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Chapter 20

Chapter 20. VESTING OF BENEFITS. Right to receive benefits NOT contingent upon continued employment. PLAN FUNDING. CONTRIBUTORY : Employees pay part of funding. NONCONTRIBUTORY : Employees DON’T pay. To record PENSION EXPENSE is simple:. Prepaid asset for over

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Chapter 20

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  1. Chapter 20

  2. VESTING OF BENEFITS • Right to receive benefits NOT contingent upon continued employment. PLAN FUNDING CONTRIBUTORY: Employees pay part of funding. NONCONTRIBUTORY: Employees DON’T pay.

  3. To record PENSION EXPENSE is simple: Prepaid asset for over payments……………….$XX.XX Pension expense……….. $XX.XX Cash……………..$XX.XX Liability for underpayments…. $XX.XX DEFINED CONTRIBUTION PLANS

  4. DEFINED BENEFIT PLAN Pension expense is MUCH MORE COMPLEX And not all that popular in private industry anymore: 18% of private sector workers have Defined Benefit Plan while 80% of government workers have them (USA Today February 21, 2007).

  5. Scenario: Lone Pine Corporation is a SOFTWARE development Co. in Central Oregon. We focus on ONE employee; Nicole Whitney. • Pension Plan: Noncontributory defined benefit plan. • Inception date: January 1, 2008. • Co. start date: January 1, 2008. • Starting salary: $45,000/year. • Age on 1/1/08: 40 • Expected retirement date: December 31, 2032 (after 25 years of service). • Expected salary at retirement: $150,000/yr • PENSION BENEFIT FORMULA: Annual retirement payment = 2%(1 year of service)(final salary) • Lone Pine vests 10% of benefits after the first year, 15% after the second year, then conforms to present ERISA schedule (20% of total benefits vested after the third year, and so forth. • Settlement/Discount rate and expected long-term rate of return on pension plan assets (expected equals actual return) is 10%.

  6. Nicole’s expected retirement period is 10 years; payments made at end of each calendar year during retirement. • Contributions are made to the pension plan (funding) at the END of the service years. • First contribution- 12/31/08 • Last contribution- 12/31/32 • Retirement benefit payments are made at the END of the retirement years: • First payment 12/31/33 • Last payment 12/31/42

  7. PENSION EXPENSE 1. SERVICE COST. 2. INTEREST COST. 3. ACTUAL RETURN ON PLAN ASSETS. 4. AMORTIZATION OF PRIOR SERVICE COST. 5. GAIN OR LOSS RECOGNIZED. S I R P G O L

  8. SERVICE COST. PENSION EXPENSE -Is the actuarial present value of the pension benefits attributed to employee service based on the pension benefit formula. In this example the formula is: Benefit payment = 2%(1 year of service)(Final salary) $3,000 = 2%(1)($150,000) This is the actual amount of money that Nicole will earn in each year of retirement based on this ONE year she just worked. Graphically it looks like this:

  9. Service Cost is the PRESENT VALUE of this $3,000 annuity stream at time zero. 12/31/32 makes it an ORDINARY annuity $3,000(6.14457) T 6-4, 10%, 10 per = $18,433.71 $3,000 $3,000 $3,000 $3,000 $3,000 $3,000 $3,000 $3,000 $3,000 $3,000 12/31/42 1/1/08 12/31/08 12/31/33 Start Time Zero First retirement check Last retirement check $18,433.71 x .10153 = $1,872 T 6-2, 10%, 24 years

  10. All those $3,000 annuity payments shrink down and become $1,872 in total as a charge against 2008 income. • If this was all we had to worry about for 2008 the pension expense entry would look like this if $1500 were contributed: Pension expense………. $1,872 Cash………………………$1,500 Pension Asset/ Liability….. $372 Is a LIABILITY which represents the amount the pensionfund is under-funded.

  11. If instead, the company had decided to pay in $1900 to fund the pension in 08 then the entry would have looked like this: Pension expense………. $1,872 Pension Asset/Liability $ 28 Cash………………………$1,900 Is an ASSET.

  12. In 2008 (first year) this is the ONLY piece of PENSION EXPENSE. But a company would also need to be compiling lots of information for the footnotes and for comprehensive income regarding the liability which is building….

  13. Employer Pension Obligations Projected Benefit Obligation Is the estimate of pension obligation based on EXPECTED FUTURE values. In our example, the PBO so far would be the PV of the service cost we just calculated or $1,872. Lone would need to currently invest $1872 in order to be able to pay out $3,000 a year when its needed in the retirement years. PBO

  14. Employer Pension Obligations Accumulated Benefit Obligation Is the estimate of pension obligation based on CURRENT salaries. Going back to the formula: .02 (1 yr) ($45,000 current salary) = $900 Then we’d have to find the PV of a $900 annuity stream which would be $900(6.14457)(.10153) = $561 ABO

  15. Employer Pension Obligations Vested Benefit Obligation Is the estimate of pension obligation based on VESTED salaries. Going back to the formula: .02 (1 yr) ($45,000 current salary)(.10 vested) = $90 Then we’d have to find the PV of a $90 annuity stream which would be $90(6.14457)(.10153) = $56 VBO

  16. Generally PBO > ABO > VBO

  17. PLAN ASSETS Represent what the firm does with money contributed to the pension plan. It is probably investments like stocks, bonds, etc.. • The plan assets ARE NOT recorded on the books of the firm. • They are instead recorded on the books of the TRUSTEE FIRM. The employing firm shows this information in their footnotes. • We usually need to obtain the FMV of the plan assets at least once a year.

  18. Remember Pension Expense is made up of multiple components: 1. Service Cost 2. Interest cost 3. Return on Plan Assets 4. Amortization of Prior Service Cost 5. Gain or loss component. So as we go into year two we’d have to calculate ANOTHER service cost but the way things work we’d first be figuring out the interest cost….

  19. INTEREST COST Represents the cost of not paying the pension. Even tho its not due yet, you still have to calculate an interest charge. Interest cost = Beginning PBO x Settlement Rate $187 = $1,872 x .10 This is the interest charge for the SECOND year of operation. In the first year the only charge was service cost of $1,872.

  20. Now for the second year, so far we know the Pension Expense has an interest cost of $187. But in the second year we can also analyze how the Return on the Plan Assets impacts the pension expense. 1. Service Cost 2. Interest cost $187 3. Return on Plan Assets 4. Amortization of Prior Service Cost 5. Gain or loss component.

  21. Actual Return on Plan Assets • If there is a positive return on plan assets, thatREDUCES the pension expense. • Makes sense; if the investment for the pension is making money, then that should reduce the cost of the pension expense. • Suppose in 2009 the actual return on plan assets = $150.

  22. You can find the actual return by using this formula: Beginning fund balance…………………… $XX.XX + Actual return on plan assets during period.. $XX.XX + Employer contributions……………………. $XX.XX - Benefit payments…………………………… $XX.XX ----------------------------------------------------------------------- Ending fund balance……………………….. $XX.XX

  23. Now pension expense looks like this: 1. Service Cost 2. Interest cost $187 3. Return on Plan Assets ($150) 4. Amortization of Prior Service Cost 5. Gain or loss component. Now its time to figure out 2009 Service Cost.

  24. Service cost for 2009 is the PV of another 10 year annuity stream earned in 09 to be given in retirement. So basically it’s the same as last time only when the PV of the lump sum is calculated its for one year less than before. 12/31/32 makes it an ORDINARY annuity $3,000(6.14457) T 6-4, 10%, 10 per = $18,433.71 $3,000 $3,000 $3,000 $3,000 $3,000 $3,000 $3,000 $3,000 $3,000 $3,000 New Time Zero 12/31/09 12/31/42 1/1/08 12/31/08 12/31/33 Start Old Time Zero First retirement check Last retirement check $18,433.71 x .11168 = $2,059 T 6-2, 10%, 23 not 24 years

  25. Now pension expense looks like this: 1. Service Cost $2,059 2. Interest cost $187 3. Return on Plan Assets ($150) ----------------------------------------------- Pension expense $2, 096 4. Amortization of Prior Service Cost 5. Gain or loss component. If in 2009, $2,000 was funded…. Pension expense…….. $2,096 Pension Asset/Liability…….. $96 Cash…………….…………$2,000

  26. PENSION WORKSHEETS

  27. Pension Worksheets bring together reports of the ACTUARY and the TRUSTEE. • FORMAL RECORDS: Are actually in the ledger and appear on the left-hand side of the work- sheet. • INFORMAL RECORDS: Do not appear on the balance sheet and are on the right-hand side of the worksheet.

  28. Formal records Informal records Dr Pension Expense Cr Pension Asset/ Liability Projected Benefit Obligation Plan Assets Cash Items

  29. Dr Pension Expense Cr Pension Asset/Liab PBO Plan Assets Cash Items Beg Bal at 1/1/09 $372 $1,872 $1,500 Pension Expense……. $1,872 Pension Asset/Liability…….…. $372 Cash………………………….. $1,500 RECONCILIATION: PBO $1,872 - Plan Assets $1,500 ---------------------- Pension Asset Liab $372 Closed out

  30. Dr Pension Expense Cr Ppd/Accd Pension Cost Cr Cash PBO Plan Assets Items Beg Bal at 1/1/09 $372 $1,872 $1,500 Service Cost $+2,059 $+2,059 Interest Cost $+187 $+187 Actual Return ($150) +150 Contributions $+2,000 $+2,000 $2,096 $96 $2,000 $4,118 $3,650 Journal Entry 12/31/09 Pension expense…. $2,096 Cash……………..…… $2,000 Pension Asset/Liability $96

  31. Dr Pension Expense Cr Ppd/Accd Pension Cost Cr Cash PBO Plan Assets Items Beg Bal at 1/1/09 $372 $1,872 $1,500 Service Cost $+2,059 $+2,059 Interest Cost $+187 $+187 PBO $4,118 - Plan Assets $3,650 ---------------------- Pension Asset/ Liab $468 Actual Return ($150) +150 Contributions $+2,000 $+2,000 $2,096 $96 $2,000 $4,118 $3,650 Journal Entry 12/31/09 RECONCILIATION: Balance 12/31/09 $468

  32. Now we can deal with the 4th component of pensions: 1. Service Cost $2,059 2. Interest cost $187 3. Return on Plan Assets ($150) 4. Amortization of Prior Service Cost 5. Gain or loss component.

  33. Amortization of Prior Service Cost • Comes from granting pension benefits for service rendered BEFORE the pension plan began or from plan amendments. • Its creation results in an INCREASE IN PBO • Assume on 1/1/09 Lone Pine Co. AMENDS its plan to award Nicole an additional annual $500 retirement benefit for service rendered in 2008. • At this time Nicole has 24 years remaining and is expected to draw 10 retirement payments.

  34. Prior Service Cost Amendment Putting this into the worksheet would look like as follows: 12/31/32 makes it an ORDINARY annuity $500(6.14457) T 6-4, 10%, 10 per = $3,072 $500 $500 $500 $500 $500 $500 $500 $500 $500 $500 12/31/42 1/1/08 1/1/09 12/31/33 Start Time Zero First retirement check Last retirement check $3,072 x .10153 = $312 T 6-2, 10%, 24 years

  35. Dr Pension Expense Cr Pension Asset/Liab Cr Cash OCI PSC Plan Assets PBO Items Beg Bal at 1/1/09 $372 $1,872 $1,500 $+312 $+312 Unamortized PSC Service Cost $+2,059 $+2,059 Interest Cost $+187 $+187 Actual Return +150 ($150) Contributions $+2,000 $+2,000 Journal Entry 12/31/09 $2,096 $96 $2,000 $4,118 $3,650

  36. Dr Pension Expense Cr Pension Asset/Liab Cr Cash OCI PSC Plan Assets PBO Items Beg Bal at 1/1/09 $372 $1,872 $1,500 $+312 $+312 Unamortized PSC Service Cost $+2,059 $+2,059 It is a worksheet entry to record its creation. Interest Cost $+187 $+187 Actual Return +150 ($150) Contributions $+2,000 $+2,000 Journal Entry 12/31/09 $2,096 $96 $2,000 $4,118 $3,650

  37. Dr Pension Expense Cr Pension Asset/Liab Cr Cash OCI PSC Plan Assets PBO Items Beg Bal at 1/1/09 $372 $1,872 $1,500 $+312 $+312 Unamortized PSC Service Cost $+2,059 $+2,059 Interest Cost $+187 $+187 PSC Amortz +31 -31 Actual Return +150 ($150) Contributions $+2,000 $+2,000 Journal Entry 12/31/09 $2,096 $2,127 $96 $2,000 $+312 $4,118 $3,650 $281 Then during 2009 part of the PSC would need to be amortized. Say 1/10

  38. Dr Pension Expense Cr Pension Asset/Liab Cr Cash OCI PSC Plan Assets PBO Items PBO $4,430 - Plan Assets $3,650 ---------------------- Pension Asset/ Liab $780 Beg Bal at 1/1/09 $372 $1,872 $1,500 $+312 $+312 Unamortized PSC Pension expense…. $2,127 OCI (PSC)………... 281 Cash……………….…… $2,000 Pension Asset/Liability… $408 Service Cost $+2,059 $+2,059 Interest Cost $+187 $+187 PSC Amortz +31 -31 RECONCILIATION: Actual Return +150 ($150) Contributions $+2,000 $+2,000 Journal Entry 12/31/09 $2,096 $2,127 $408 $96 $2,000 $+312 $4,118 $4,430 $3,650 $281 AOCI 1/1/09 $0 $780 $281 Bal 12/31/09

  39. Gain or Loss COMPONENT of Pension Expense • Is made up of TWO PARTS. UNEXPECTED GAINS and LOSSES Also called ASSET GAINS/LOSSES Other Comprehensive Income (G/L)

  40. Other Comprehensive Income (G/L) There are (2) kinds of OCI (G/L) pension gains/losses: 1. LIABILITY GAINS/LOSSES Actual PBO does not equal Actuary PBO 2. UNEXPECTED GAINS/LOSSES Actual Return on Plan Assets does not equal Expected Return on Plan Assets

  41. Other Comprehensive Income (G/L) These two together form ONE CLASSIFICATION of pension expense known as OCI (G/L) 1. LIABILITY GAINS/LOSSES Actual PBO does not equal Actuary PBO + 2. UNEXPECTED GAINS/LOSSES Actual Return on Plan Assets does not equal Expected Return on Plan Assets OTHER COMPREHENSIVE INCOME GAINS/LOSSES

  42. OCI (G/L) They are put in comprehensive income because they are not charged to Pension Expense right away. Instead they are stored and amortized over a period of years (if ever). If they ever do get recognized they have to be bigger than something known as the CORRIDOR. That’s because the FASB is trying to cut the volatility of such increases/decreases.

  43. Going back to our example, remember that on 12/31/09 our PBO had grown to $4,118 (rounded) (before considering the ‘what if’ PSC change). • Suppose that on 1/1/10 the discount rate is changed from 10% to 8% resulting in an INCREASE in the PBO to $6,857. • Thus: • We thought our obligation was $4,118 • But its actually now…………… 6,857 LIABILITY LOSS………….. $2,739 • Assume no unexpected gain occurs (ARPA = ERPA) • THUS this liability is the total OCI (G/L).

  44. THE FIRST RULE IS, THAT THIS OCI (G/L) MUST SIT FOR AN ENTIRE YEAR BEFORE IT CAN EVEN BE CONSIDERED AS A POSSIBLE PART OF PENSION EXPENSE. It would get logged into the pension worksheet as follows: OCI (G/L) Little OCI loss waiting a year

  45. Dr Pension Expense Cr Pension Asset/Liab Cr Cash OCI G(/L) Plan Assets PBO Items Beg Bal at 1/1/09 $372 $1,872 $1,500 Service Cost $+2,059 $+2,059 Interest Cost $+187 $+187 Actual Return +150 ($150) Contributions $+2,000 $+2,000 Journal Entry 12/31/09 $2,096 $96 $2,000 $4,118 $3,650 Liab increase +$2,739 ($2,739)

  46. At the end of the 2009, NONE of that liability loss (OCI (G/L) would be eligible to go into pension expense. THE BALANCE MUST EXIST IN OCI (G/L) AT THE START OF THE YEAR IN ORDER TO BE CONSIDERED ELIGIBLE. OCI (G/L)

  47. The Corridor.... Is the BARRIER that keeps unexpected gains/losses from being recognized EVEN AFTER they’ve waited for a whole year. THE CORRIDOR EQUALS THE GREATER OF: 10% x Beginning value of PBO OR 10% x Beginning Market Related Value of Plan Assets

  48. The Corridor.... OCI (G/L) Suppose at the BEGINNING of a year there existed an $1,800 OCI (L). Also beginning PBO was $20,000 and beginning MRVPA was $15,000. THE CORRIDOR EQUALS THE GREATER OF: 10% x $20,000 = 2,000 OR 10% x $15,000 = $1,500 Thus $2,000 corridor > $1,800 OCI loss and NONE is recognized for current year.

  49. Suppose instead that beginning OCI loss was $100,000. Also, as before beginning PBO was $20,000 and beginning MRVPA was $15,000. $2000 is still the corridor THE CORRIDOR EQUALS THE GREATER OF: 10% x $20,000 = 2,000 OR 10% x $15,000 = $1,500 Thus $2,000 corridor < $100,000 OCI loss so $98,000 is ELIGIBLE for amortization in current year. However, it may be spread out for years based on service yrs (e.g., $98,000/20 = $4,900 is added to pension expense.

  50. Suppose instead that beginning OCI loss was $100,000. Also, as before beginning PBO was $20,000 and beginning MRVPA was $15,000. $2000 is still the corridor THE CORRIDOR EQUALS THE GREATER OF: 10% x $20,000 = 2,000 OR 10% x $15,000 = $1,500 Thus $2,000 corridor < $100,000 OCI loss so $98,000 is ELIGIBLE for amortization in current year. However, it may be spread out for years based on service yrs (e.g., $98,000/20 = $4,900 is added to pension expense.

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