Pensions

RCJ Chapter 14

Key Issues
1. Types of pension plans: defined benefit vs. defined contribution 2. Pension liability: PBO, ABO, VBO 3. Assumptions: discount rate%, salary growth rate%, E(ROA)%, actuarial 4. PENSION assets 5. Primary (ongoing) factors 6. Journal entries 7. Smoothing of transitory gains and losses 12. Corridor amortization 13. Pension worksheet 8. Types of transitory gains and losses 14. Footnote disclosures 9. Additional factors 15. Correction JE 10. Funded status reconciliation 16. OPEBs 11. Minimum liability

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Structure of Pension Plan

firm or employee pension fund retiree
Cash Pay benefits

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Types of Pension Plans

1. Defined contribution: employee bears risk, no firm liability 2. Defined benefit: firm bears risk and has liability (our focus)

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Ex. Defined Benefit Plan

workers age = 60 service = 30 yrs so far retire @ 65 (5 more years) current salary = $50,000 Pension contract: X% per year * final salary (X = # of years of service @ retirement) Example: 35% x $50,000 = $17,500

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Pension Liabilities
Pension liability: discounted PV of expected future cash payments - like any other non-current liability (effective interest method). compare to other non-current liabilities: r% Bonds known Leases known? Pensions ? E(CF) known known ?

Both discount rate and expected cash flows are subjective

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3 Definitions of Liabilities

PBO = PV of expected payments, given expected future salaries

ABO= PV of expected payments, given current salaries

VBO =PV of vested portion of expected payments, given current salaries PBO ABO VBO Which definition is appropriate for which case? 1. valuing a going concern 2. Takeover 3. Firm in bankruptcy Well use PBO, unless otherwise stated.
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Key Assumptions

discount rate = r% salary growth rate = g% (for PBO) actuarial (life span, tenure, turnover, etc.)

What are managements incentives?

EROA% (expected rate of return on pension assets), see below

Q: Is liability bigger for older or younger workers?

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Ex. Defined Benefit Plan, Continued

Assumptions Expected salary growth rate = 5% Discount rate = 10% Life expectancy = 80 years (15 years in retirement)

Expected final salary = 50,000 * (1.05)5 = 63,814 30% * 63,814 = 19,144 = amount hell receive per year in retirement (based on service so far) PV of annuity factor, 10%, 15 yrs = 7.606 19,144 * 7.606 = 145,611 = PV @ retirement

PBO = 145,611/(1.10)5 = 90,413 = PV of annuity now ABO = (30% * 50,000 * 7.606)/1.105 = 70,841

PBO > ABO due to expected salary growth

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Primary (Ongoing) Factors Affecting PBO

PBO

DR pay benefits

+ CR Interest cost Service cost

def: interest cost = r% * PBO @ beginning of year

(remember: effective interest method) [debt accretion, like zero coupon bond]

def: service cost = PV of future benefits earned this year

Ex. E14-1, E14-13

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Ex. Defined Benefit Plan, Continued

Interest cost = 90413*.10 = 9041 Service cost = (1% * 63,814 * 7.606)/1.105 = 3014 Q: how does a higher or lower r% affect interest cost? Q: how does an employees age affect his service cost?

E14-1,13

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Pension Assets

Pension assets: FMV of assets (stocks, bonds, etc.) Funded status (true, economic position): Pension assets PBO Overfunded: assets > PBO Underfunded: assets < PBO Severely underfunded: assets < ABO

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Primary (Ongoing) Factors Affecting Pensions Assets

Assets

+ DR Funding (contribution) (ROA)Return on assets#

CR Pay benefits

# note: this is actual ROA; ROA is shown as +, but could be

Ex. E14-6, E14-13

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Primary Journal Entries

DR service, interest Funding (contributions) benefits ROA Pension expense Assets PBO Assets(actual ROA)* UNL CR PBO Cash Assets Pension Expense (expected ROA= EROA%*beginning assets) or UNG

* note: actual ROA is shown as +, but could be

UNL = unexpected net loss (if actual ROA < expected ROA) UNG = unexpected net gain (if actual ROA > expected ROA)
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Ex. Defined Benefit Plan, Continued

Assume: pension assets = 100,000 E(ROA)% = 10% actual ROA = 15,000

DR assets 15,000 CR Pension expense 10,000 CR UNGain 5,000

Q: How does assumed EROA% affect FMV of assets?

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Primary Factors Affecting Pension Expense

Pension Expense + DR Service Interest CR E(ROA)

Q: What is the effect of funding on expense?

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Ex. Defined Benefit Plan, Continued

Service Interest 3,014 9,041

E(ROA) pension expense

(10,000) 2,055

Ex. E14-12 without amortization and unexpected loss

P 14-1, Parts 1-3 in Summary So Far

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Smoothing of Transitory Gains and Losses

def: unrecognized = deferred (in footnotes) def: recognized = amortized (into pension expense on I/S)

Transitory gains, losses are CRd (gains) or DRd (losses) to unrecognized (footnote) accounts, rather than recognized as gain or loss on I/S. The unrecognized balances are amortized onto I/S. This smooths NI and keeps assets and PBO off of B/S.

Full Exp For E14-13

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Smoothing (contd): Intuition

Loss in DR, Gain in CR

DR CR Asset or liab. Unrecognized loss

Loss:

Amortn: Exp.(recorded)

Unrecognized loss

Gain:

Asset or liab.

Unrecognized gain Exp.(recorded)

Amortn: Unrecognized gain

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Types of Transitory Gains, Losses

DR
asset gain: actual ROA > expected ROA asset loss: actual ROA < expected ROA Assets Assets UNL

CR
Pension expense UNG Pension expense

* assets are DRd (or CRd) for actual ROA; pension expense is CRd for expected ROA; difference is UNG or UNL (see slide #15)

liability loss (due to assumption r%, g%, etc.)

UNL

PBO

liability gain (due to assumption r%, g%, etc.)

PBO

UNG

note: asset and liability gains and losses are all aggregated into one UNG/L account
note: liability gains and losses are also called actuarial gains and losses

Q: What happens if EROA% is set too high (higher than true average

ROA%)?

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2 Types of Liability Gain/Loss

1. Change in assumptions 2. Change in contracts Intuition: What affects r% and E(CF)s

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Types of Transitory Gains, Losses (contd)

DR
Change in pension contract: sweetening UPSC

CR
PBO

Change in pension contract: souring

PBO

UPSC

def: UPSC = unrecognized prior service cost (retroactive benefits)

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Ex. Defined Benefit Plan, Continued

1. assume benefits are sweetened to pay 1.1% * final salary per year (increased by 10%) increase in PBO = 10% * 90,413 = 9041 DR UPSC 9041 CR PBO 9041 2. assume salary growth rate is increased to 6% (final salary = 66,912), so PBO = 94,802 and increase in PBO = 4389 (94,802 90,413) DR UNLoss 4389 CR PBO 4389
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Additional Factors Affecting PBO

PBO
DR (+) Pay benefits Primary factors Service cost Liability gain Additional factors Souring Liability loss ( assumptions) Sweetening ( contracts) CR (-) Interest cost

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Additional Factors Affecting Pension Expense

Expense
DR (+) Primary factors Additional factors Interest cost Service cost loss amortization Gain amortization E(ROA) CR (-)

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Additional Factors Affecting Pension Expense (contd)

Loss amortization: DR Pension expense CR UPSC or UNL or UTL Gain amortization: DR UPSC or UNG or UTA CR Pension expense
UTA, UTL = unrecognized transition asset, liability = net position (assets - PBO) @ adoption of SFAS #87

remember: amortization = recognized into expense amortization is generally SL over average remaining service life of employees

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Ex. Defined Benefit Plan, Continued

Amortize UPSC over 5 years: 9041/5 = 1808 DR pension expense 1808 CR UPSC 1808 service interest E(ROA) UPSC Amort. 3,014 9,041 (10,000) 1,808

pension expense

3,863

E 14-12 w/o Loss

Ex. E14-13 GM disclosure

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Funded Status Reconciliation

Reconcile true vs. recognized position
assets - PBO funded status (can be net asset or net liability): true position + UNL (or - UNG) Unrecognized + UPSC Gains/Losses + UTL (or - UTA) recognized (on B/S) position: prepaid pension cost (asset) or deferred pension cost (liab)

note: funded status (true economic position) vs. recognized position unrecognized losses & liabs make the recognized position better than the true position unrecognized gains & assets make the recognized position worse than the true position
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Ex. E14-14, 19

Minimum Liability

if ABO > assets the pension plan is considered severely underfunded and a liab. (ABO - assets) must be recognized. if recognized position is asset (prepaid cost) or liab (accrued cost) < (ABO-assets), additional entry is needed to bring recognized position to minimum level: DR Intangible asset* CR Additional liability
* should be DR to a loss account

additional liab can be shown separately or aggregated with accrued pension cost on B/S
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Ex. E14-2, E14-5

Corridor (Minimum) Amortization

UNL or UNG must be amortized only if it > corridor corridor = 10% of bigger (PBO, assets) @BOY amortization is down to corridor, not zero if amortn is required one year, it might or might not be the next year, and vice versa

UNG/L
DR *BOY net loss Current year loss gain amortn #EOY net loss CR *BOY net gain (* for current year amortn test) Current year gain loss amortn (amortn only if required) #EOY net gain (# for next years amortn test)
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Ex. P14-1, sec 1-6 E14-18

Pension Worksheet Recognized (on FS) bal. Pen. exp Service cost Interest cost ROA Funding (contribution) Benefits liability loss6 Sweetening7 Amortization UNL8 DR DR DR CR CR DR DR CR Cash ppd/acc cost

put it all

together - relate to funded status reconciliation

Unrecognized (footnote) balances Pen Ass Pen Liab UNGL CR CR plug DR CR CR CR DR DR UPSC

Amortization of UPSC (from sweetening)9

Summary JE; only recognized (on FS) JE

DR
DR CR CR or DR

CR

6. reverse DR and CR for a liability gain 7. reverse DR and CR for souring

8. reverse DR and CR for amortn of unrecognized gain 9. reverse DR and CR for amortn from souring

Note: recognized asset/liab (prepaid/accrued pension cost) is net of all unrecognized accounts

Exercise problems

E14-3, E14-4, E14-7 E14-17, 20 P14-2, P14-3 P14-13

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Footnote Disclosures
The pension footnote includes: 1. total pension expense and its components 2. reconciliation of BOY vs EOY PBO and asset accounts (like t-accounts) 3. funded status reconciliation 4. assumptions (r%, g%, EROA%)

C 14-2,3
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Correction JE
(to put assets and liabs on B/S)

using information in pension footnote, put pension assets and liab on B/S; replace recognized position with true position DR pension assets accrued pension cost R/E CR PBO Prepaid pension cost R/E

or or

1. put pension assets and PBO on B/S 2. remove accrued or prepaid pension cost from B/S 3. plug: DR or CR R/E = cumulative unrecognized gains/losses (sum of UNGL, UPSC, UTAL) note: DR or CR to R/E rather than current year gain or loss
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Other Post-Employment Benefits (OPEBs)

Same accounting as pensions, with minor differences 1. ABO instead of PBO (OPEBs not tied to salary) 2. significance of (TL) transition liability (no incentive to fund, so ABO > assets) firms can: amortize TL over <= 20 years DR OPEB expense CR Accrued OPEB cost or take loss as change in accounting principle (below the line): DR loss due to change in acct principle CR Accrued OPEB cost most firms chose latter: why? 3. service cost is accrued (earned) over short (vesting) period, since benefits dont increase with tenure

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