Postretirement Benefit Plans

1. Postretirement Benefit Plans The accounting treatment we discuss is not U.S. GAAP or IFRS. Instead, it is based on IAS 19, “Employee Benefits,” as modified by the International Accounting Standards Board’s Discussion Paper Preliminary Views on Amendments to IAS 19 Employee Benefits, published on March 27, 2008. Strategic Accounting

2. PENSION PLANS  Pension plans 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.

3. 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.

4. Defined Contribution Plans Contributions are established by formula or contract. Employer deposits an agreed upon amount into an employee-directed investment fund. Employee bears all risk of pension fund performance.

5. Defined Benefit Pension Plans Employer is committed to specified retirement benefits. Retirement benefits are based on a formula that considers years of service, compensation level, and age. Employer bears all risk of pension fund performance.

6. 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 40 years of service, with a final salary of $100,000, would be: 1 1/2 % x 40 years x $100,000 = $60,000

7. PENSION OBLIGATION Defined benefit obligation (DBO) – 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.

8. DEFINED BENEFIT OBLIGATION Jessica Farrow was hired by Global Communications in 1998. 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 2037 after 40 years service. Her retirement period is expected to be 20 years. At the end of 2007, 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 Defined benefit obligation with respect to Jessica Farrow?

9. DEFINED BENEFIT OBLIGATION Steps to calculate the defined 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.

10. DBO IN 2007  present value [n=30, i=6%]  actuary estimates employee has of retirement benefits at 2007 is earned (as of 2007) retirement benefits of $688,195 x .17411 = 1.5% x 10 years x $400,000 = $119,822$60,000 per year 1998 2007 2037 2057 ____________________________________________________________ 10 years 30 years 20 years Service period Retirement  present value [n=20, i=6%] of the retirement annuity at the retirement date is $60,000 x 11.46992 =$688,195 This is the DBO

11. If the actuary’s estimate of the final salary hasn’t changed, the DBO at the end of 2008 would be $139,715:

12. DBO IN 2008  actuary estimates employee has earned (as of 2008) retirement benefits of 1.5% x 11 years x $400,000 = $66,000 per year 1998 2008 2037 2057 ____________________________________________________________ 11 years29 years 20 years Service period Retirement  present value [n=20, i=6%] of the retirement annuity at the retirement date is $66,000 x 11.46992 =$757,015 2007 10 years 30 years

13. DBO IN 2008  present value [n=29, i=6%]  actuary estimates employee has of retirement benefits at 2008 is earned (as of 2008) retirement benefits of $757,015 x .18456 = 1.5% x 11 years x $400,000 = $139,822$66,000 per year 1998 2008 2037 2057 ____________________________________________________________ 11 years29 years 20 years Service period Retirement  present value [n=20, i=6%] of the retirement annuity at the retirement date is $66,000 x 11.46992 =$757,015

14. Changes in the DBO Notice that the DBO increased during 2008 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.

15. HOW THE DBO CHANGED IN 2008 DBO at the beginning of 2008 (end of 2007) $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 2008 service to 2037 * to 2008 ** Interest cost: $119,822 x 6% 7,189 DBO at the end of 2008 $139,712 * present value of an ordinary annuity of $1: n=20, i=6% ** present value of $1: n=29, i=6%

16. Defined Benefit Obligation

17. Pension Obligation Service cost is the increase in the DBO attributable to employee service performed during the period.

18. Pension Obligation Past service costis the increase in the DBO from using a new, more generous pension formula to determine the pension obligation for prior years.

19. Past Service Cost Assume the formula’s salary percentage is increased in 2008 from 1.5% to 1.7%: 1.7% x Service years x Final year’s salary [Revised Pension Formula] The increase in the DBO attributable to making a plan amendment retroactive is referred to as Past service cost.

20. Past Service Cost DBO Without Amendment DBO With Amendment 1.5 x 10 years x $400,000 = $60,000 1.7 x 10 years x $400,000 = $68,000  $60,000 x 11.46992 = $688,195 $68,000 x 11.46992 = $779,955 $688,195 x .17411 = $119,822$779,955 x .17411 = $135,798 $15,976Past service cost

21. Pension Obligation Interest cost is the interest on the DBO during the period.

22. Pension Obligation Financing Loss or gain is the increase or decrease in the DBO from a change in the discount rate used to calculated the DBO.

23. Pension Obligation Remeasuement Loss or gain is the increase or decrease in the DBO from a change in an assumption used to calculated the DBO.

24. REMEASUREMENT GAIN OR LOSS  Many estimates are needed to derive the DBO. When one or more of these estimates requires revision, the estimate of the DBO also will require revision. The resulting decrease or increase in the DBO is referred to as a remeasurement gain or loss, respectively.

25. REMEASUREMENT GAIN OR LOSS Assume the estimate of Farrow’s final salary should be increased by 5% to $420,000. This would affect the estimate of the DBO as follows: DBO Without DBO With Revised Estimate Revised Estimate 1.7 x 12 years x $400,000 = $81,600 1.7 x 12 years x $420,000 = $85,680  $81,600 x 11.46992 = $935,945 $85,680 x 11.46992 = $982,743  $935,945 x .19563 = $183,099$982,743 x .19563 = $192,254 $9,155 Loss on DBO

26. Pension Obligation The obligation is reduced as benefits actually are paid to retired employees.

27. ILLUSTRATION EXPANDED TO THE ENTIRE EMPLOYEE POOL ($ in millions) DBO at the beginning of 2009 (amount assumed) $400 Service cost, 2009(amount assumed) 41 Past service cost 0* Interest cost: $400 x 6% 24 Financing loss—change in discount rate 3 Loss—change in salary expectation (amount assumed) 25 Gain—change in turnover assumption (amount assumed)(5) Less: Retiree benefits paid(amount assumed) (38) DBO at the end of 2009 $450 *The past service cost increased the DBO (by $60 million) when the plan was amended last year (in 2008).

28. 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 Past service cost. Cash of $48 million was contributed to the pension fund in 2009. Plan assets at the beginning of 2009 were valued at $300 million. The rate of return in 2009 was 10%. Retirement benefits of $38 million were paid at the end of 2009 to retired employees. What is the value of the company’s pension plan assets at the end of 2009? ($ in millions) Plan assets at the beginning of 2009 $300 Return on plan assets(10% x $300) 30 Cash contributions 48 Less: Retiree benefits paid (38) Plan assets at the end of 2009 $340

29. OVERFUNDED Market value of plan assets exceeds the obligation to pay benefits, the DBO. Funded Status of Pension Plan UNDERFUNDED Market value of plan assets is below the obligation to pay benefits, the DBO.

30. This amount is reported in the balance sheet as a Net Pension Liability or Net Pension Asset. Funded Status of Pension Plan Defined Benefit Obligation (DBO) - Plan Assets at Fair Value Underfunded / Overfunded Status

31. REPORTING THE FUNDED STATUS OF THE PENSION PLAN ($ in millions)2009 2008 Defined benefit obligation (DBO) $450 $400 Fair value of plan assets 340 300 Underfunded status $110 $100 Because the plan is underfunded, Global reports a Net pension liability of $110 million in its 2009 balance sheet and $100 million in 2008. If the plan becomes overfunded in the future, Global will report a net pension asset instead.

32. Balance Sheet

33. PENSION EXPENSE PLAN($ in millions)DBO ASSETS Beginning of 2009 $400 Beginning of 2009 $300 Service cost 41 Return on plan assets, Interest cost, 6% 24 10% (9% expected) 30 Loss (gain) on DBO 23 Cash contributions 48 Less: Retiree benefits (38) Less: Retiree benefits (38) End of 2009 $450End of 2009 $340 Net Past service cost of $60 million due to a plan amendment increasing the DBO at beg. of 2007. Net loss is $55 million. Avg. service life of employees is 15 yrs. Global’s 2009 pension expense is determined as follows: Service cost $41 Interest cost 24 Expected return on the plan assets ($30 actual, less $3 gain) (27) Amortization of Past service cost 4 Amortization of net loss 1 Pension expense $43

34. RECOGNIZING CHANGES IN THE INCOME STATEMENT Revenue   $xxx Operating expenses (including pension employment cost)  (xx) Finance costs (including pension finance cost) xx Profit before tax    $xxx Tax expense   (xx) Profit from continuing operations  $xxx Remeasurements arising from   changes in pension assumptions (net of tax)  xx Gains or losses on discontinued operations (net of tax) xx Net income   $xxx

35. RECOGNIZING CHANGES IN THE INCOME STATEMENT Pension employment cost($ in millions)  Service cost $41  Past service cost 0* $41 Pension finance cost Interest cost $24  Loss (gain) on DBO- change in discount rate 3  Return on plan assets (30)(3) Pension remeasurement cost Loss (gain) on DBO- change in salary estimate $25  Loss (gain) on DBO- change in employee turnover estimate (5) 20 Net periodic pension cost$58 * Last year (2008) this amount was $60 million.

36. RECOGNIZING CHANGES IN THE INCOME STATEMENT Pension employment cost($ in millions) Service cost $41  Past service cost 0* $41 Pension finance cost Interest cost $24  Loss (gain) on DBO- change in discount rate 3 Return on plan assets (30)(3) Pension remeasurement cost Loss (gain) on DBO- change in salary estimate $25  Loss (gain) on DBO- change in employee turnover estimate (5) 20 Net periodic pension cost$58 * Last year (2008) this amount was $60 million. Changes in the DBO

37. RECOGNIZING CHANGES IN THE INCOME STATEMENT Pension employment cost($ in millions)  Service cost $41  Past service cost 0* $41 Pension finance cost Interest cost $24  Loss (gain) on DBO- change in discount rate 3 Return on plan assets (30)(3) Pension remeasurement cost Loss (gain) on DBO- change in salary estimate $25  Loss (gain) on DBO- change in employee turnover estimate (5) 20 Net periodic pension cost$58 * Last year (2008) this amount was $60 million. Change in Plan Assets

38. RECORDING PENSION COSTS To Record Net Periodic Pension Cost($ in millions) Pension employment cost 41 DBO (service cost) 41 Pension employment cost 0 DBO (past service cost) 0 Pension financing cost 24 DBO (interest cost) 24 Pension financing cost 3 DBO (change in change in discount rate) 3 Plan assets (return on plan assets) 30 Pension financing cost (return on plan assets) 30 Pension remeasurement cost 25 DBO (change in change in future salary estimate) 25 DBO (change in change in employee turnover estimate) 5 Pension remeasurement cost 5

39. RECORDING PENSION COSTS ($ in millions) Or, equivalently: Pension employment cost 41 DBO (service cost) 41 Plan assets (return on plan assets) 30 DBO (interest cost) 24 DBO (change in discount rate) 3 Pension financing cost (to balance) 3 Pension remeasurement cost 20 DBO (change in employee turnover estimate) 5 DBO (change in future salary estimate) 25 or Net periodic pension cost 58 Plan assets (return on plan assets) 30 DBO ($41 + 24 + 3 – 5 + 25) 88

40. U.S. GAAP SFAS 158 specifies accounting for pensions and other postretirement benefit plans under U.S. GAAP. Like IFRS, it requires companies to report the funded status of a plan as a net pension liability or net pension asset in the balance sheet. However unlike IFRS all changes in that amount are not reported in the income statement. In fact, the only components of the net pension cost under IFRS that also are components of the net pension cost under U.S. GAAP are the service cost and interest cost. Past service cost and gains or losses are instead reported in OCI and included in income later only under limited circumstances. And only the “expected return” on assets is included. The difference between that amount and the actual return are treated as gains or losses, lumped together with other gains or losses, and reported as OCI.

41. U.S. GAAP SFAS 158 specifies accounting for pensions and other postretirement benefit plans under U.S. GAAP. Like IFRS, it requires companies to report the funded status of a plan as a net pension liability or net pension asset in the balance sheet. However unlike IFRS all changes in that amount are not reported in the income statement. In fact, the only components of the net pension cost under IFRS that also are components of the net pension cost under U.S. GAAP are the service cost and interest cost. Past service cost and gains or losses are instead reported in OCI and included in income later only under limited circumstances. And only the “expected return” on assets is included. The difference between that amount and the actual return are treated as gains or losses, lumped together with other gains or losses, and reported as OCI.

42. AMORTIZATION OF PAST SERVICE COST By the straight-line method, past service cost is recognized over the average remaining service life of the active employee group. ($ in millions) Service cost $41 Interest cost 24 Expected return on plan assets ($30 actual, less $3 gain) (27) Amortization of Past service cost-AOCI ($60 million ÷ 15 years) 4 Amortization of net loss-AOCI 1 Pension expense $43

43. Gains and Losses

44. Actual Return Expected Return The dividends, interest, and capital gains generated by the fund during the period. Trustee’s estimate of long-term rate of return. Return on Plan Assets

45. Corridor Amount DBO at the beginning of the period. The corridor amount is 10% of the greater of . . . Or Fair value of plan assets at the beginning of the period.

46. AMORTIZATION OF NET LOSS Assume a net loss-AOCI of $55 million at the beginning of 2009. The DBO 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 2009 pension expense $ 1

47. Record Gains and Losses ($ in millions) Loss–OCI (from change in assumptions) 23 DBO 23 Plan assets 3 Gain–OCI (from actual return exceeding expected return) 3  Gains and losses are not immediately included in pension expense and net income.  Instead, they are reported in the statement of comprehensive income. 23­DBO 3­Less: plan assets 20 ­Net pension liability  The gain and loss become part of the net loss–AOCI account which is a shareholders’ equity account. Note: Any new Past service cost should it arise, is reported as Other comprehensive income in the same manner.

48. RECORD PENSION EXPENSE IN 2009 ($ in millions) Pension expense (calculated above) 43 Plan assets ($27 expected return on assets) 27 DBO ($41 service cost + $24 interest cost) 65 Amortization of prior service cost–OCI 4 Amortization of net loss–OCI 1 OCI = Other comprehensive income Service cost and interest cost add to Global’s DBO. The return on plan assets adds to the plan assets. Amortization of OCI items also is OCI. Service cost $41 Interest cost 24 Expected return on plan assets ($30 actual, less $3 gain) (27) Amortization of prior service cost 4 Amortization of net loss 1 Pension expense $43 65 ­DBO27 ­Less: plan assets 38 ­Net pension liability

49. RECORD PENSION FUNDING  When Global adds its annual cash investment to its plan assets, the value of those plan assets increases by $48 million: ($ in millions) Plan assets 48 Cash (contribution to plan assets) 48 DBO 48 ­Less: plan assets 48¯ Net pension liability

50. Accumulated Other Comprehensive Income Global Communication Balance Sheets For Years Ended December 31 2009 2008 Assets Current assets $xxx $xxx Property, plant, and equipment xxx xxx Liabilities Current Liabilities $xxx $xxx Net pension liability 110 100 Other long-term liabilities xxx xxx Shareholders’ Equity Common stock $xxx $xxx Retained earnings xxx xxx Accumulated other comprehensive income Net unrealized holding gains on investments xxx xxx Net loss–AOCI (74) (55) Net prior service cost–AOCI (52) (56)