CHAPTER 17

Pensions

Accounting for pension benefits recognizes that they represent deferred compensation for current service. Accordingly, the cost of these benefits is recognized on an accrual basis during the years that employees earn the benefits.

Part A – The Nature of Pension Plans

I. Nature of Pension Plans

A. Pension plans provide income to employees during their retirement years.

B. Employers set aside funds during an employee’s working years so that at retirement, the accumulated funds plus earnings from investing those funds are available to replace wages.

C. Defined contribution pension plans and defined benefit pension plans have the common objective of providing income to employees during their retirement years. However, they differ regarding who bears the risk of ensuring that the objective is achieved.

II. Types of Pension Plans

A. Defined contribution pension plans promise fixed annual contributions to a pension fund (4% of employees' pay, for example).

1. Employees choose where funds are invested, within set options.

2. The employees’ retirement pay depends on the accumulated balance of the invested funds at retirement.

3. As a result, the employee bears the risk of uncertain investment returns. The employer is free of any further obligation.

4. Defined contribution pension plans have several variations, but the most common are 401(k) plans – named after the Tax Code section which specifies the conditions for the favorable tax treatment of these plans. Such plans permit voluntary contributions by employees, which often are matched by employers (dollar for dollar, 1 for 2, etc.).

5. The employer simply records pension expense equal to the cash contribution.

B. Defined benefit pension plans promise fixed retirement benefits that are “defined” by a pension formula.

1. The employer is accountable for ensuring that sufficient funds are available to provide the promised benefits.

2. A typical pension formula specifies that a retiree will receive annual retirement benefits based on the employee’s years of service and annual pay at retirement.

III. Defined Benefit Pension Plans

A. The fundamental components of a defined benefit pension plan are:

1. The employer’s obligation to pay retirement benefits in the future.

2. The plan assets set aside by the employer from which to pay the retirement benefits in the future.

3. The periodic expense of having a pension plan.

B. The employer’s obligation and plan assets are not included on a company’s primary financial statements, but are reported in disclosure notes.

C. The third component, pension expense, is reported on the income statement. The pension expense is comprised of several elements that include changes in the employer’s obligation and plan assets, so we discuss those first before looking at the components of pension expense.

Part B: The Pension Obligation and Plan Assets

I. The Pension Obligation

A. There are three different ways to measure the pension obligation:

1. Accumulated Benefit Obligation (ABO) – present value of estimated retirement benefits earned so far by employees, estimated by plugging existing compensation levels into the pension formula.

2. Vested Benefit Obligation (VBO) - vested portion of the accumulated benefit obligation – part that plan participants are entitled to receive regardless of their continued employment.

3. Projected Benefit Obligation (PBO) – present value of estimated retirement benefits earned so far by employees, estimated by plugging projected compensation levels into the pension formula. A company usually hires an actuary to make these estimates.

B. The PBO can change due to:

1. Service cost - the increase in the PBO attributable to employee service this year.

2. Interest cost - the accrual of interest as time passes (beginning PBO x discount rate).

3. Prior service cost - the cost of making plan amendments retroactive to prior years

4. Loss (gain) on PBO - the periodic adjustments to PBO when estimates change.

5. Retiree benefits paid - the benefits actually paid to retired employees.

II. The Plan Assets

A. To pay the pension obligation companies accumulate funds known as the plan assets.

B. A trustee usually is hired who:

1. Accepts employer contributions.

2. Invests the contributions.

3. Accumulates the earnings on the investments.

4. Pays benefits from the plan assets to retired employees or their beneficiaries.

C. The balance in pension plan assets is not formally recognized on the balance sheet, but is actively monitored in the employer’s informal records.

D. The plan assets can change due to:

1. Return on plan assets - dividends, interest, market price appreciation.

2. Cash contributions - employer contributions.

3. Retiree benefits paid - benefits actually paid to retired employees.

Part C: Determining Pension Expense

I. Composition of Pension Expense

A. Employees receive pension benefits long after they earn those benefits. However, the employer’s cost of providing those benefits is allocated to the periods the services are performed.

B. The periodic pension expense is a composite of periodic changes in both the pension obligation and the plan assets.

1. The service cost is the increase in the PBO attributable to employee service and is the primary component of pension expense.

2. The interest and return-on-assets components are “financial items” created only because the compensation is delayed and the obligation is funded currently.

a. The actual return on assets is increased by the loss on plan assets so that effectively the expected return is the component of pension expense.

b. This is due to the desire to achieve income smoothing by delaying the recognition of both the loss (gain) on the PBO and the loss (gain) on plan assets.

c. If gains and losses were immediately recognized in pension expense, the annual pension expense, and therefore earnings, would rise and fall frequently with each difference between results and expectations.

C. By the straight-line method, prior service cost is recognized over the average remaining service life of the active employee group.

D. Delaying the recognition of both the loss (gain) on the PBO and the loss (gain) on plan assets means these amounts are set aside for possible future recognition.

a. When a net gain or net loss gets “too large,” a portion of the excess is included in pension expense.

b. The FASB defines too large as being greater than 10% of either plan assets or the PBO (at the beginning of the year), whichever is larger.

c. The amount amortized is the excess divided by the average remaining service life of the active employee group.

II. Recording the Expense

A. The debit to pension expense and the credit to cash rarely will be the same because measurement of the periodic pension expense and the funding of the pension plan are two separate determinations, motivated by different decisions.

B. Whether it’s a debit or credit difference, a single account “prepaid (accrued) pension cost” is used to record any difference between pension expense and the cash contribution to plan assets.

C. When the account has a debit balance it‘s reported as an asset; a credit balance is reported as a liability.

Part D – Reporting Issues

I. A Pension Spreadsheet

A. A pension spreadsheet can be useful to see how each element relates to the others.

B. The net total of all the “memorandum” accounts equals the prepaid (accrued) pension cost balance.

II. Minimum Liability

A. The prepaid (accrued) pension cost account is insufficient in representing the pension plan when the employer’s obligation is underfunded (assets less than liability).

B. To reflect a minimum liability equal to the underfunded amount, any balance in that account should be increased.

C. The underfunded liability is measured as the accumulated benefit obligation (ABO) (rather than the PBO) minus plan assets.

D. An employer must report a pension liability at least equal to the amount by which its ABO exceeds its plan assets.

III. Transition Amount

A. In 1987, when firms adopted the pension provisions of SFAS 87, a difference usually existed between (a) the funded status of their pension plans under the new standard (the difference between the PBO and plan assets) and (b) the prepaid (accrued) pension cost existing at that date from following the provisions of the previous standard.

B. This amount represents the transition liability or transition asset.

C. Its balance was not recorded, but rather is monitored like prior service cost or unrecognized net gains or net losses in the informal records.

D. The transition amount is periodically amortized to pension expense.

IV. Pension Disclosures

A. The pension amounts that are reported in the disclosure notes fill a reporting gap created by not reporting certain amounts in the primary financial statements.

B. Disclosures include:

1. The components of the annual pension expense.

2. The projected benefit obligation (as well as the accumulated benefit obligation, and vested benefit obligation).

3. Other information that makes it possible for interested analysts to reconstruct the financial statements with pension assets and liabilities included.

PENSION PLANS

Pension plans are designed to provide income to individuals during their retirement years. This is accomplished by setting aside funds during an employee’s working years so that at retirement, the accumulated funds plus earnings from investing those funds are available to replace wages.

TYPES OF PENSION PLANS

Defined contribution pension plans promise fixed annual contributions to a pension fund (say, 10% of the employees' pay). The employee chooses (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.

DEFINED BENEFIT PENSION PLANS

A pension formula might define annual retirement benefits as:

1 ¹/₂ % x Years of service x Final year’s salary

By this formula, the annual benefits to an employee who retires after 30 years of service, with a final salary of $100,000, would be:

1 ¹/₂ % x 40 years x $100,000 = $60,000

PENSION OBLIGATION

Three different ways to measure the pension obligation have meaning in pension accounting:

î 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 to existing compensation levels.

î Vested benefit obligation (VBO) - The portion of the accumulated benefit obligation that plan participants are entitled to receive regardless of their continued employment.

î 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 to estimated future compensation levels. [If the pension formula does not include future compensation levels, the PBO and the ABO are the same.]

PROJECTED BENEFIT OBLIGATION

Jessica Farrow was hired by Global Communications in 1989. The company has a defined benefit pension plan that specifies annual retirement benefits equal to:

1.5% x service years x final year’s salary

Farrow is expected to retire in 2028 after 40 years service. Her retirement period is expected to be 20 years. At the end of 1998, 10 years after being hired, her salary is $100,000. The interest rate is 6%. The company’s actuary projects Farrow’s salary to be $400,000 at retirement.

What is the company’s projected benefit obligation with respect to Jessica Farrow?

Steps to calculate the projected benefit obligation:

1. Use the pension formula (including a projection of future salary levels) to determine the retirement benefits.

2. Find the present value of the retirement benefits as of the retirement date.

3. Find the present value of retirement benefits as of the current date.

PBO IN 1998

l present value [n=30, i=6%] j actuary estimates employee has
of retirement benefits at 1998 is earned (as of 1998) retirement benefits of
$688,195 x .17411 = 1.5% x 10 years x $400,000 =

$119,822 $60,000 per year

1989 1998 2028 2048

_______t________________________________________

10 years 30 years 20 years

Service period Retirement

‹

k present value [n=20, i=6%] of the
retirement annuity at the retirement date is
$60,000 x 11.46992 =
$688,195

PBO IN 1999

If the actuary’s estimate of the final salary hasn’t changed, the PBO at the end of 1999 would be $139,715:

l present value [n=29, i=6%] j actuary estimates employee has
of retirement benefits at 1999 is earned (as of 1999) retirement benefits of
$757,015 x .18456 = 1.5 x 11 years x $400,000 =

$139,715 $66,000 per year

1989 1999 2028 2048

_______t________________________________________

11 years 29 years 20 years

Service period Retirement

‹

k present value [n=20, i=6%] of the
retirement annuity at the retirement date is
$66,000 x 11.46992 =
$757,015

Notice that the PBO increased during 1999 from $119,822 to $139,715 for two reasons:

1. One more service year is included in the pension formula calculation.

2. The employee is one year closer to retirement, causing the present value of benefits to increase due to the time value of future benefits.

CHANGES IN THE PBO

1 – SERVICE COST

The 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.

2 – INTEREST COST

The second reason the PBO increased 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.

HOW THE PBO CHANGED IN 1999

PBO at the beginning of 1999 (end of 1998) $119,822

Service cost: (1.5 x 1 yr. x $400,000) x 11.46992 x .18456 12,701

annual retirement benefits to discount to discount
from 1999 service to 2028 * to 1999 **

Interest cost: $119,822 x 6% 7,189

PBO at the end of 1999 $139,712^***

^* present value of an ordinary annuity of $1: n=20, i=6%

^** present value of $1: n=29, i=6%

***differs from $139,715 due to rounding

3 – Prior Service Cost

Assume the formula’s salary percentage is increased in 1999 from 1.5% to 1.7%:

1.7% x Service years x Final year’s salary

[Revised Pension Formula]

The increase in the PBO attributable to making a plan amendment retroactive is referred to as prior service cost.

PBO Without Amendment PBO With Amendment

j 1.5 x 10 years x $400,000 = $60,000 1.7 x 10 years x $400,000 = $68,000
k $60,000 x 11.46992 = $688,195 $68,000 x 11.46992 = $779,955
l $688,195 x .17411 = $119,822 $779,955 x .17411 = $135,798

144442444443

$15,976
Prior service cost

4 – GAIN OR LOSS ON THE PBO

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.

Assume the estimate of Farrow’s final salary should be increased by 5% to $420,000. This would affect the estimate of the PBO as follows:

PBO Without PBO With

Revised Estimate Revised Estimate

j 1.7 x 12 years x $400,000 = $81,600 1.7 x 12 years x $420,000 = $85,680
k $81,600 x 11.46992 = $935,945 $85,680 x 11.46992 = $982,743
l $935,945 x .19563 = $183,099 $982,743 x .19563 = $192,254

144442444443

$9,155

Loss on PBO

5 – PAYMENT OF RETIREMENT BENEFITS

Another change in the PBO occurs when the obligation is reduced as benefits actually are paid to retired employees.

ILLUSTRATION EXPANDED TO THE
ENTIRE EMPLOYEE POOL

($ in millions)

PBO at the beginning of 2000 (amount assumed) $400

Service cost, 2000 (amount assumed) 41

Interest cost: $400 x 6% 24

Loss (gain) on PBO (amount assumed) 23

Less: Retiree benefits paid (amount assumed) (38)

PBO at the end of 2000 $450

The PBO is not formally recognized as a liability on the balance sheet. It is, however, actively monitored in the employer’s informal records because its balance must be reported in disclosure notes to the financial statements.

PENSION PLAN ASSETS

Global Communications funds its defined benefit pension plan by contributing each year the year’s service cost plus a portion of the prior service cost. Cash of $48 million was contributed to the pension fund in 2000.

Plan assets at the beginning of 2000 were valued at $300 million. The expected rate of return on the investment of those assets was 9%, but the actual return in 2000 was 10%. Retirement benefits of $38 million were paid at the end of 2000 to retired employees.

What is the value of the company’s pension plan assets at the end of 2000?

($ in millions)

Plan assets at the beginning of 2000 $300

Return on plan assets (10% x $300) 30

Cash contributions 48

Less: Retiree benefits paid (38)

Plan assets at the end of 2000 $340

PENSION EXPENSE

Changes in the Pension Liability and
Pension Plan Assets Affect Pension Expense

Changes in the PBO:

Included currently:

Service cost – increase in the employer’s obligation attributed to employee service during the period

Interest – interest accrued on the obligation during the period (balance at the beginning of the period multiplied by the interest rate)

Delayed recognition (recognized in pension expense over time):

Losses or (gains) on the PBO – increases or (decreases) in the estimate of the PBO from revisions in underlying assumptions

Prior service cost – increase in the employer’s obligation due to giving credit to employees for years of service provided before the pension plan is amended (or initiated)

Changes in Plan Assets:

Included currently:

Actual return on the plan assets – increase in the value of plan assets during the period, adjusted for employer contributions and benefits paid to retirees

Adjusted for: Losses or (gains) on the plan assets

Ð

Delayed Recognition (recognized in pension expense over time):

Losses or (gains) on the plan assets – return on plan assets lower or (higher) than expected

PENSION EXPENSE

Reports from the actuary and the trustee of plan assets:

PLAN
($ in millions) PBO ASSETS

Beginning of 2000 $400 Beginning of 2000 $300

Service cost 41 Return on plan assets,

Interest cost, 6% 24 10% (9% expected) 30

Loss (gain) on PBO 23 Cash contributions 48

Less: Retiree benefits (38) Less: Retiree benefits (38)

End of 2000 $450 End of 2000 $340

Informal records also indicate an unrecognized prior service cost incurred at the beginning of the previous year of $60 million due to a plan amendment increasing the PBO at that time. At the beginning of 2000 Global had an unrecognized net loss of $55 million. The average remaining service life of the active employee group is 15 years in both 1999 and 2000.

Global’s 2000 pension expense is determined as follows:

Service cost $41

Interest cost 24

Actual return on the plan assets (30)

Adjusted for: gain on the plan assets 3 (27)

Amortization of prior service cost 4

Amortization of net loss 1

Pension expense $43

AMORTIZATION OF PRIOR SERVICE COST

STRAIGHT-LINE METHOD

By the straight-line method, prior service cost is recognized over the average remaining service life of the active employee group.

($ in millions)

Service cost $41

Interest cost 24

Actual return on the plan assets (30)

Adjusted for: gain on the plan assets 3 (27)

Amortization of prior service cost
($60 million ÷ 15 years) 4

Amortization of net loss 1

Pension expense $43

GAINS AND LOSSES

Projected Benefits Return on
Obligation Plan Assets

________________________

Higher

Than Loss Gain

Expected

________________________

Lower

Than Gain Loss

Expected

________________________

AMORTIZATION OF DEFERRED NET LOSS

We assume an unrecognized net loss of $55 million at the beginning of 2000. The PBO and plan assets are $400 million and $300 million, respectively, at that time.

($ in millions)

Net loss (previous losses exceeded previous gains) $55
10% of $400 ($400 is greater than $300) 40
Excess at the beginning of the year $15

Average remaining service period ÷ 15 yrs
Amount amortized to 2000 pension expense $ 1

FINANCIAL STATEMENT DISCLOSURES

($ in millions)

Statement of Income:
Pension expense $ 43

Balance Sheet:
Assets:
Prepaid pension cost $ 16
Intangible pension asset 26

Liabilities:
Pension liability [$16 + (26)] $(10)

Stockholders' equity:
Unrealized pension cost none

DISCLOSURE NOTES

1. Description of the plan, including:
4 Employee groups covered
4 Type of benefit formula
4 Funding policy
4 Type of assets held and significant nonbenefit liabilities
4 Nature and effect of significant matters affecting comparability
2. Composition of pension expense, showing separately the
4 Service cost $ 41
4 Interest cost 24
4 Return on plan assets
[actual return, $30, less $3 gain, equals expected return] (27)
4 Net total of other components [$4+ $1] 5
$43

3. Reconciliation schedule – relating funded status
and balance sheet amounts, including:

4 Vested benefits [amount not assumed]

4 Accumulated benefit obligation $(350)
4 Projected benefit obligation $(450)
4 Fair value of plan assets 340
Underfunded amount $(110)
4 Unrecognized prior service cost 52
4 Unrecognized net loss (gain) 74
4 Unrecognized transition cost 0
4 Prepaid (accrued) pension cost $ 16
4 Additional liability (26)

4. The discount rate (6%), the assumed rate of compensation increase used to measure the PBO (not given), and the expected long-term rate of return on plan assets (9%).

5. Amounts and types of securities included in plan assets, the approximate amount of annual benefits of employees and retirees, the amortization method used, and the existence and nature of any commitments to make future amendments.