Pensions

1. Pensions RCJ Chapter 14

2. Key Issues • Types of pension plans: defined benefit vs. defined contribution • Pension liability: PBO, ABO, VBO • Assumptions: discount rate%, salary growth rate%, E(ROA)%, actuarial • PENSION assets • Primary (ongoing) factors • Journal entries • Smoothing of transitory gains and losses • Types of transitory gains and losses • Additional factors • Funded status reconciliation • Minimum liability Corridor amortization Pension worksheet Footnote disclosures Correction JE OPEB’s Paul Zarowin

3. Structure of Pension Plan firm or employee  pension fund  retireeCash Pay benefits Paul Zarowin

4. Types of Pension Plans 1. Defined contribution: employee bears risk, no firm liability 2. Defined benefit: firm bears risk and has liability (our focus) Paul Zarowin

5. Ex. Defined Benefit Plan • worker’s age = 60 • service = 30 yrs so far • retire @ 65 (5 more years) • current salary = $50,000 Pension contract: X% per year * final salary (X = # of years of service @ retirement) Example: 35% x $50,000 = $17,500 Paul Zarowin

6. Pension Liabilities Pension liability: discounted PV of expected future cash payments - like any other non-current liability (effective interest method). compare to other non-current liabilities: r%E(CF) Bonds known known Leases known? known Pensions ? ? Both discount rate and expected cash flows are subjective Paul Zarowin

7. 3 Definitions of Liabilities • PBO = PV of expected payments, given expected future salaries • ABO= PV of expected payments, given current salaries • VBO =PV of vested portion of expected payments, given current salaries PBO  ABO  VBO Which definition is appropriate for which case? 1. valuing a going concern 2. Takeover 3. Firm in bankruptcy We’ll use PBO, unless otherwise stated. Paul Zarowin

8. Key Assumptions • discount rate = r% • salary growth rate = g% (for PBO) • actuarial (life span, tenure, turnover, etc.) • EROA% (expected rate of return on pension assets), see below Q: Is liability bigger for older or younger workers? What are management’s incentives? Paul Zarowin

9. Ex. Defined Benefit Plan, Continued • Assumptions • Expected salary growth rate = 5% • Discount rate = 10% • Life expectancy = 80 years (15 years in retirement) • Expected final salary = 50,000 * (1.05)5 = 63,814 • 30% * 63,814 = 19,144 = amount he’ll receive per year in retirement (based on service so far) • PV of annuity factor, 10%, 15 yrs = 7.606 • 19,144 * 7.606 = 145,611 = PV @ retirement PBO = 145,611/(1.10)5 = 90,413 = PV of annuity now ABO = (30% * 50,000 * 7.606)/1.105 = 70,841 PBO > ABO due to expected salary growth Paul Zarowin

10. Primary (Ongoing) Factors Affecting PBO PBO - + DRCR pay benefits Interest cost Service cost def:interest cost = r% * PBO @ beginning of year (remember: effective interest method) [debt accretion, like zero coupon bond] def:service cost = PV of future benefits earned this year Ex. E14-1, E14-13 Paul Zarowin

11. Ex. Defined Benefit Plan, Continued Interest cost = 90413*.10 = 9041 Service cost = (1% * 63,814 * 7.606)/1.105 = 3014 Q: how does a higher or lower r% affect interest cost? Q: how does an employee’s age affect his service cost? E14-1,13 Paul Zarowin

12. Pension Assets • Pension assets: FMV of assets (stocks, bonds, etc.) • Funded status (true, economic position): Pension assets – PBO • Overfunded: assets > PBO • Underfunded: assets < PBO • Severely underfunded: assets < ABO Paul Zarowin

13. Primary (Ongoing) Factors Affecting Pensions Assets Assets + - DRCR Funding (contribution) Pay benefits (ROA)Return on assets# #note: this is actual ROA; ROA is shown as +, but could be – Ex. E14-6, E14-13 Paul Zarowin

14. Primary Journal Entries * note: actual ROA is shown as +, but could be – UNL = unexpected net loss (if actual ROA < expected ROA) UNG = unexpected net gain (if actual ROA > expected ROA) Paul Zarowin

15. Ex. Defined Benefit Plan, Continued Assume: • pension assets = 100,000 • E(ROA)% = 10% • actual ROA = 15,000 DR assets 15,000 CR Pension expense 10,000 CR UNGain 5,000 Q: How does assumed EROA% affect FMV of assets? Paul Zarowin

16. Primary Factors Affecting Pension Expense Pension Expense + - DRCR Service E(ROA) Interest Q: What is the effect of funding on expense? Paul Zarowin

17. Ex. Defined Benefit Plan, Continued Service 3,014 Interest 9,041 E(ROA) (10,000) pension expense 2,055 Ex. E14-12 without amortization and unexpected loss P 14-1, Parts 1-3 in Summary So Far Paul Zarowin

18. Smoothing of Transitory Gains and Losses def: unrecognized = deferred (in footnotes) def: recognized = amortized (into pension expense on I/S) • Transitory gains, losses are CR’d (gains) or DR’d (losses) to unrecognized (footnote) accounts, rather than recognized as gain or loss on I/S. The unrecognized balances are amortized onto I/S. This smooths NI and keeps assets and PBO off of B/S. Full Exp For E14-13 Paul Zarowin

19. Smoothing (cont’d): Intuition • Loss in DR, Gain in CR DRCR Loss: Unrecognized loss Asset or liab. Amort’n: Exp.(recorded) Unrecognized loss Gain: Asset or liab. Unrecognized gain Amort’n: Unrecognized gain Exp.(recorded) Paul Zarowin

20. Types of Transitory Gains, Losses note: liability gains and losses are also called actuarial gains and losses Q:What happens if EROA% is set too high (higher than true average ROA%)?

21. 2 Types of Liability Gain/Loss • Change in assumptions • Change in contracts Intuition: What affects r% and E(CF)’s Paul Zarowin

22. Types of Transitory Gains, Losses (cont’d) def: UPSC = unrecognized prior service cost (retroactive benefits) Paul Zarowin

23. Ex. Defined Benefit Plan, Continued 1. assume benefits are sweetened to pay 1.1% * final salary per year (increased by 10%) increase in PBO = 10% * 90,413 = 9041 DR UPSC 9041 CR PBO 9041 2. assume salary growth rate is increased to 6% (final salary = 66,912), so PBO = 94,802 and increase in PBO = 4389 (94,802 – 90,413) DR UNLoss 4389 CR PBO 4389 Paul Zarowin

24. Additional Factors Affecting PBO ( assumptions) ( contracts) Paul Zarowin

25. Additional Factors Affecting Pension Expense Paul Zarowin

26. Additional Factors Affecting Pension Expense (cont’d) Loss amortization: DR Pension expense CR UPSC or UNL or UTL Gain amortization: DR UPSC or UNG or UTA CR Pension expense UTA, UTL = unrecognized transition asset, liability = net position (assets - PBO) @ adoption of SFAS #87 • remember: amortization = recognized into expense • amortization is generally SL over average remaining service life of employees Paul Zarowin

27. Ex. Defined Benefit Plan, Continued Amortize UPSC over 5 years: 9041/5 = 1808 DR pension expense 1808 CR UPSC 1808 service 3,014 interest 9,041 E(ROA) (10,000) UPSC Amort. 1,808 pension expense 3,863 Ex. E14-13 GM disclosure E 14-12 w/o Loss Paul Zarowin

28. Funded Status Reconciliation Reconcile true vs. recognized position assets - PBO funded status (can be net asset or net liability): ‘true position’ + UNL (or - UNG) + UPSC + UTL (or - UTA) recognized (on B/S) position: prepaid pension cost (asset) or deferred pension cost (liab) • note: funded status (true economic position) vs. recognized position • unrecognized losses & liab’s make the recognized position better than the true position • unrecognized gains & assets make the recognized position worse than the true position Ex. E14-14, 19 Unrecognized Gains/Losses Paul Zarowin

29. Minimum Liability • if ABO > assets the pension plan is considered ‘severely underfunded’ and a liab.  (ABO - assets) must be recognized. • if recognized position is asset (prepaid cost) or liab (accrued cost) < (ABO-assets), additional entry is needed to bring recognized position to minimum level: DR Intangible asset* CR Additional liability * should be DR to a loss account • additional liab can be shown separately or aggregated with accrued pension cost on B/S Paul Zarowin Ex. E14-2, E14-5

30. Corridor (Minimum) Amortization • UNL or UNG must be amortized only if it > “corridor” • corridor = 10% of bigger (PBO, assets) @BOY • amortization is down to corridor, not zero • if amort’n is required one year, it might or might not be the next year, and vice versa Ex. P14-1, sec 1-6 E14-18

31. Pension Worksheet - put it all together - relate to funded status reconciliation 6. reverse DR and CR for a liability gain 8. reverse DR and CR for amort’n of unrecognized gain 7. reverse DR and CR for souring 9. reverse DR and CR for amort’n from souring Note: recognized asset/liab (prepaid/accrued pension cost) is net of all unrecognized accounts

32. Exercise problems • E14-3, E14-4, E14-7 E14-17, 20 • P14-2, P14-3 • P14-13 Paul Zarowin

33. Footnote Disclosures The pension footnote includes: • total pension expense and its components • reconciliation of BOY vs EOY PBO and asset accounts (like t-accounts) • funded status reconciliation • assumptions (r%, g%, EROA%) C 14-2,3 Paul Zarowin

34. Correction JE (to put assets and liabs on B/S) • using information in pension footnote, put pension assets and liab on B/S; replace recognized position with true position DRCR pension assets PBO accrued pension cost or Prepaid pension cost R/E or R/E • put pension assets and PBO on B/S • remove accrued or prepaid pension cost from B/S • plug: DR or CR R/E = cumulative unrecognized gains/losses (sum of UNGL, UPSC, UTAL) note: DR or CR to R/E rather than current year gain or loss Paul Zarowin

35. Other Post-Employment Benefits (OPEB’s) Same accounting as pensions, with minor differences 1. ABO instead of PBO (OPEB’s not tied to salary) 2. significance of (TL) transition liability (no incentive to fund, so ABO > assets) firms can: amortize TL over <= 20 years DR OPEB expense CR Accrued OPEB cost ortake loss as change in accounting principle (below the line): DR loss due to change in acct principle CR Accrued OPEB cost • most firms chose latter: why? 3. service cost is accrued (earned) over short (vesting) period, since benefits don’t increase with tenure Paul Zarowin