Session 5 Flashcards
Types of post employment benefit obligation
Pensions
Health care benefits
Other deferred compensation
Main emphasis on pension schemes
Objective of pension scheme for employees
2 types of pension scheme
Defined benefit
Defined contribution
Retirement annuity
Retirement annuity contracts are individual contracts between you and the pension provider - usual insurance company
Promises lifetime guaranteed monthly/annual income for retiree until death - often funded years in advance, either lump sum or through a series of Reg payments
Retirement annuity- advantages
Can provide lifetime income
Taxes on deferred annuities are only due upon the withdrawal of funds
Guarantee a rate of return - translating to a steady income stream
Retirement annuity disadvantages
Complex and hard to understand
Fees make annuities more expensive than other retirement investments
Net returns on withdrawals are taxed as ordinary income
Employee benefit obligations (EBOS)
Defined benefit
Defined contribution
Hybrid plans
Defined contribution - how they work
Employees and usually employers make defined contributions into a saving account
These contributions are then invested, usually in a mix of equities, bonds and cash but may include alternative assets
When the employees reach retirement age the accumulated funds are traditionally used to purchase an annuity
Defined contribution characteristics
Employer’s contributions to employees savings are defined
Retirement benefit received by employee is not defined
Employee bears investment risk
- inflation risk
- Risk of poor investment returns
Employee beats risk of changing demographics and life expectancy
Annuity risk rate
Defined benefit - how they work
Employer offers employee pension plan members a defined benefit when they reach a specified retirement age
Defined benefit - characteristics
Employees benefit due on retirement
Employers obligation to pay the benefit is defined
Employers contribution although defined for any given period is subject to revsion as actuarial assumptions are updated to reflect changing market conditions and experience
Funding defined benefit pensions - how they work - employers
Accrued benefits are a liability to the company
For each year of an employee’s service, funds are set aside to meet the future liability
Following several major scandals, UK funds are now held in trust separate from other assets and liabilities of the company
Accumulated funds are invested in the hope that they will grow sufficiently to meet the benefit obligations
When the funds are insufficient, firms are required to make additional contributions to meet the deficit
Risks of Defined benefit plans - employer
The return on plan assets falls short in expectations
Employee wages rise faster than anticipated
The interest rates used go discount liabilities falls
The annuity rate falls
The demographic profile of employees changes adversely for the employer
Potential takeover targets becomes too expensive
Pension protection fund (90%) funded by levy on firms with a DB plans
Risks of defined benefit plans - employee
risk that the DB plan is underfunded and that the employer defaults on the obligation
The present value of future benefits earned by employees for services provided to date
IFRS: defined benefit obligations
US GAAP: projected benefit obligation
& vested benefit obligation - employee is entitled to this benefit if they leave the firm today
Accumulated benefit obligation
Employer has accumulated this benefit, but may not be entitled to it if they leave the firm today
Also this definition does not take into account projected salary increases
Likely to be more then VBO but less then PBO
Current service cost
- Calculated using the projected unit credit method
- Reflects the obligation to employees accrued from each year of service
Benefits paid to retirees
Money paid out from the scheme as pensions to members who have already retired
Interest cost
Reflects the unwinding of discounting of plan liabilities
Actuarial gains and losses
Experience gains and losses
Drivers of pension liabilities and assets - comparison between firms
Types of scheme operated - DB/DC
Demographic profile of firm i.e. proportion of pensioners relative to current workers and age profile of current workers
Drivers of liabilities and assets - older firm
More likely to have a large DB legacy
Drivers of liabilities and assets - labour intensive industry
More likely to have a DB legacy
Macro factors which affect all DB schemes
Life expectancy
Interest rates
Investment returns
Salary increases
Employee benefit obligations involve SUMMARY
Liabilities
Assets
Valuation of EBO assets and Liabilities is difficult SUMMARY
requires forecasting over long time horizons
Forecasts sensitive to assumptions
Small change in assumptions, big change in valuations
EBO assets and liabilities are often not fully accounted for on the balance sheet SUMMARY
Bringing them onto the balance sheet changes the reported value of the firm and shareholders equity
