Conducted by: Mr. Koy Chumnith

Pensions and Other Postretirement Benefits

17

McGraw-Hill/Irwin 2011, Royal University of Law and Economics

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Nature of Pension Plans1. Pension plans provide income to

individuals during their retirement years.

2. 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.

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Nature of Pension Plans

FFor a pension plan to qualify for special tax treatment it must meet the following requirements:1.Cover at least 70% of employees.2.Cannot discriminate in favor of highly compensated employees.3.Must be funded in advance of retirement through an irrevocable trust fund.4.Benefits must vest after a specified period of service.5.Complies with timing and amount of contributions.

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Nature of Pension Plans

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Contributions are defined

by agreement.

Contributions are defined

by agreement.

Employer deposits an agreed-upon amount into

an employee-directed

investment fund.

Employer deposits an agreed-upon amount into

an employee-directed

investment fund.

Employee bears all risk of pension

fund performance.

Employee bears all risk of pension

fund performance.

Plan CharacteristicsPlan Characteristics

Defined Contribution Pension Plans

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Defined Contribution Pension Plans

Let’s assume that the annual contribution is to be 3% of an employee’s salary. If an employee earned $110,000 during the year, the company

would make the following entry:

Pension expense 3,300Cash 3,300

The employee’s retirement benefits are totally dependent upon how well investments perform.

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Employer is committed to

specified retirement benefits.

Employer is committed to

specified retirement benefits.

Retirement benefits are based on a

formula that considers years of service,

compensation level, and age.

Retirement benefits are based on a

formula that considers years of service,

compensation level, and age.

Employer bears all risk of pension

fund performance.

Employer bears all risk of pension

fund performance.

Plan CharacteristicsPlan Characteristics

Defined Benefit Pension Plans

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Defined Benefit Pension Plan

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 30 years of service,

with a final salary of $100,000, would be:

1 1/2 % x 30 years x $100,000 = $45,000

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Defined Benefit Pension Plan

The key elements of a defined benefit pension plan are:1.The employer’s obligation to pay retirement benefits in the future.2.The plan assets set aside by the employer from which to pay the retirement benefits in the future.3.The periodic expense of having a pension plan.

An actuary assesses the various uncertainties (employee turnover, salary levels, mortality, etc.)

and estimates the company’s obligation to employees in connection with its pension plan.

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Pension Expense—An OverviewThe annual pension expense reflects

changes in both the pension obligation and the plan assets.

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The Pension Obligation1. Accumulated benefit obligation (ABO) The actuary’s

estimate of the total retirement benefits (at their discounted present value) earned so far by employees, applying the pension formula using existing compensation levels.

2. Vested benefit obligation (VBO) The portion of the accumulated benefit obligation that plan participants are entitled to receive regardless of their continued employment.

3. Projected benefit obligation (PBO) The actuary’s estimate of the total retirement benefit (at their discounted present value) earned so far by employees, applying the pension formula using estimated future compensation levels. (If the pension formula does not include future compensation levels, the PBO and the ABO are the same.

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The Pension Obligation

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Projected Benefit Obligation

Jessica Farrow was hired by Global Communications in 2000. She Jessica Farrow was hired by Global Communications in 2000. She is eligible to participate in the company's defined benefit pension is eligible to participate in the company's defined benefit pension plan. The benefit formula is:plan. The benefit formula is:

Annual salary in year of retirement

× Number of years of service

× 1.5%

Annual retirement benefits

 Farrow is expected to retire in 2039 after 40 years of service. Her Farrow is expected to retire in 2039 after 40 years of service. Her retirement period is expected to be 20 years. At the end of 2009, retirement period is expected to be 20 years. At the end of 2009, 10 years after being hired, her salary is $100,000. The interest 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 rate is 6%. The company’s actuary projects Farrow’s salary to be $400,000 at retirement.$400,000 at retirement.

The PBO is a more meaningful measurement because it includes a projection of what the salary

might be at retirement.

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Projected Benefit ObligationStep 1. Step 1. Use the pension formula to determine the retirement Use the pension formula to determine the retirement benefits earned to date. benefits earned to date.

$400,000

× 10

× 1.5%

$ 60,000 per year 

Step 2. Step 2. Find the present value of the retirement benefits as of the Find the present value of the retirement benefits as of the retirement date.retirement date.

The present value (n=20, The present value (n=20, ii=6%,) of the retirement annuity at =6%,) of the retirement annuity at the retirement date is $688,195 ($60,000 the retirement date is $688,195 ($60,000 × 11.46992).

Step 3. Step 3. Find the present value of the retirement benefits as of the Find the present value of the retirement benefits as of the current date.current date.

The present value (n=30, The present value (n=30, ii=6%,) of the retirement benefits at =6%,) of the retirement benefits at 2009 is $119,822 ($688,195 2009 is $119,822 ($688,195 × .17411). This is the PBO.

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Projected Benefit Obligation

Step 1. Step 1. Use the pension formula to determine the retirement Use the pension formula to determine the retirement benefits earned to date. benefits earned to date.

$400,000

× 11

× 1.5%

$ 66,000 per year 

Step 2. Step 2. Find the present value of the retirement benefits as of the Find the present value of the retirement benefits as of the retirement date.retirement date.

The present value (n=20, The present value (n=20, ii=6%,) of the retirement annuity at =6%,) of the retirement annuity at the retirement date is $757,015 ($66,000 the retirement date is $757,015 ($66,000 × 11.46992).

Step 3. Step 3. Find the present value of the retirement benefits as of the Find the present value of the retirement benefits as of the current date.current date.

The present value (n=The present value (n=2929, , ii=6%,) of the retirement benefits at =6%,) of the retirement benefits at 2010 is $139,715 ($757,015 2010 is $139,715 ($757,015 × .18456). This is the PBO.

If the actuary’s estimate of the final salary hasn’t changed, If the actuary’s estimate of the final salary hasn’t changed, the PBO a year later at the end of 2010 would be $139,715.the PBO a year later at the end of 2010 would be $139,715.

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Projected Benefit Obligation

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Service cost is the increase in the PBO attributable to employee service performed

during the period.

Projected Benefit Obligation

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Interest cost is the interest on the PBO during the period.

Projected Benefit Obligation

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Prior service cost is the increase in the PBO due to a plan change that provides credit for employee

service rendered in prior years.

Projected Benefit Obligation

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Loss or gain on PBO results from revising estimates used to determine the PBO.

Projected Benefit Obligation

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Retiree benefits paid reduce the PBO.

Projected Benefit Obligation

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Projected Benefit Obligation

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Pension Plan Assets

The pension plan assets are not reported separately in the balance sheet but are netted together with the PBO to report either a net pension asset (debit balance) or a

net pension liability (credit balance).

The higher the expected return on plan assets, the less

the employer must actually contribute. On the other hand,

a relatively low expected return means the difference must be made up by higher

contributions.

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Pension Plan AssetsGlobal Communications funds its defined benefit pension plan by contributing the year’s service cost plus a portion of the prior service cost each year. Cash of $48 million was contributed to the pension fund in 2011.

Plan assets at the beginning of 2011 were valued at $300 million. The expected rate of return on the investment of those assets was 9%, but the actual return in 2009 was 10%. Retirement benefits of $38 million were paid at the end of 2011 to retired employees. The plan assets at the end of 2011 will be:

Plan assets at the beginning of 2011 $ 300,000,000

Return on plan assets (10% x $300 million) 30,000,000

Cash contributions 48,000,000

Less: Retiree benefits paid (38,000,000)

Plan assets at the end of 2011 $ 340,000,000

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Funded Status of the Pension Plan

OVERFUNDED

Market value of plan Market value of plan assets exceeds the assets exceeds the

actuarial present value actuarial present value of all benefits earned by of all benefits earned by

participants.participants.

UNDERFUNDED

Market value of plan Market value of plan assets is below the assets is below the

actuarial present value actuarial present value of all benefits earned by of all benefits earned by

participants.participants.

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Reporting the Funded Status of Pension Plan

Projected Benefit Obligation (PBO)

- Plan Assets at Fair Value

Underfunded / Overfunded Status

Projected Benefit Obligation (PBO)

- Plan Assets at Fair Value

Underfunded / Overfunded Status

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The Relationship Between Pension Expense and Changes in the PBO and Plan Assets

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Service Cost

Actuaries have determined that Global Actuaries have determined that Global Communications has service cost of Communications has service cost of

$41,000,000 in 2011.$41,000,000 in 2011.

Service cost 41$ Interest costExpected return on the plan assetsAmortization of prior service cost Amortization of net loss Pension expense 41$

Global's 2011 Pension Expense ($ in millions)

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Service cost 41$ Interest cost 24 Expected return on the plan assetsAmortization of prior service cost Amortization of net loss Pension expense 65$

Global's 2011 Pension Expense ($ in millions)

Interest CostInterest cost is calculated as:Interest cost is calculated as:

PBOPBOBegBeg × Discount rate × Discount rate

Global had PBO of $400,000,000 on 1/1/11. The Global had PBO of $400,000,000 on 1/1/11. The actuary uses a discount rate of 6%.actuary uses a discount rate of 6%.

2011 Interest Cost

PBO 1/1/11 $400,000,000 × 6% = $24,000,000

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Return on Plan Assets The plan trustee reports that plan assets were The plan trustee reports that plan assets were

$300,000,000 on 1/1/11. The trustee uses an expected $300,000,000 on 1/1/11. The trustee uses an expected return of 9% and the actual return is 10%.return of 9% and the actual return is 10%.

Beginning value of plan assets 300,000,000$ Rate of return 10%Return on plan assets 30,000,000 Beginning value of plan assets 300,000,000$ Adjustment (10% - 9%) 1%Adjusted for gain on plan assets 3,000,000 Expected return on plan assets 27,000,000$

Beginning value of plan assets 300,000,000$ Rate of return 10%Return on plan assets 30,000,000 Beginning value of plan assets 300,000,000$ Adjustment (10% - 9%) 1%Adjusted for gain on plan assets 3,000,000 Expected return on plan assets 27,000,000$

Service cost 41$ Interest cost 24 Expected return on the plan assets (27) Amortization of prior service cost Amortization of net lossPension expense 38$

Global's 2011 Pension Expense ($ in millions)

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Amortization of Prior Service Cost

In 2010, Global Communications amended the pension plan, increasing the PBO at that time. For all plan participants, the prior service cost was $60

million at 1/1/10. The average remaining service life of the active employee group is 15 years.

$60,000,000 PSC ÷ 15 = $4,000,000 per year

Service cost 41$ Interest cost 24 Expected return on the plan assets (27) Amortization of prior service cost 4Amortization of net loss Pension expense 42$

Global's 2011 Pension Expense ($ in millions)

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Gains and Losses

Projected Benefits Obligation

Return on Plan Assets

Higher than Expected Loss Gain

Low er than Expected Gain Loss

Only if a net gain or net loss exceeds the “corridor” is a charge to pension

expense allowed.

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Corridor Amount

The corridor The corridor amount is 10% of amount is 10% of

the the greatergreater of of

PBO at the PBO at the beginning of the beginning of the period.period.

Fair value of plan Fair value of plan assets at the assets at the beginning of the beginning of the period.period.

OrOr

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Gains and Losses

Net unrecognized gain or loss at beginning of year

Average remaining service period of activeemployees expected to receive benefits under the plan

Corridor amount

־

If the beginning net unrecognized gain or loss exceeds the corridor amount,

amortization is recognized using the following formula . . .

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Gains and Losses

2011 Net Loss Amortization ($ in millions)

PBO 400$

Fair value of plan assets 300

Net loss for 2011 55

Average service life 15

Net loss 55$

Corridor amount ($400 x 10%) 40

Excess at the beginning of the year 15$

$15,000,000 $15,000,000 ÷ 15 years = $1,000,000÷ 15 years = $1,000,000

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Determining Pension Expense

Service cost 41$ Interest cost 24 Expected return on the plan assets (27) Amortization of prior service cost 4Amortization of net loss 1Pension expense 43$

Global's 2011 Pension Expense ($ in millions)

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Recording Gains and Losses

For 2011, the actual return on plan assets exceeded the expected return by $3 million. In addition, there was a $23

million loss from changes made by the actuary when it revised its estimate of future salary levels causing its PBO

estimate to increase. Global would make the following journal entry to record the gain and loss:

OCI = Other comprehensive income

Loss—OCI 23,000,000PBO 23,000,000

Plan assets 3,000,000Gain—OCI 3,000,000

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RECORD PENSION EXPENSE IN 2009 ($ in millions)

Pension expense (calculated above) 43Plan assets ($27 expected return on assets) 27

PBO ($41 service cost + $24 interest cost) 65Amortization of prior service cost–OCI 4Amortization of net loss–OCI 1

OCI = Other comprehensive income

Service cost and interest cost add to Global’s PBO. The return on plan assets adds to the plan assets. Amortization of OCI items also is OCI.

Service cost $41Interest cost 24Expected return on plan assets ($30 actual, less $3 gain) (27)Amortization of prior service cost 4Amortization of net loss 1 Pension expense $43

65 PBO27 Less: plan assets 38 Net pension liability

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Recording the Funding of Plan Assets

Plan assets 48,000,000Cash 48,000,000

It’s not unusual for the cash contribution to differ from that year’s pension expense. After all,

determining the periodic pension expense and the funding of the pension plan are two separate

processes.

When Global adds its annual cash investment of $48 million to its plan assets, the value of those plan

assets increases by $48 million.

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Recording the Funding of Plan Assets

PBO 38,000,000 Plan assets 38,000,000

Global pays $38 million in retirement pension benefits.

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U. S. GAAP vs. IFRS

• Permits but does not require that gains and losses be included among OCI items in the statement of comprehensive income.

• Gains and losses become part of Unrecognized net gain or loss reported as an offset or increase to the net pension liability (or net pension asset) in the liability section of the balance sheet.

• Requires that gains and losses be included among OCI items in the statement of comprehensive income.

• Gains and losses become part of AOCI in the shareholders’ equity section of the balance sheet.

Differences in accounting for actuarial gains and losses using U.S. GAAP and IFRS.

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U. S. GAAP vs. IFRS

U.S. GAAP and IFRS treat prior service cost (PSC) differently.

• PSC is expensed immediately to the extent it relates to benefits that have vested. The amount not yet expensed (nonvested portion) is reported as an offset or increase to the defined benefit obligation.

• PSC is included among OCI items in the statement of comprehensive income and thus subsequently becomes part of AOCI where it is amortized over the average remaining service period.

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Comprehensive Income

Comprehensive income is a more expansive view of income than traditional net income.

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Comprehensive Income

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U. S. GAAP vs. IFRS

As part of a joint project with the FASB, the IASB issued a revised version of IAS No.1, “Presentation of Financial Statements,” that revised the standard to bring international reporting of comprehensive

income largely in line with U.S. standards. IFRS does not permit reporting other comprehensive income in the statement of shareholders’ equity.

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PENSION SPREADSHEET( )s indicate credits; debits otherwise

($ in millions)

PBO

Plan Assets

Prior

Service Cost-AOCI

Net Loss-AOCI

Pension Expense

Cash

Net

Pension (Liability)

/ Asset

Balance, Jan. 1, 2011 (400) 300 56 55 (100)

Service cost (41) 41 (41)

Interest cost, 6% (24) 24 (24)

Expected return on assets 27 (27) 27

Gain on assets 3 (3) 3

Amortization of:

Prior service cost-AOCI (4) 4

Net loss-AOCI (1) 1

Prior service cost (new)* (0) 0 0

Loss on PBO (23) 23 (23)

Contributions to fund 48 (48) 48

Retiree benefits paid 38 (38)

Balance, Dec. 31, 2011 (450) 340 52 74 43 (110)

*This amount was $60 million in the 2009 pension spreadsheet.

ReportedRecorded in Accounts Only

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U. S. GAAP vs. IFRS

Under IFRS there is no requirement to present the various components of pension expense as

a single net amount.

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Postretirement Benefits Other Than Pensions

Estimated medicalEstimated medicalcosts in eachcosts in each

year of retirementyear of retirement

Estimated medicalEstimated medicalcosts in eachcosts in each

year of retirementyear of retirement

Estimated Estimated netnetcost of benefitscost of benefitsEstimated Estimated netnet

cost of benefitscost of benefits

RetireeRetireeshare ofshare of

costcost

RetireeRetireeshare ofshare of

costcost

MedicareMedicarepaymentspaymentsMedicareMedicarepaymentspayments

Less:Less:

Equals:Equals:

Net Cost of BenefitsMany companies also furnish other

postretirement benefits to their

retired employees.

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Postretirement Benefit Obligation

1. Expected Postretirement Benefit Obligation (EPBO) – The actuary's estimate of the total postretirement benefits (at their discounted present value) expected to be received by plan participants.

2. Accumulated Postretirement Benefit Obligation (APBO) – The portion of the EPBO attributed to employee service to date.

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POSTRETIREMENT BENEFIT OBLIGATION

Assume the actuary estimates the net cost of providing health care benefits to a particular employee during her retirement years to have a present value of $10,842 as of the end of 2009. This is the EPBO. If the benefits (and therefore the costs) relate to an estimated 35 years of service and 10 of those years have been completed, the APBO would be:

2009 $10,842 x 10/35 = $3,098 EPBO fraction APBO

attributed

x 1.06

2010 $11,492 x 11/35 = $3,612 EPBO fraction APBO

attributed

The obligation increases by the 6% accrued interest

She now has worked 11 of her estimated 35 years

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HOW THE APBO CHANGED

APBO at the beginning of the year $3,098

Interest cost: $3,098 x 6% 186

Service cost: ($11,492 x 1/35) 328

portion of EPBO

attributed to the year

APBO at the end of the year $3,612

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Attribution

The process of The process of assigningassigning the cost of the cost of benefits to the years during which benefits to the years during which those benefits are those benefits are assumed to be assumed to be

earned earned by employees.by employees.

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Accounting for Postretirement Benefit Plans Other Than Pensions

Measuring Service Cost

Attribute a portion of the accumulated postretirement benefit obligation to each year

as the service cost for that year.

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Appendix 17: Service Method of Allocating Prior Service Cost

The allocation approach that reflects the declining service pattern of employees is called the service

method. The method requires that the total number of service years for all employees be calculated. This calculation is usually done by the actuary.

Assume Global Communications has 2,000 employees Assume Global Communications has 2,000 employees and the company’s actuary determined that the total and the company’s actuary determined that the total

number of service years of these employees is 30,000. number of service years of these employees is 30,000. We would calculate the following amortization We would calculate the following amortization

fraction:fraction:

Assume Global Communications has 2,000 employees Assume Global Communications has 2,000 employees and the company’s actuary determined that the total and the company’s actuary determined that the total

number of service years of these employees is 30,000. number of service years of these employees is 30,000. We would calculate the following amortization We would calculate the following amortization

fraction:fraction:

30,00030,0002,0002,000 == 15 average service years15 average service years

End of Chapter 17