety. Many companies are terminating long-standing defined benefit plans and substituting defined contribution plans.
Reasons = 3.
- Gov regulations make defined benefit plans cumbersome and costly to administer.
- Employers are increasingly unwilling to bear the risk of defined benefit plans; with defined contribution plans, the company’s obligation ends when contributions are made.
- There has been a shift among many employers from trying to “buy long-term loyalty” (with defined benefit plans) to trying to attract new talent (with more mobile defined contribution plans).
Defined Contribution plans
Increasingly more popular vehicles for employers to provide retirement income without the paperwork, cost, and risk generated by the more traditional defined benefit plans.
- Defined contribution plans promise fixed periodic contributions to a pension fund. Retirement income depends on the size of the fund at retirement. No further commitment is made by the employer regarding benefit amounts at retirement.
Defined contribution plan entry
The employer simply records pension expense equal to the cash contribution. e.g.
Pension Expense $3,300
Cash $3,300
Cash ($110,000 x 3%)
Actuary
A pro trained in a particular branch of stats & math, to asses the various uncertainties (employee turnover, salary levels, mortality, etc.) and to estimate the company’s obligation to employees in connection with its pension plan.
A pension formula typically defines retirement pay based on the employee’s… (3 things)
- Years of service.
- Annual compensation.
- Age.
The key elements of a defined pension plan
- The employer’s obligation to pay retirement benefits in the future.
- The plan assets set aside by the employer from which to pay the retirement benefits in the future.
- The periodic expense of having a pension plan.
Pension gains and losses occur when…
when the return on plan assets is higher or lower than expected.
Both pension obligation and the plan assets are…
(a) are reported as a net amount in the balance sheet, and (b) their balances are reported in disclosure notes. And, importantly, the pension expense reported in the income statement is a direct composite of periodic changes that occur in both the pension obligation and the plan assets.
The pension expense
The pension expense is a direct composite of periodic changes that occur in both the pension obligation and the plan assets.
Components of Pension Expense
+ Service cost ascribed to employee service during the period
+ Interest accrued on the pension liability
(Interest and investment
return are financing
aspects of the pension
cost.)
- Return on the plan assets*
Amortized portion of:
+ Prior service cost attributed to employee service before an amendment to the pension plan
+ or (−) Losses or (gains) from revisions in the pension liability or from investing plan assets
(The recognition of some
elements of the pension
expense is delayed.)
= Pension expense
Accumulated benefit obligation (ABO)
The actuary’s estimate of the total retirement benefits (at their discounted present value) earned so far by employees, applying the pension formula using existing compensation levels.
Vested benefit obligation (VBO)
The portion of the accumulated benefit obligation that plan participants are entitled to receive regardless of their continued employment.
Projected benefit obligation (PBO)
The actuary’s estimate of the total retirement benefits (at their discounted present value) earned so far by employees, applying the pension formula using estimated future compensation levels. (If the pension formula does not include future compensation levels, the PBO and the ABO are the same.)
The accumulated benefit obligation (ABO)
is an estimate of the discounted present value of the retirement benefits earned so far by employees, applying the plan’s pension formula using existing compensation levels.
Vested Benefits
are those that employees have the right to receive even if their employment were to cease today.
Before the Employee Retirement Income Security Act (ERISA) was passed in 1974, horror stories relating to lost benefits were commonplace.
Vesting requirements were tightened drastically to protect employees. These requirements have been changed periodically since then. Today, benefits must vest (a) fully within five years or (b) 20% within three years with another 20% vesting each subsequent year until fully vested after seven years. Five-year vesting is most common.
Projected benefit obligation (PBO)
The PBO estimates retirement benefits by applying the pension formula using projected future compensation levels. (If the pension formula does not include future compensation levels, the PBO and the ABO are the same.)
Accumulated benefit obligation
is an estimate of the discounted present value of the retirement benefits earned so far by employees, applying the plan’s pension formula using existing compensation levels.
Vested benefits
are those that employees have the right to receive even if their employment were to cease today.
Service cost
PBO increases each year by the amount of that year’s service cost. This represents the increase in the projected benefit obligation attributable to employee service performed during the period. As we explain later, it also is the primary component of the annual pension expense.
Interest cost
The second reason the PBO increases is called the interest cost. Even though the projected benefit obligation is not formally recognized as a liability in the company’s balance sheet, it is a liability nevertheless. And, as with other liabilities, interest accrues on its balance as time passes. The amount can be calculated directly as the assumed discount rate multiplied by the projected benefit obligation at the beginning of the year.
Prior service cost
Another reason the PBO might change is when the pension plan itself is amended to revise the way benefits are determined. For example, Global Communications in our illustration might choose to revise the pension formula by which benefits are calculated.
Prior service cost
When a pension plan is amended, credit often is given for employee service rendered in prior years. The cost of doing so is called prior service cost.
Gain or loss on the PBO
We mentioned earlier that a number of estimates are necessary to derive the PBO. When one or more of these estimates requires revision, the estimate of the PBO also will require revision. The resulting decrease or increase in the PBO is referred to as a gain or loss, respectively.
Payment of retirement benefits.
Another change in the PBO occurs when the obligation is reduced as benefits actually are paid to retired employees.
Remember, though, in reality the actuary would make these calculations for the entire pool of employees covered by the pension plan. But the concepts involved would be the same.
the five ways the PBO can change.
Service cost
+
Each period
Interest cost
+
Each period (except the first period of the plan, when no obligation exists to accrue interest)
Prior service cost
+
Only if the plan is amended (or initiated) that period
Loss or gain on PBO
+ or –
Whenever revisions are made in the pension liability estimate
Retiree benefits paid
–
Each period (unless no employees have yet retired under the plan)
pension plan assets
Like the PBO, the pension plan assets are not reported separately in the employer’s balance sheet but are netted together with the PBO to report either a net pension asset (debit balance) or a net pension liability (credit balance). Its separate balance, too, must be reported in the disclosure notes to the financial statements (as does the separate PBO balance), and as explained below, the return on these assets is included in the calculation of the periodic pension expense.
trustee
A trustee manages pension plan assets.
expected return on plan assets
When an employer estimates how much it must set aside each year to accumulate sufficient funds to pay retirement benefits as they come due, it’s necessary to estimate the return those investments will produce.
Prior service cost
Prior service cost is recognized as pension expense over the future service period of the employees whose benefits are recalculated.
Prior service cost is not expensed as it is incurred. Instead, it is reported as a component of AOCI to be amortized over time.
Where we report gains and losses…
We report gains and losses as OCI in the statement of comprehensive income.
The service cost component of pension expense is reported…
The service cost component of pension expense is reported separate from the other components of pension expense in the income statement as part of the total compensation costs.
