Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Pensions and Other...

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Pensions and Other

Postretirement Benefits

17

17-2

Nature of Pension Plans

SponsorSponsor

I agree to make payments I agree to make payments into a fund for future into a fund for future

retirement benefits for retirement benefits for employee services.employee services.

ParticipantParticipant

I am the employee for I am the employee for whom the pension plan whom the pension plan

provides benefits.provides benefits.

17-3


For a pension plan to qualify for special tax For a pension plan to qualify for special tax treatment it must meet the following requirements:treatment it must meet the following requirements:

1.1. Cover at least 70% of employees.Cover at least 70% of employees.

2.2. Cannot discriminate in favor of highly Cannot discriminate in favor of highly compensated employees.compensated employees.

3.3. Must be funded in advance of retirement through Must be funded in advance of retirement through a trust.a trust.

4.4. Benefits must vest after a specified period of Benefits must vest after a specified period of service.service.

5.5. Complies with timing and amount of contributions.Complies with timing and amount of contributions.

17-4


The right to receive earned pension The right to receive earned pension benefits benefits vestvest (vested benefits) when it is (vested benefits) when it is

no longer contingent on continued no longer contingent on continued employment. employment.

17-5

Learning Objectives

Explain the fundamental differences between a defined contribution pension plan and a

defined benefit pension plan.

17-6

Contributions are Contributions are established by established by

formula or formula or contract.contract.

Contributions are Contributions are established by established by

formula or formula or contract.contract.

Employer deposits Employer deposits an agreed-upon an agreed-upon amount into an amount into an

employee-directed employee-directed investment fund.investment fund.

Employer deposits Employer deposits an agreed-upon an agreed-upon amount into an amount into an

employee-directed employee-directed investment fund.investment fund.

Employee Employee bears all risk of bears all risk of pension fund pension fund performance.performance.

Employee Employee bears all risk of bears all risk of pension fund pension fund performance.performance.

Defined Contribution Defined Contribution PlansPlans

Defined Contribution Defined Contribution PlansPlans

17-7

Employer is Employer is committed to committed to

specified specified retirement retirement benefitsbenefits..

Employer is Employer is committed to committed to

specified specified retirement retirement benefitsbenefits..

Retirement Retirement benefits are based benefits are based on a formula that on a formula that

considers years of considers years of service, service,

compensation compensation level, and age.level, and age.

Retirement Retirement benefits are based benefits are based on a formula that on a formula that

considers years of considers years of service, service,

compensation compensation level, and age.level, and age.

Employer bears Employer bears all risk of all risk of

pension fund pension fund performance.performance.

Employer bears Employer bears all risk of all risk of

pension fund pension fund performance.performance.

Defined Benefit Defined Benefit Pension PlansPension Plans

Defined Benefit Defined Benefit Pension PlansPension Plans

17-8

Defined Benefit Plan

Pension expense is measured by Pension expense is measured by assigning pension benefits to periods assigning pension benefits to periods of employee service as defined by the of employee service as defined by the

pension benefit formulapension benefit formula..

Pension expense is measured by Pension expense is measured by assigning pension benefits to periods assigning pension benefits to periods of employee service as defined by the of employee service as defined by the

pension benefit formulapension benefit formula..

A typical benefit formula might be:A typical benefit formula might be:1% 1% × Years of Service × Final year’s salary× Years of Service × Final year’s salary

So, for 35 years of service and a final salary of $80,000, So, for 35 years of service and a final salary of $80,000, the employee would receive:the employee would receive:1% × 35 × $80,000 = $28,000 per year1% × 35 × $80,000 = $28,000 per year

17-9

Pension Expense – An Overview

Components of Pension Expense+ Service cost ascribed to employee service this period+ Interest accrued on pension liability

+ or - Return on plan assets+ Amortized portion of Prior Service Cost

+ or - Losses or gains from revision of pension liability and plan assets= Pension expense

17-10

Learning Objectives

Distinguish among the vested benefit obligation, the accumulated benefit obligation,

and the projected benefit obligation.

17-11

Pension Obligation

Present value of Present value of benefits at present benefits at present

pay levels.pay levels.

Present value of Present value of nonvested benefits nonvested benefits

at present pay at present pay levels.levels.

Present value of Present value of additional benefits additional benefits related to projected related to projected

pay increases.pay increases.

VBOVBO ABOABO PBOPBO

Accumulated Accumulated Benefit ObligationBenefit Obligation

Projected Benefit Projected Benefit ObligationObligation

Vested Benefit Vested Benefit ObligationObligation

17-12

Learning Objectives

Describe the five events that might change the balance of the PBO.

17-13

Projected Benefit Obligation

The PBO changes as a result of:Cause Effect Frequency

Service Cost + Each period

Interest Cost+

Each period (except the first period of the plan)

Prior Service Cost +

Only if the plan is amended (or initiated) that period

Loss or Gain on PBO + or -

Whenever revisions are made in the pension liability estimate

Retiree Benefits Paid -

Each period (unless no employees have yet retired under the plan)



Interest Cost+








17-14



Interest Cost+










Interest Cost+








Pension Obligation

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

performed during the period.performed during the period.

17-15



Interest Cost+










Interest Cost+








Pension Obligation

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

17-16



Interest Cost+










Interest Cost+








Pension Obligation

Prior service costPrior service cost effects result from effects result from changes in the pension benefit changes in the pension benefit

formula or plan terms.formula or plan terms.

17-17



Interest Cost+










Interest Cost+








Pension Obligation

Loss or gain on PBOLoss or gain on PBO results from results from required revisions of estimates used required revisions of estimates used

to determine PBO.to determine PBO.

17-18



Interest Cost+










Interest Cost+








Pension Obligation

Retiree benefits paidRetiree benefits paid are the are the result of paying benefits to retired result of paying benefits to retired

employees.employees.

17-19

Learning Objectives

Explain how plan assets accumulate to provide retiree benefits and understand the role of the

trustee in administering the fund.

17-20

Pension Plan Assets

Pension plan assets (like the PBO) are not formally recognized on the balance sheet.

A trustee manages the pension plan assets.

17-21

Pension Plan Assets

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.

17-22

Learning Objectives

Describe how pension expense is a composite of periodic changes that occur in both the pension obligation and the plan assets.

17-23

Pension Expense

Pension expense is the Pension expense is the net costnet cost of: of: Service costService cost Interest costInterest cost Return on plan assetsReturn on plan assets Amortization of prior service costsAmortization of prior service costs Gain or loss recognized.Gain or loss recognized.

17-24

Defined Benefit PlanYou go to work for Matrix, Inc. on 1/1/06. You are eligible to participate You go to work for Matrix, Inc. on 1/1/06. You are eligible to participate in the company's defined benefit pension plan. The benefit formula is:in the company's defined benefit pension plan. The benefit formula is:

Annual salary in year of retirement

× Number of years of service

× 1.5%

Annual retirement benefits

You are 25 years old when you start work and may accumulate 40 years You are 25 years old when you start work and may accumulate 40 years of service before retiring at age 65. If your salary is $200,000 during of service before retiring at age 65. If your salary is $200,000 during your last year of service, you will receive the following annual benefits:your last year of service, you will receive the following annual benefits:

$200,000

× 40

× 1.5%

$120,000

You are not required to make any contributions. The plan vests at the You are not required to make any contributions. The plan vests at the rate of 20% per year. The plan actuary estimates that upon reaching rate of 20% per year. The plan actuary estimates that upon reaching age 65, you will receive payments for 15 years. The actuary uses an 8% age 65, you will receive payments for 15 years. The actuary uses an 8% discount rate in all present value computations.discount rate in all present value computations.

17-25


At December 31, 2006, the end of your first year of service, the At December 31, 2006, the end of your first year of service, the actuary must calculate the present value of the pension benefits actuary must calculate the present value of the pension benefits earned by you during 2005. Remember that you will not receive earned by you during 2005. Remember that you will not receive pension benefits until you are 65 and the actuary estimates pension benefits until you are 65 and the actuary estimates payments will be made for 15 years after you retire. After one year payments will be made for 15 years after you retire. After one year of service you will have earned $3,000 in pension benefits:of service you will have earned $3,000 in pension benefits:

Pension benefits = .015 Pension benefits = .015 ×× 1 yr of service 1 yr of service ×× $200,000 $200,000

Pension benefits = $3,000Pension benefits = $3,000 Service cost is the present value of these benefits and is calculated Service cost is the present value of these benefits and is calculated as follows:as follows:

Service cost = $3,000 Service cost = $3,000 ×× 8.55948 8.5594811 ×× .049713 .04971322

Service cost = $1,277Service cost = $1,277

11Present value of an ordinary annuity at 8% for 15 years.Present value of an ordinary annuity at 8% for 15 years.

22Present value of $1 at 8% for 39 years.Present value of $1 at 8% for 39 years.

17-26


Based on the given information, the actuary calculates Based on the given information, the actuary calculates your accumulated benefit obligation (ABO) as follows:your accumulated benefit obligation (ABO) as follows:

Retirement benefits = .015 Retirement benefits = .015 ×× 1 yr 1 yr ×× $25,000 $25,000

Retirement benefits = $375Retirement benefits = $375

ABO = $375 ABO = $375 ×× 8.55948 8.55948 ×× .049713 .049713

ABO = $160ABO = $160 Your vested benefit obligation (VBO) is calculated as Your vested benefit obligation (VBO) is calculated as follows:follows:

Vested benefits = .015 Vested benefits = .015 ×× 1 1 ×× $25,000 $25,000 ×× .2 .2

Vested benefits = $75Vested benefits = $75

VBO = $75 VBO = $75 ×× 8.55948 8.55948 ×× .049713 .049713

VBO = $32VBO = $32

17-27


A reconciliation of the VBO, ABO and PBO would look like thisA reconciliation of the VBO, ABO and PBO would look like this:

VBO

$ 32

Non-vested benefits

128

ABO

$ 160

Adjustment for future salary

478

PBO

$ 638

The adjustment for future salary of $478, is determine by the The adjustment for future salary of $478, is determine by the plan actuary. If you are the only employee at Matrix, the plan actuary. If you are the only employee at Matrix, the computations would be similar for future years. Let’s assume computations would be similar for future years. Let’s assume Matrix funds $500 of its pension costs with the plan trustee Matrix funds $500 of its pension costs with the plan trustee on December 31, 2006. The journal entry to record the on December 31, 2006. The journal entry to record the pension costs and funding would be:pension costs and funding would be:

Pension expense

638

Accrued pension cost

138

Cash

500

17-28


Let’s look at an example for Matrix, Inc.Let’s look at an example for Matrix, Inc.


+ or - Return on plan assets+ Amortized portion of prior service cost



+ or - Return on plan assets+ Amortized portion of prior service cost


17-29


Actuaries have determined that Matrix, Inc. Actuaries have determined that Matrix, Inc. has service cost of $150,000 in 2006 and has service cost of $150,000 in 2006 and

$155,000 in 2007.$155,000 in 2007.

We can begin the process of determining We can begin the process of determining pension expense for the company.pension expense for the company.

17-30

Service Cost

17-31

Interest Cost

Interest costInterest cost is the growth in PBO is the growth in PBO during a reporting period.during a reporting period.

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

PBOPBOBegBeg × Discount rate × Discount rate

17-32

Interest Cost

Actuaries determined that Matrix, Inc. Actuaries determined that Matrix, Inc. had PBO of $500,000 on 1/1/06, and had PBO of $500,000 on 1/1/06, and

$640,000 on 1/1/07. $640,000 on 1/1/07.

The actuary uses a discount rate of 10%.The actuary uses a discount rate of 10%.

17-33

Interest Cost

2006: PBO 1/1/06 $500,000 × 10% = $50,0002006: PBO 1/1/06 $500,000 × 10% = $50,000

2007: PBO 1/1/07 $640,000 × 10% = $64,0002007: PBO 1/1/07 $640,000 × 10% = $64,000

17-34

Return on Plan Assets

Trustee’s estimate of Trustee’s estimate of long-term rate of long-term rate of

return.return.

Expected Expected ReturnReturn

Expected Expected ReturnReturn

The dividends, interest, The dividends, interest, and capital gains and capital gains

generated by the fund generated by the fund during the period.during the period.

Actual Actual ReturnReturnActual Actual ReturnReturn

17-35


The plan trustee reports that plan The plan trustee reports that plan assets were $450,000 on 1/1/06, assets were $450,000 on 1/1/06,

and $600,000 on 1/1/07. and $600,000 on 1/1/07.

The trustee uses an expected return The trustee uses an expected return of 9% and the actual return is 10% of 9% and the actual return is 10%

in both years.in both years.

17-36


Beginning value of plan assets 450,000$ Rate of return 10%Return on plan assets 45,000 Beginning value of plan assets 450,000$ Adjustment (10% - 9%) 1%Adjusted for gain on plan assets 4,500 Expected return on plan assets 40,500$


20062006



20072007

17-37


17-38

Amortization of Prior Service Cost

Prior service cost (PSC)Prior service cost (PSC) results from plan results from plan amendments granting increased pension amendments granting increased pension benefits for service rendered before the benefits for service rendered before the

amendment.amendment.

PSC is the present value of the retroactive PSC is the present value of the retroactive benefits, and increases PBO.benefits, and increases PBO.

17-39


Benefits attributable to prior service are Benefits attributable to prior service are assumed to benefit future periods by:assumed to benefit future periods by:

Improving employee productivity.Improving employee productivity.

Improving employee morale.Improving employee morale.

Reducing turnover.Reducing turnover.

Reducing demands for pay raises.Reducing demands for pay raises.

17-40


PSC is PSC is amortizedamortized over the remaining service period over the remaining service period of those employees active at the date of the of those employees active at the date of the

amendment who are expected to receive benefits amendment who are expected to receive benefits under the plan.under the plan.

If most of a plan’s participants are inactive, then If most of a plan’s participants are inactive, then amortize PSC over the participants’ remaining life amortize PSC over the participants’ remaining life

expectancy.expectancy.

17-41


Two approaches to amortizing PSC:Two approaches to amortizing PSC: Straight-line methodStraight-line method

Amortize PSC over the average remaining Amortize PSC over the average remaining service period. service period.

Service methodService methodAmortize PSC by allocating equal amounts to Amortize PSC by allocating equal amounts to

each employee’s service years remaining.each employee’s service years remaining.

17-42


Effective 1/1/07, Matrix, Inc. amends the retirement Effective 1/1/07, Matrix, Inc. amends the retirement plan to provide increased benefits attributable to plan to provide increased benefits attributable to

service performed before 1/1/03, for all active service performed before 1/1/03, for all active employees. employees.

The present value of the increased benefits (PSC) at The present value of the increased benefits (PSC) at 1/1/07, is $60,000.1/1/07, is $60,000.

The average remaining service life of the active The average remaining service life of the active employee group is 12 years.employee group is 12 years.

Effective 1/1/07, Matrix, Inc. amends the retirement Effective 1/1/07, Matrix, Inc. amends the retirement plan to provide increased benefits attributable to plan to provide increased benefits attributable to

service performed before 1/1/03, for all active service performed before 1/1/03, for all active employees. employees.

The present value of the increased benefits (PSC) at The present value of the increased benefits (PSC) at 1/1/07, is $60,000.1/1/07, is $60,000.

The average remaining service life of the active The average remaining service life of the active employee group is 12 years.employee group is 12 years.

17-43


Since the amendment was not effective Since the amendment was not effective until the beginning of 2007, pension until the beginning of 2007, pension

expense for 2006 is not affected.expense for 2006 is not affected.

2007: $60,000 PSC 2007: $60,000 PSC ÷÷ 12 = $5,000 12 = $5,000

17-44


17-45

Gains and Losses

Projected Benefits

ObligationReturn on

Plan AssetsHigher than Expected Loss Gain

Lower than Expected Gain Loss

17-46

Corridor Amount

Amortization is not required if the net Amortization is not required if the net unrecognized gain or loss at the unrecognized gain or loss at the

beginning of the period is a minimum beginning of the period is a minimum amount amount (corridor amount)(corridor amount)..

17-47

Corridor Amount

The corridor The corridor amount is 10% of amount is 10% of the greater of . . .the greater 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

17-48

Gains and Losses

If the beginning net unrecognized gain or If the beginning net unrecognized gain or loss exceeds the corridor amount, loss exceeds the corridor amount, amortization is recognized as . . . amortization is recognized as . . .

If the beginning net unrecognized gain or If the beginning net unrecognized gain or loss exceeds the corridor amount, loss exceeds the corridor amount, amortization is recognized as . . . amortization is recognized as . . .

Net unrecognized gain or lossNet unrecognized gain or loss at beginning of yearat beginning of year

Average remaining service period of active employees Average remaining service period of active employees expected to receive benefits under the planexpected to receive benefits under the plan

Corridor Corridor amountamount

— —

17-49

Gains and Losses

Let’s determine the amortization of the Let’s determine the amortization of the net gain in 2007.net gain in 2007.

Amounts at January 1, 2007

PBO 640,000$

Fair value of plan assets 600,000

Net gain for 2007 73,000

Average service life 9

There was no gain or loss amortized in 2006.There was no gain or loss amortized in 2006.

17-50

Gains and Losses

Corridor amount ($640,000 x 10%) 64,000$

Net gain for 2007 73,000

Gain in excess of corridor 9,000$

$9,000 $9,000 ÷ 9 years = $1,000 per year.÷ 9 years = $1,000 per year.

17-51

Pension Expense

17-52

Pension Expense

Matrix contributed $200,000 to the plan Matrix contributed $200,000 to the plan trustee at the end of 2007. The journal entry trustee at the end of 2007. The journal entry

to record the pension expense is:to record the pension expense is:

17-53

Learning Objectives

Understand the interrelationships among the elements that constitute a defined benefit

pension plan.

17-54

Reconciliation of Pension Amounts

Four “off-balance sheet” accounts:Four “off-balance sheet” accounts:PBOPBOPlan AssetsPlan AssetsUnamortized PSCUnamortized PSCUnamortized Gain or LossUnamortized Gain or Loss

Four “off-balance sheet” accounts:Four “off-balance sheet” accounts:PBOPBOPlan AssetsPlan AssetsUnamortized PSCUnamortized PSCUnamortized Gain or LossUnamortized Gain or Loss

17-55

Reconciliation of Pension Amounts

The four amounts shown on the The four amounts shown on the previous slide combine to account for previous slide combine to account for

the the oneone pension account that is pension account that is reported on the balance sheet:reported on the balance sheet:

prepaid pension asset prepaid pension asset oror pension pension liability. liability.

The four amounts shown on the The four amounts shown on the previous slide combine to account for previous slide combine to account for

the the oneone pension account that is pension account that is reported on the balance sheet:reported on the balance sheet:

prepaid pension asset prepaid pension asset oror pension pension liability. liability.

17-56

Minimum Liability

To discourage To discourage underreportingunderreporting of of pension liability, pension liability, SFAS No. 87SFAS No. 87

requires recognition of an additional requires recognition of an additional minimum pension liability under minimum pension liability under

certain circumstances.certain circumstances.

17-57

Measurement Issue

Accumulated Benefit Obligation (ABO)

- Plan Assets at Fair Value

Minimum Pension Liability

Accumulated Benefit Obligation (ABO)

- Plan Assets at Fair Value

Minimum Pension Liability

This amount is also called the This amount is also called the underfundedunderfunded ABO. ABO.

17-58

Offsetting

SFAS No. 87 requires offsetting of the SFAS No. 87 requires offsetting of the pension liability and the plan assets pension liability and the plan assets

when determining the minimum liability.when determining the minimum liability.

SFAS No. 87 requires offsetting of the SFAS No. 87 requires offsetting of the pension liability and the plan assets pension liability and the plan assets

when determining the minimum liability.when determining the minimum liability.

17-59

Additional Liability

An additional pension liability is recognized if total An additional pension liability is recognized if total minimum liability minimum liability exceedsexceeds accrued pension cost. accrued pension cost.

Total minimum liability

Accrued pension cost balance (liability)

Additional pension liability balance

Total minimum liability

Prepaid pension cost balance (asset)

Additional pension liability balance

–

+

17-60

Learning Objectives

Describe how pension disclosures fill a reporting gap left by the minimal disclosures in

the primary financial statements.

17-61

Pension Disclosures – A Compromise

The pension information actually reported in the financial statements falls short of the conceptual ideal and even shy

of the FASB’s own preferences. Here are the items included in the income statement and balance sheet.

Income StatementPension expense

Balance SheetAssets:

Intangible pension assetLiabilities:

Pension liabilityShareholders' equity:

Accumulated other comprehensive income:Unrealized pension cost

17-62

Settlements and Curtailments

Pension plan Pension plan settlementssettlementsReduce PBO and are viewed as the realization of a Reduce PBO and are viewed as the realization of a

portion of the net unrecognized gain or loss and a portion of the net unrecognized gain or loss and a portion of the unrecognized transition asset.portion of the unrecognized transition asset.

Pension plan Pension plan curtailmentscurtailmentsOften reduce PBO, resulting in a gain, which reduces Often reduce PBO, resulting in a gain, which reduces

accrued pension cost.accrued pension cost.

17-63

Learning Objectives

Describe the nature of postretirement benefit plans other than pensions and identify the

similarities and differences in accounting for those plans and pensions.

17-64

Postretirement Benefit Plan

Encompass all types of retiree health and Encompass all types of retiree health and welfare benefits including . . .welfare benefits including . . .

Medical coverage,Medical coverage, Dental coverage,Dental coverage, Life insurance,Life insurance, Group legal services, andGroup legal services, and Other benefits.Other benefits.

17-65

Postretirement Health Benefits andPension Benefits Compared

Pension Plan BenefitsPension Plan BenefitsUsually based on Usually based on years of service.years of service.

Identical payments Identical payments for same years of for same years of service.service.

Cost of plan usually Cost of plan usually paid by employer.paid by employer.

Vesting usually Vesting usually required.required.

Pension Plan BenefitsPension Plan BenefitsUsually based on Usually based on years of service.years of service.

Identical payments Identical payments for same years of for same years of service.service.

Cost of plan usually Cost of plan usually paid by employer.paid by employer.

Vesting usually Vesting usually required.required.

Postretirement Health Postretirement Health BenefitsBenefitsTypically unrelated to Typically unrelated to service.service.

Payments vary Payments vary depending on depending on medical needs.medical needs.

Company and retiree Company and retiree share the costs.share the costs.

True vesting does True vesting does not exist.not exist.

Postretirement Health Postretirement Health BenefitsBenefitsTypically unrelated to Typically unrelated to service.service.

Payments vary Payments vary depending on depending on medical needs.medical needs.

Company and retiree Company and retiree share the costs.share the costs.

True vesting does True vesting does not exist.not exist.

17-66

The Net Cost of Benefits

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:

17-67

The Net Cost of Benefits

Estimating postretirement health care benefits is Estimating postretirement health care benefits is like estimating pension benefits, but there are like estimating pension benefits, but there are

some additional assumptions required:some additional assumptions required: Current cost of providing health care benefits (per Current cost of providing health care benefits (per

capita claims cost).capita claims cost). Demographic characteristics of participants.Demographic characteristics of participants. Benefits provided by Medicare.Benefits provided by Medicare. Expected health care cost trend rate.Expected health care cost trend rate.

Estimating postretirement health care benefits is Estimating postretirement health care benefits is like estimating pension benefits, but there are like estimating pension benefits, but there are

some additional assumptions required:some additional assumptions required: Current cost of providing health care benefits (per Current cost of providing health care benefits (per

capita claims cost).capita claims cost). Demographic characteristics of participants.Demographic characteristics of participants. Benefits provided by Medicare.Benefits provided by Medicare. Expected health care cost trend rate.Expected health care cost trend rate.

17-68

Learning Objectives

Explain how the obligation for postretirement benefits is measured and how the obligation

changes.

17-69

Postretirement Benefit Obligation

Accumulated (APBO)Accumulated (APBO)The portion of the EPBO The portion of the EPBO attributed to employee attributed to employee

service to date.service to date.

Accumulated (APBO)Accumulated (APBO)The portion of the EPBO The portion of the EPBO attributed to employee attributed to employee

service to date.service to date.

Expected (EPBO)Expected (EPBO)The actuary’s estimate of the total The actuary’s estimate of the total

postretirement benefits (at their postretirement benefits (at their discounted present value) expected discounted present value) expected to be received by plan participants.to be received by plan participants.

Expected (EPBO)Expected (EPBO)The actuary’s estimate of the total The actuary’s estimate of the total

postretirement benefits (at their postretirement benefits (at their discounted present value) expected discounted present value) expected to be received by plan participants.to be received by plan participants.

17-70

Measuring the Obligation

On December 31, our actuary estimates that the On December 31, our actuary estimates that the present value of the expected benefit obligation for present value of the expected benefit obligation for your postretirement health care costs is $10,250. your postretirement health care costs is $10,250. You have worked for the company for 6 years and You have worked for the company for 6 years and

are expected to have 30 years of service at are expected to have 30 years of service at retirement. The actuary uses a 6% discount rate.retirement. The actuary uses a 6% discount rate.

Let’s calculate the APBO. Let’s calculate the APBO.

On December 31, our actuary estimates that the On December 31, our actuary estimates that the present value of the expected benefit obligation for present value of the expected benefit obligation for your postretirement health care costs is $10,250. your postretirement health care costs is $10,250. You have worked for the company for 6 years and You have worked for the company for 6 years and

are expected to have 30 years of service at are expected to have 30 years of service at retirement. The actuary uses a 6% discount rate.retirement. The actuary uses a 6% discount rate.

Let’s calculate the APBO. Let’s calculate the APBO.

17-71


EPBOEPBO

Fractionattributed toservice to

date

Fractionattributed toservice to

date

APBOAPBO×× ==

$10,250$10,250 663030 = $2,050= $2,050××

APBO at the beginning of the year.APBO at the beginning of the year.APBO at the beginning of the year.APBO at the beginning of the year.

17-72


EPBOEPBOBeginningBeginning

of Yearof Year×× (1 + Discount Rate)(1 + Discount Rate) ==

EPBOEPBOEnd End

of Yearof Year

To calculate the APBO at the end of the year, To calculate the APBO at the end of the year, we start by determining the ending EPBO.we start by determining the ending EPBO.

$10,250 × 1.06 = $10,865$10,250 × 1.06 = $10,865

APBO End APBO End of Yearof Year$10,865$10,865 ××

77 3030 = $2,535= $2,535

17-73


APBO may also be calculated like this:APBO may also be calculated like this:

The APBO increases because of interestThe APBO increases because of interestand the service fraction (service cost).and the service fraction (service cost).

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Attribution

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

earned by employees.earned by employees.

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Learning Objectives

Determine the components of postretirement benefit expense.

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Postretirement Benefit Expense

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Interest accrues on the APBO as time passes.Interest accrues on the APBO as time passes.APBO at the beginning of the year times theAPBO at the beginning of the year times the

assumed discount rate equals the interest cost.assumed discount rate equals the interest cost.

Interest accrues on the APBO as time passes.Interest accrues on the APBO as time passes.APBO at the beginning of the year times theAPBO at the beginning of the year times the

assumed discount rate equals the interest cost.assumed discount rate equals the interest cost.

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Unlike pension plans, many postretirement benefitUnlike pension plans, many postretirement benefitplans are not funded currently. For funded plans, theplans are not funded currently. For funded plans, the

earnings on plan assets reduce postretirementearnings on plan assets reduce postretirementbenefit expense.benefit expense.

Unlike pension plans, many postretirement benefitUnlike pension plans, many postretirement benefitplans are not funded currently. For funded plans, theplans are not funded currently. For funded plans, the

earnings on plan assets reduce postretirementearnings on plan assets reduce postretirementbenefit expense.benefit expense.

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Prior service cost is allocated over the averagePrior service cost is allocated over the averagetime from the date of the amendment to the time from the date of the amendment to the datedate

for active employeesfor active employees, not the expected, not the expectedretirement date.retirement date.

Prior service cost is allocated over the averagePrior service cost is allocated over the averagetime from the date of the amendment to the time from the date of the amendment to the datedate

for active employeesfor active employees, not the expected, not the expectedretirement date.retirement date.

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The amount subject to amortization is the net gain or loss atThe amount subject to amortization is the net gain or loss atthe beginning of the year in excess of 10% of the APBO orthe beginning of the year in excess of 10% of the APBO or10% of the plan assets. The excess is amortized over the10% of the plan assets. The excess is amortized over the

average remaining service period of active employees.average remaining service period of active employees.

The amount subject to amortization is the net gain or loss atThe amount subject to amortization is the net gain or loss atthe beginning of the year in excess of 10% of the APBO orthe beginning of the year in excess of 10% of the APBO or10% of the plan assets. The excess is amortized over the10% of the plan assets. The excess is amortized over the

average remaining service period of active employees.average remaining service period of active employees.

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Amortize Net Losses or Gains

APBOReturn on

Plan Assets

Higher Than Expected Loss Gain

Lower Than Expected Gain Loss

APBOReturn on

Plan Assets

Higher Than Expected Loss Gain

Lower Than Expected Gain Loss

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Amortization of the transition amount is part of expense in theAmortization of the transition amount is part of expense in thecurrent period. For financial reporting, the amortization reducescurrent period. For financial reporting, the amortization reducescurrent earnings. For income tax purposes, income is reducedcurrent earnings. For income tax purposes, income is reduced

when actual payments are made. This creates a temporarywhen actual payments are made. This creates a temporarydifference between financial and taxable income.difference between financial and taxable income.

Amortization of the transition amount is part of expense in theAmortization of the transition amount is part of expense in thecurrent period. For financial reporting, the amortization reducescurrent period. For financial reporting, the amortization reducescurrent earnings. For income tax purposes, income is reducedcurrent earnings. For income tax purposes, income is reduced

when actual payments are made. This creates a temporarywhen actual payments are made. This creates a temporarydifference between financial and taxable income.difference between financial and taxable income.

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Amortization of Transition Amount

An employer may choose to recognize:An employer may choose to recognize:

The entire transition obligation immediately,The entire transition obligation immediately, oror

Amortize the transition obligation on a straight-Amortize the transition obligation on a straight-line basis over the plan participants’ future line basis over the plan participants’ future service periods (or 20 years if that is longer).service periods (or 20 years if that is longer).

An employer may choose to recognize:An employer may choose to recognize:

The entire transition obligation immediately,The entire transition obligation immediately, oror

Amortize the transition obligation on a straight-Amortize the transition obligation on a straight-line basis over the plan participants’ future line basis over the plan participants’ future service periods (or 20 years if that is longer).service periods (or 20 years if that is longer).

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Determining the Expense

Recall our example of postretirement benefits.Recall our example of postretirement benefits.

Let’s calculate postretirement benefits expense.Let’s calculate postretirement benefits expense.

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Determining the Expense

The beginning APBO ($2,050) is the initial transition liability. The beginning APBO ($2,050) is the initial transition liability. Your service life is 24 years (30 - 6). The amortization amount Your service life is 24 years (30 - 6). The amortization amount

is is $85$85 rounded ($2,050 ÷ 24 years). rounded ($2,050 ÷ 24 years).

The beginning APBO ($2,050) is the initial transition liability. The beginning APBO ($2,050) is the initial transition liability. Your service life is 24 years (30 - 6). The amortization amount Your service life is 24 years (30 - 6). The amortization amount

is is $85$85 rounded ($2,050 ÷ 24 years). rounded ($2,050 ÷ 24 years).

Because most postretirement health plansBecause most postretirement health plansare not funded, there are no fund assets,are not funded, there are no fund assets,

no credit for prior service, and no net loss.no credit for prior service, and no net loss.

Because most postretirement health plansBecause most postretirement health plansare not funded, there are no fund assets,are not funded, there are no fund assets,

no credit for prior service, and no net loss.no credit for prior service, and no net loss.

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Pension Disclosures

• Description of the pension plan.Description of the pension plan.

• Estimates of the obligations PBO, ABO, vested benefit Estimates of the obligations PBO, ABO, vested benefit obligation, EPBO, and APBO).obligation, EPBO, and APBO).

• Description of the pension plan.Description of the pension plan.

• Estimates of the obligations PBO, ABO, vested benefit Estimates of the obligations PBO, ABO, vested benefit obligation, EPBO, and APBO).obligation, EPBO, and APBO).

The disclosure requirement of pension plans and postretirement benefits are very similar. On this and the next three screens are the disclosures for FedEx in the

Appendix to Chapter 1.

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Pension Disclosures

• The percentage of total plan assets for each major The percentage of total plan assets for each major category of assets (equity securities, debt securities, real category of assets (equity securities, debt securities, real estate, other) as well as a description of investment estate, other) as well as a description of investment strategies, including any target asset allocations and risk strategies, including any target asset allocations and risk management practices.management practices.

• A breakdown of the components of the annual pension and A breakdown of the components of the annual pension and postretirement benefit expenses for 2004, 2003, and 2002.postretirement benefit expenses for 2004, 2003, and 2002.

• The percentage of total plan assets for each major The percentage of total plan assets for each major category of assets (equity securities, debt securities, real category of assets (equity securities, debt securities, real estate, other) as well as a description of investment estate, other) as well as a description of investment strategies, including any target asset allocations and risk strategies, including any target asset allocations and risk management practices.management practices.

• A breakdown of the components of the annual pension and A breakdown of the components of the annual pension and postretirement benefit expenses for 2004, 2003, and 2002.postretirement benefit expenses for 2004, 2003, and 2002.

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Pension Disclosures

• A reconciliation of the changes in the plans’ benefit A reconciliation of the changes in the plans’ benefit obligation and fair value of assets over a two year period obligation and fair value of assets over a two year period ended May 31, 2004, and a statement of the funded ended May 31, 2004, and a statement of the funded status. status.

• The discount rates, the assumed rate of compensation The discount rates, the assumed rate of compensation increases used to measure the PBO, the expected long-increases used to measure the PBO, the expected long-term rate of return on plan assets and the expected rate term rate of return on plan assets and the expected rate of increase in future medical and dental benefit costs.of increase in future medical and dental benefit costs.

• A reconciliation of the changes in the plans’ benefit A reconciliation of the changes in the plans’ benefit obligation and fair value of assets over a two year period obligation and fair value of assets over a two year period ended May 31, 2004, and a statement of the funded ended May 31, 2004, and a statement of the funded status. status.

• The discount rates, the assumed rate of compensation The discount rates, the assumed rate of compensation increases used to measure the PBO, the expected long-increases used to measure the PBO, the expected long-term rate of return on plan assets and the expected rate term rate of return on plan assets and the expected rate of increase in future medical and dental benefit costs.of increase in future medical and dental benefit costs.

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Pension Disclosures

• Estimated benefit payments presented separately for Estimated benefit payments presented separately for years 2005-2009 and in the aggregate for years 2010-years 2005-2009 and in the aggregate for years 2010-2014. 2014.

• Estimate of expected contributions to fund the plan for Estimate of expected contributions to fund the plan for 2005.2005.

• Other information to make it possible for interested Other information to make it possible for interested analysts to reconstruct the financial statements with plan analysts to reconstruct the financial statements with plan assets and liabilities includedassets and liabilities included

• Estimated benefit payments presented separately for Estimated benefit payments presented separately for years 2005-2009 and in the aggregate for years 2010-years 2005-2009 and in the aggregate for years 2010-2014. 2014.

• Estimate of expected contributions to fund the plan for Estimate of expected contributions to fund the plan for 2005.2005.

• Other information to make it possible for interested Other information to make it possible for interested analysts to reconstruct the financial statements with plan analysts to reconstruct the financial statements with plan assets and liabilities includedassets and liabilities included

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Appendix 17

Service Method of Allocating Prior Service Cost

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The Service Method

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 Matrix, Inc. has 2,000 employees and the Assume Matrix, Inc. has 2,000 employees and the company’s actuary determined that the total number of company’s actuary determined that the total number of service years of these employees is 30,000. We would service years of these employees is 30,000. We would

calculate the following amortization fraction:calculate the following amortization fraction:

Assume Matrix, Inc. has 2,000 employees and the Assume Matrix, Inc. has 2,000 employees and the company’s actuary determined that the total number of company’s actuary determined that the total number of service years of these employees is 30,000. We would service years of these employees is 30,000. We would

calculate the following amortization fraction:calculate the following amortization fraction:

30,00030,0002,0002,000

== 15 average service years15 average service years

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End of Chapter 17

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Pensions and Other...

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