Session 5

Question 1

Types of post employment benefit obligation

Answer 1

Pensions
Health care benefits
Other deferred compensation

Question 2

Main emphasis on pension schemes

Answer 2

Objective of pension scheme for employees

Question 3

2 types of pension scheme

Answer 3

Defined benefit

Defined contribution

Question 4

Retirement annuity

Answer 4

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

Question 5

Retirement annuity- advantages

Answer 5

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

Question 6

Retirement annuity disadvantages

Answer 6

Complex and hard to understand
Fees make annuities more expensive than other retirement investments
Net returns on withdrawals are taxed as ordinary income

Question 7

Employee benefit obligations (EBOS)

Answer 7

Defined benefit
Defined contribution
Hybrid plans

Question 8

Defined contribution - how they work

Answer 8

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

Question 9

Defined contribution characteristics

Answer 9

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

Question 10

Defined benefit - how they work

Answer 10

Employer offers employee pension plan members a defined benefit when they reach a specified retirement age

Question 11

Defined benefit - characteristics

Answer 11

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

Question 12

Funding defined benefit pensions - how they work - employers

Answer 12

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

Question 13

Risks of Defined benefit plans - employer

Answer 13

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

Question 14

Risks of defined benefit plans - employee

Answer 14

risk that the DB plan is underfunded and that the employer defaults on the obligation

Question 15

The present value of future benefits earned by employees for services provided to date

Answer 15

IFRS: defined benefit obligations
US GAAP: projected benefit obligation
& vested benefit obligation - employee is entitled to this benefit if they leave the firm today

Question 16

Accumulated benefit obligation

Answer 16

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

Question 17

Current service cost

Answer 17

• Calculated using the projected unit credit method

- Reflects the obligation to employees accrued from each year of service

Question 18

Benefits paid to retirees

Answer 18

Money paid out from the scheme as pensions to members who have already retired

Question 19

Interest cost

Answer 19

Reflects the unwinding of discounting of plan liabilities

Question 20

Actuarial gains and losses

Answer 20

Experience gains and losses

Question 21

Drivers of pension liabilities and assets - comparison between firms

Answer 21

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

Question 22

Drivers of liabilities and assets - older firm

Answer 22

More likely to have a large DB legacy

Question 23

Drivers of liabilities and assets - labour intensive industry

Answer 23

More likely to have a DB legacy

Question 24

Macro factors which affect all DB schemes

Answer 24

Life expectancy
Interest rates
Investment returns
Salary increases

Question 25

Employee benefit obligations involve SUMMARY

Answer 25

Liabilities

Assets

Question 26

Valuation of EBO assets and Liabilities is difficult SUMMARY

Answer 26

requires forecasting over long time horizons
Forecasts sensitive to assumptions
Small change in assumptions, big change in valuations

Question 27

EBO assets and liabilities are often not fully accounted for on the balance sheet SUMMARY

Answer 27

Bringing them onto the balance sheet changes the reported value of the firm and shareholders equity