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Pensions

Pensions. ACCTG 5120 David Plumlee. Important fact…. Accounting we are talking about is for the company! The pension fund is actually managed and accounted for separately legal and accounting entity of its own…..

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Pensions

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  1. Pensions ACCTG 5120 David Plumlee

  2. Important fact… • Accounting we are talking about is for the company! • The pension fund is actually managed and accounted for separately • legal and accounting entity of its own….. • We focus on the impact of an asset/liability/expense for payment of the pension obligation from the company’s perspective

  3. Funding Payments Employer Pension Fund Trustee Invests funds to earn a return and payout cash to retiree Benefit Payments Retiree Pensions: The Big Picture

  4. Basic questions What is employer’s liability/asset (how should this be reported on the balance sheet)? What is the current year’s expense associated with the plan?

  5. Defined Contribution Plan • Employer contracts for an amount to be contributed • Example Plan The company will make a contribution under the plan equal to a stated percentage of the employee’s current annual salary. The percentages applied vary according to age (see attached table). All employees are required to make a 5% minimum contribution. Ownership of all contributions is fully vested in the participant.

  6. Defined Contribution Plan Employee Employees Company%Wages < age 45 7.0% $150,000 45 to 49 8.5% $350,000 50 to retirement 11.5 % $200,000

  7. Company contribution =$1,500,000* .07 + $3,500,000*.085 + $2,000,000*.115 =$335,000

  8. Benefit period Total Employment Period Defined Contribution Example

  9. Defined Benefit Plan • Employer contracts for future payouts • Example Plan The company agrees to provide to all employees at age 65, an annual pension benefit computed in accordance with the “benefit formula.” Ownership of all benefits becomes fully vested following three years of continuos employment with the company.

  10. Total Employment Period Benefit period Defined Benefit Example

  11. Determining Employer Contribution What does the employer need to do? What is the amount of that liability?

  12. Actuarial Assumptions Assume for an employee who works for this company: • Benefits are $4,000 per year in retirement for every year worked • Expected # of years at company = 20 yrs • Employee will live 15 years beyond retirement • Settlement rate is 6%. (The interest rate implicit in the annuity contract at retirement.) • Expected rate of return 8%. ( The amount that funding will earn.)

  13. Actuarial Estimate of Retirement Benefits = PV of Benefits @ Settlement Rate Total Employment Period Current period Retirement Actuaries Determine Benefits

  14. Current period Retirement = 15 years Actuaries Determine Benefits Retirement Benefits = Remaining Employment Period = 20 years

  15. Actuaries Determine Funding So, how much should the company fund this year? What is that amount in this example?

  16. Remaining Employment Period = 20 years Current period Retirement = 15 years Actuaries Determine Funding

  17. Benefit Employer’s contribution is based on expected payout Contract is for payments to retired employees employer bears risk associated with plan performance Great uncertainty regarding annual pension expense Contribution Employer’s contribution to the plan is defined No promises regarding ultimate pension benefit Employees bear risk associated with plan performance No uncertainty regarding annual pension expense Defined contribution vs. benefit plans

  18. Accounting for Defined Contribution Plans Assume required contribution under terms of plan for 2003 is $335,000 Employer Funding Contribution Status Case A: $335,000 fully funded Case B: $300,000 under funded Case C: $600,000 over funded

  19. Accounting for Defined Contribution Plans Case A: Case B: Case C:

  20. Defined BENEFIT Options Cash basis accounting • wait until employees retire • expense actual payments to retired employees Modified cash basis accounting • fund plan prior to retirement • expense funding payments Accrual basis accounting (FAS 87) • expense pension related cost of services provided in current year by employees

  21. What is the ‘obligation’? • Accumulated benefit obligation (ABO) Estimate of total retirement benefits based on current salary levels • Vested benefit obligation Portion of ABO that is vested • Projected benefit obligation (PBO) Estimate of total retirement benefits based on future salary levels

  22. Major Components of a Pension Plan • PBO actuarial present value of future pension benefits earned to date to be paid to employees in the future • Pension plan assets value of assets set aside to satisfy obligation **net pension obligation (asset) =PBO-pension assets** • Pension expense amount charged to income for the period

  23. Important Terms Benefit payments • pension payments to participants Funding payments • payments made to the trustee to fund the plan Transition adjustment • “catch-up” adjustment that arose when firms first adopted FAS 87

  24. Important Terms Current service cost (CSC) • present value of benefits earned during the current period Actual return on plan assets • includes dividends, interest income and capital gains and losses Expected return on plan assets • anticipated return on plan assets based on the expected long-term rate of return on plan assets

  25. Important Terms Experience gain or loss • difference between actual and expected return on plan assets Actuarial gain or loss • a change in the value of the PBO resulting from a change in actuarial assumptions Prior service cost (PSC) • cost of retroactive benefits granted in a plan amendment

  26. Pension Fund Trustee Invests funds to earn a return and payout cash to retiree Pension Assets opening balance + actual return on plan assets + funding payments - benefit payments to retirees closing balance

  27. Employer Projected Benefit Obligation opening balance + current service cost + prior service cost + interest on obligation - benefit payments to retirees +/- changes in assumptions (i.e. actuarial gains/losses) closing balance

  28. Pension Expense + current service cost + interest on pension obligation - actual return on plan assets +/- deferral of experience gain/loss +/- amortization of unrecognized gain/loss (including experience and actuarial gains/losses) + amortization of unrecognized prior service cost +/- amortization of transition adjustment pension expense

  29. Total Employment Period Current period Retirement Current Service Cost Actuarial present value of new benefits earned by employees during current period PV of additional retirement benefits

  30. PBO Service cost is starting point Current service cost will increase PBO on an annual basis Expense Current service cost increases in first year of plan, same as for PBO Effect of Service Cost Assume a $500,000 increase of PBO due to additional year of service Beg Bal. $1,300,000 Current SC 500,000 $ 500,000

  31. Prior Service Cost • Credit given to employees for past service • Initiate or amend a plan • Retroactive benefits • really retroactive? • Expectation of future service…. • Increases PBO • Amortize PSC for pension expense • Years of service method • prior service cost = $100,000, 5 year amortization

  32. Total Employment Period Current period Retirement Prior Service Cost Prior service period PV of benefits due to plan amendment or adoption for past periods Plan Amendment

  33. PBO Increases by total amount in year of change Expense amortized into over estimated life of employees effected, beginning with year of change Effect of PSC Beg Bal. $1,300,000 Current SC 500,000 $ 500,000 PSC 100,000 20,000

  34. Interest on Pension Obligation • Employee is one year closer to retirement, which increase present value of benefits due to the time value of future benefits • Interest on the pension obligation (i.e. projected benefit obligation) outstanding during the period = beginning-of-year balance x settlement rate • Assume settlement rate = 10%

  35. Increases PBO Increases expense Effect of Interest Beg Bal $1,300,000 Current SC 500,000 $ 500,000 PSC 100,000 20,000 Interest 130,000 130,000

  36. Payments and changes in assumptions • Benefit payments reduce PBO • Payments have NO EFFECT on pension expense • Assume $30,000 funding payment • Changes in actuarial assumptions • Increase or decrease PBO • Amortized in pension expense (when too big!) • Assume actuarial assumptions change amount is increase in PBO of $40,000

  37. Payments decrease PBO Changes in actuarial assumptions change PBO No effect Changes in actuarial assumptions are amortized into expense using corridor approach Effect of payments and changes in assumptions Beg Bal $1,300,000 Current SC 500,000 $ 500,000 PSC 100,000 20,000 Interest 130,000 130,000 Benefit pmt ( 30,000) 00 Actuarial loss 40,000 00*

  38. Pension Fund Trustee Return on Plan Assets Actual return = interest + dividends + cap. gains - cap. losses Expected return = actuary’s expected rate of return x plan assets Difference is the ‘experience gain or loss’

  39. Details of expected return • Actual return reduces pension expense with ‘experience’ gains/losses deferred • Net result is EXPECTED return reduces pension expense • Amortize experience gains/losses when they gets too large

  40. Return on plan assets • Plan assets = $1,000,000 • Actual return at 25%= $250,000 • Expected return at 11% = $110,000 • unexpected gain (i.e. experience gain) = 250,000-110,000=140,000 • Reduce pension expense by $250,000 • Defer experience gain of $140,00 (incr. Pension exp.)

  41. No effect Reduces expense by expected return Actual return less the deferred ‘experience gain/loss’ Effect of return on plan assets Beg Bal $1,300,000 Current SC 500,000 $ 500,000 PSC 100,000 20,000 Interest 130,000 130,000 Benefit pmt ( 30,000) 00 Actuarial loss 40,000 00* Actual return 000 (250,000) Deferred exp gain 000 140,000

  42. Delayed Recognition Under FAS 87 Impact of following items not fully recognized when they occur • experience gains and losses • actuarial gains and losses (i.e. impact of changes in assumptions) • prior service cost • transition adjustment (IGNORE!!)

  43. With Full Recognition:

  44. Effect of Delayed Recognition Prepaid (accrued) pension reported on balance sheet may not equal net pension asset (obligation) • i.e. frequently companies have significant off-balance sheet pension liabilities or pension assets Total pension expense does not equal the change in the PBO

  45. The Corridor Approach Minimum amortization • allow gains less losses to accumulate until net amount deferred exceeds a defined threshold • amortization required when beginning-of-year net gain or loss exceeds 10% of maximum opening (PBO or fair value of plan assets) • amortization period is Estimated Average Remaining Service Life of the active employees expected to receive benefits • amount amortized is the EXCESS over the corridor amount. • (beginning net deferred gain/loss - threshold)/EARSL

  46. Corridor Example • Beginning fair value of plan assets = $1,000,000 • Beginning of year PBO = $ 1,300,000 • Beginning of year deferred gain/loss = $180,000 • End of year deferred gain = $320,000 • EARSL = 10 years

  47. Corridor Solution • Determine 10% threshold • 10% of beginning PBO = $130,000 • 10% of beginning FV plan assets = $100,000 • Amortization amount Beginning deferred gain/loss = $180,000 Corridor (10% of PBO) 130,000 Total amort. Amount $50,000 (This year’s portion $50,000/10=$5,000)

  48. No effect Increases expense Effect of amortization Beg Bal $1,300,000 Current SC 500,000 $ 500,000 PSC 100,000 20,000 Interest 130,000 130,000 Benefit pmt ( 30,000) 00 Actuarial loss 40,000 00* Actual return 000 (250,000) Deferred exp gain 000 140,000 Amortization 000 5,000

  49. What do we record? • Journal entry to record pension expense • as calculated above • Entry to record funding payment • Balance to pension asset/liability

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