Pensions – Costs and Obligations

1. Pensions – Costs and Obligations Lesson 7

2. Story • Starting in year 2008, I want to take two years off to do some research and write a book. Based on my calculations I will need $3,500 per month for living, travel, and research expenses during those two years.

3. I conservatively estimate that I can invest money to earn 6% for the entire 7 year period.

4. Problems • 1. How much money will I need at the beginning of year 2008? • 2. How much must I contribute at the beginning of each of the next five years to reach my goal?

5. December 31 2009 January 1 2008 0 1 2 3 21 22 23 24 3,500 3,500 3,500 3,500 3,500 3,500 3,500 PV How much will I need at the beginning of year 2008? PV = (3,500 x P/AD, 0.5%*, 24) = $79,364 * 6% compounded monthly / 12 months = 0.5% per month

6. January 1 2003 0 3 4 5 1 2 13,282 Pmt 13,282 Pmt 13,282 Pmt 13,282 Pmt 13,282 Pmt FV = 79,364 Pmt 2. How much must I contribute at the beginning of each year? December 31 2007

7. The Plan

8. Actual Experience

9. Lesson 7 Pension costs and obligations This lesson deals with pensions — long-term obligations to employees — and the pension fund assets segregated to service such obligations. Generally, a financial statement element related to pensions is disclosed as a long-term liability or a long-term asset. The standards for measuring pension costs and obligations and establishing disclosure are critically evaluated.

10. Lesson 7 What is a pension plan? • A pension plan consists of: • segregated assets, held by a trustee and invested over the long-term, and • an actuarially-determined long-term liability to employees for pension entitlements earned.

11. Lesson 7 What is a defined contribution plan? • Defined contribution plans define the annual contributions employers must make. • Pensions paid depend on contributions plus earnings. • Accounting is straightforward: payments made are expensed.

12. Lesson 7 What is a defined benefit plan? • Defined benefit plans define the eventual benefits (pensions) paid to employees. • Employers must make payments that, over time, will fund the pensions to be paid to employees.

13. Lesson 7 How are payments to defined plans determined? • Actuaries develop estimates of future retirement benefit payments to be paid to an employee according to the pension plan formula. • The company’s pension plan obligation is measured using actuarial cost methods to establish funding.

14. Lesson 7 Actuarial cost methods: • Level funding method: equal annual payments, project final pay, project total years of service. • Projected benefit method: increasing annual payments, project final pay only. • Accumulated benefit funding method: increasing annual payments, project nothing.

15. Lesson 7 Important acronyms: • Actuarial present value (APV) • Current service cost (CSC) • Past service cost (PaSC) • Prior service cost (PrSC) • Expected period to full eligibility (EPFE) • Average remaining service period (ARSP) • Pension benefit obligation (PBO)

16. Lesson 7 Definitions • Current service cost is the actuarial present value of the cost of pension entitlements earned in the current period. • Past service cost is the actuarial present value of pension entitlements granted for work in periods prior to a new pension plan. • Prior service cost is the APV of pension entitlements granted for work in periods before an improvement to an existing plan.

17. Memory Hooks • PrSC • PaSc doption ecent all time revision

18. Lesson 7 How is pension expense measured? • Pension expense must be measured using the projected benefits method. • Pension expense is the sum of: • current service cost • interest cost • return on plan assets (a reduction) • amortization of PaSC • amortization of PrSC • actuarial gains or losses, if needed

19. Lesson 7 • Amortization periods: • PaSC: EPFE. • PrSC: EPFE or period until next amendment expected. • Actuarial G/L: If within 10% corridor, no amortization is needed. If over 10% corridor, excess amount must be amortized over the average remaining service period (ARSP). These are minimums; the company can include all or amortize greater amounts. • 10% corridor: 10% of larger of pension assets or PBO at the beginning of the year.

20. Lesson 7 What does the journal entry look like? • Debit pension expense, as calculated • Credit cash, as paid • Difference is to deferred balance sheet account

21. Lesson 7 What disclosure is required in the financial statements? • The value of pension fund assets (held by the trustee) and the actuary’s estimate of the pension liability to employees must be disclosed. • Considerable note disclosure is required for important accounting policies and measurements used for pension accounting. • The cash flow statement reflects cash paid in the operations section.

22. Lesson 7 What does the balance sheet account include? • The balance sheet pension asset or liability is equal to the difference between pension assets and the actuary’s estimate of pension liability plus or minus the unrecognized (unamortized) portions of past and prior service costs, actuarial/experience gains or losses.