Pensions and Other Post-Retirement Benefits

2. Pensions and Other Post-Retirement Benefits Chapter 20

3. Types of Pension Plans • There are two general types of pension plans: • defined contribution plans • defined benefit plans • Defined contribution plan:the employer (and often the employee) make agreed upon cash contributions to the plan each period, which are invested by a trustee on behalf of the employee • The task of figuring out how much the employer should contribute to a pension plan is the task of the actuary

4. Types of Pension Plans (cont.) • Defined benefit plan:the eventual benefits to the employee are stated in the pension plan • The essential difference between the two types of plans can be summarized as follows:

5. Contributory vs. Non-Contributory Vested vs. Unvested Trusteed Registered Pension Variables

6. Probability Factors investment earnings future salary increases future inflation rates employee turnover mortality rates life expectancy after retirement Funding vs. Accounting Pension Variables (cont.)

7. Contributory vs. Non-Contributory • Pension plans are contributory when the employee pays into the plan; contributory plans are usually defined contribution plans • Any amounts paid into a defined contribution plan will increase the eventual pension; voluntary contributions (by the employee) are usually permitted • Defined benefit plans are usually non-contributory; the cost of the pension is borne entirely by the employer, since it is a risk of the employer that the contributed amounts may not earn a high enough rate of return • Employee contributions would not increase the eventual pension, which is fixed

8. Vested vs. Unvested • An employee does not have a guaranteed pension until the pension rights have vested • Employee contributions are always vested • In most provinces, vesting of employer contributions is legally required when an employee has reached the age of 45 and has worked for the company for 10 years • Some provinces require faster vesting of employer’s contributions (e.g., after only two years in Ontario)

9. Pension plans normally are trusteed, wherein the employer pays required amounts into the pension plan and the trustee administers the plan, invests the contributions, and pays out the benefits Trustees of pension funds are financial institutions such as trust companies and banks; a pension trustee is not an individual person When a plan is administered by a trustee, the plan assets are beyond control of the company’s managers; neither the plan assets nor the pension liability are reported on the employer’s balance sheet Trusteed

10. Trusteeship does not absolve the employer of responsibility to make sure that the pension plan is solvent A plan must be trusteed in order for the employer to be able to deduct pension plan contributions from taxable income Trusteeship is also essential for a plan to be registered Trusteed (cont.)

11. Registered • Pension plans are usually registered with the pension commissioner in the province of jurisdiction • Employers can deduct their contributions to a pension plan from taxable income when a formal plan is registered (and trusteed) • The commissioner’s office is responsible for seeing that the pension plan abides by the pension legislation, including requirements for funding, reporting, trusteeship, actuarial valuation, and control over surpluses

12. Probability Factors • In a defined benefit plan, the future benefit is known, but the annual contributions that are necessary to provide that defined future benefit must be estimated • Many factors must be taken into account in order to estimate the current cost of the distant benefit • investment earnings • future salary increases • future inflation rates • employee turnover • mortality rates • life expectancy after retirement

13. Actuaries often are very conservative, and they may estimate the return on plan assets on the low side and the projected rate of salary increases on the high side The company need not use the same estimates for accounting purposes that is used by their actuaries for funding purposes The auditor needs to ascertain that the estimates used by management are best estimates and that they are internally consistent Probability Factors (cont.)

14. In approaching the issue of pension accounting for defined benefit plans, it is extremely important to keep the accounting measurements separate from the plan funding Funding:the manner in which the employer (or the trustee, on behalf of the employer) calculates the necessary contributions to the plan Keeping accounting separate from funding is difficult because identical factors and the same family of methods are used for both Funding vs. Accounting

15. Defined Contribution Plans • Defined contribution pension plans are relatively easy to deal with, both for the company and for the accountant • Because the contribution is agreed upon, there is little uncertainty about either the cash flow or the accounting measurement • The one uncertainty that arises is that if the plan is not fully vesting from the start of an individual’s employment with the company, it will be necessary to estimate the probable portion of individuals who will stay with the company long enough for the pension to become vested

16. Defined Contribution Plans (cont.) • For a defined contribution plan, there can be three components of pension expense: • current service cost • past service cost • interest on accrued contributions

17. There are three basic methods used to calculate the cash contributions that a company must make in order to provide for defined pension benefits Accumulated benefit method:calculates the contributions that an employer must make in order to fund the pension to which the employee currently is entitled, based on the years of service to date and on the current salary Defined Benefit Plans: Actuarial Methods

18. Defined Benefit Plans: Actuarial Methods(cont.) • Projected benefit method:calculates the required funding based on the years of service to date but on a projected estimate of the employee’s salary at the retirement date • Level contribution method:projects both the final salary and the total years of service, and then allocates the cost evenly over the years of service

19. Pension Expense--List of Ingredients • Under current pension recommendations, there are 10 components of pension expense, including continuing components and special components: • continuing components: • current service costs • plus: interest on the accumulated accrued benefit obligation • minus: expected earnings on plan assets • plus: amortization of past service cost from plan initiation or amendment • plus (or minus): amortization of excess actuarial loss (or gain)

20. Pension Expense – List of Ingredients (cont.) • special components: • amortization of the transitional obligation (or asset) • any changes to the valuation allowance for pension plan assets • gain or loss on the plan’s settlement or curtailment • any expense recognized for termination benefits • any amount recognized as a result of a temporary deviation from the plan

21. Current Service Cost • The current service cost is an estimate of the cost of providing the pension entitlement that the employee earned in the current year of employment • The AcSB recommends that the current service cost be measured by using • the projected benefit method when future salary levels affect the amount of the employees’ future benefits • the accumulated benefit method when the future salary levels do not affect future benefits

22. Interest on Accrued Obligation • The accrued benefit obligation:the present value of the post-retirement benefits that the employees have earned to date • The accrued accrued benefit obligation is sensitive to the assumed interest rate because it is a present value of a future stream of payments • The AcSB recommends that the rate used to discount the obligation should be based on “market rates” at the measurement date

23. Expected Earnings on Plan Assets • Expected earnings on the plan assets reduces the amount of pension expense • The expected earnings is based on the expected long-term rate of return on plan assets, multiplied by the weighted average of the value of the plan assets over the year • The rate of return may be equal to the rate used by the actuary for funding calculations but if the actuary’s rate is conservative, then a more realistic rate should be used by the company to calculate the expected earnings

24. Expected Earnings on Plan Assets (cont.) • The value of the plan assets that is used in this calculation may be either • the fair value of the plan assets or • a market-related value • Amarket-related value:one that is based on fair values but that is not actually the current fair value

25. Past Service Cost from Plan Initiation • The past service cost:an estimate of the present value of the retroactive pension entitlements relating to previous years’ service when a new pension plan is instituted • Past service costs (PaSC) are deferred and amortized over the expected period to full eligibility, which for pensions is normally the estimated average remaining service life of the employee group • Funding of past service costs generally is limited to no more than 15 years

26. From time to time a company will amend its pension plan, usually to increase benefits either as the result of collective bargaining or to remedy purchasing power erosion that has occurred due to inflation When a plan is amended to increase benefits, an additional unfunded obligation is established that relates to prior service The liability that arises from a plan amendment is known as prior service cost (PrSC) Past Service Cost from Plan Amendment

27. Actuarial gains and losses arise either because: actual experience is different from expectations assumptions about the future are changed, or both Actuarial Gains and Losses

28. Actuarial gains and losses must be amortized only if the accumulated amount exceeds 10% of the higher of the accrued pension obligation or the value of the plan assets at the beginning of the year Only the excess over the 10% corridor need be amortized Actuarial Gains and Losses

29. Actuarial Gains and Losses (cont.) • The amortization period is the average remaining service period (ARSP) of the employee group • A company may choose to amortize actuarial gains and losses on a different basis, as long as the amortization is at least equal to the “corridor amortization” • A company may also elect to recognize actuarial gains and losses in income in the period in which they arise • Any amortization policy must be used consistently for all plans

30. Pension gains and losses arise from periodic actuarial revaluations Pension legislation usually requires an employer to have an actuarial revaluation at least once every three years Surpluses that arise as the result of an actuarial revaluation (such as an unexpectedly high return on plan assets) are not withdrawn from the pension plan, but usually entitle the employer to take a pension holiday by using the surplus to reduce or eliminate payments for the current service costs Actuarial Gains and Losses (cont.)

31. Special Components of Pension Expense • Special Components of Pension Expense: • transitional amortization • valuation allowance for pension plan assets • gains and losses on plan settlements and curtailments • termination benefits • temporary deviations from the plan

32. Disclosure Recommendations • The disclosure recommendations for post-retirement benefits are unusually extensive • The financial statements themselves include only two amounts relating to pensions and other post-retirement benefits: • on the income statement, the amount of the expense relating to providing post-retirement benefits • on the balance sheet, the net deferred pension cost or liability that reflects the difference between the accumulated accounting expense and the accumulated funding

33. Disclosure Recommendations (cont.) • There are two levels of disclosure: • disclosure for all companies • additional disclosure for public companies • The AcSB recommends that all disclosures be provided separately for: • pension plans • other post-retirement benefits

34. Basic Disclosures • All companies should disclose: • important accounting policies • important measurements being used for pension accounting • The policy disclosures belong in the accounting policy note or description, along with other policy choices that the company has made

35. Disclosure Recommendations (cont.) • The AcSB suggests several relevant policy disclosures, including: • the amortization period for past service costs • the method chosen for recognizing actuarial gains and losses and the period of amortization (if amortization is being used) • the valuation method for plan assets

36. Disclosure Recommendations (cont.) • The measurement disclosures include: • the amount of the deferred pension cost or accrued pension liability that has been included in the balance sheet • the amount of expense recognized for the period • the actuarial present value of accrued pension benefits at the end of the period • the fair value of the pension plan assets • the resulting plan surplus or deficit • the amount of funding contributions made by the company during the period

37. Disclosure Recommendations (cont.) 7. the amount of contributions by employees, if any 8. the amount of benefits paid • important measurement variables– discount rate, expected long-term rate on plan assets, the projected rate of compensation increase, and the assumed health care cost trend rate

38. Additional Disclosures for Public Companies • The AcSb recommends that public companies disclose the following additional information: • a reconciliation of beginning and ending balances of the accrued benefit obligation for the period, showing separately: • the current service costs • the amount of benefits paid • the interest costs • actuarial gains and losses arising during the period

39. Additional Disclosure for Public Companies (cont.) • a reconciliation of beginning and ending balances of the fair value of the plan assets for the period, showing separately: • the amount of funding contributions by the employer and by the employees • the amount of benefits paid • the actual return on plan assets

40. Additional Disclosure for Public Companies (cont.) • the balance of unamortized amounts not recognized in the financial statements, showing separately: • unamortized past service costs • unamortized actuarial gains and losses • unamortized transitional obligation or asset • the expected return on plan assets • the current period’s amortization of • past service costs • actuarial gains or losses • the transitional obligation or asset

41. Additional Disclosure for Public Companies (cont.) • The AcSB also suggests that: • entities are encouraged to provide additional disclosures about the actuarial assumptions underlying the reported amount of an entity’s accrued benefit obligation when the disclosure will enhance financial statements users’ understanding of that amount