CHAPTER 14

EMPLOYEE COMPENSATION:
POSTEMPLOYMENT AND SHARE-BASED
Presenters name
Presenters title
dd Month yyyy

TYPES OF POSTEMPLOYMENT BENEFITS:

PENSION PLANS
Amount of
Future benefit to
Employee

Contribution
from Employer

Defined
contribution
(DC) pension
plan

Depends on
investment
performance of
plan assets

Amount (if any)

is defined in
each period

Defined
benefit (DB)
pension plan

Defined based
on plans
formula

Depends on
current period
estimate and
investment
performance of
plan assets

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TYPES OF POSTEMPLOYMENT BENEFITS:

PENSION PLANS & EMPLOYERS OBLIGATION

Type of Benefit
Defined
contribution
Defined benefit

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Amount of
Future benefit to
Employee
Depends
Defined

Contribution
from Employer

Employers
Prefunding of Its
Future
Obligation

Defined

N/A

Depends

Typically
prefunded;
regulatory
requirements.

TYPES OF POSTEMPLOYMENT BENEFITS:

OTHER

Type of Benefit
Other
postemployment
benefits (e.g.,
retirees health
care)

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Amount of
Future benefit
to Employee

Employers
Prefunding of
its Future
Obligation

Contribution
from Employer
Eventual benefits
are specified.
Depends on plan The amount of
specifications
the future
Typically not
and type of
obligation must
prefunded.
benefit.
be estimated in
the current
period.

MEASURING A DEFINED BENEFIT

PENSION OBLIGATION
Pension obligation is measured as the present value of estimated
future payments to employees for benefits earned to date.
Measured without deducting any plan assets.
Requires company to make actuarial assumptions:
- Estimated future benefits.
- The discount rate at which to discount future payments.

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MEASURING NET PENSION LIABILITY

(OR ASSET) FOR DB OBLIGATIONS
Pension obligation is measured without deducting any plan assets.
The net pension deficit (or surplus) deducts fair value of plan assets.
Present value of the DB obligation Fair value of the plan assets
= Funded status

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NET PENSION LIABILITY (OR ASSET)

Underfunded
- Pension obligation exceeds pension plan assets.
- Liability equal to the net pension obligation is reported.
Overfunded
- Pension plan assets exceed the pension obligation.
- Asset equal to the overfunded pension obligation is reported,
subject to limitations.

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COMPONENTS OF A COMPANYS DEFINED

BENEFIT PENSION EXPENSE

Return on
Plan Assets

Past
Service
Cost

Actuarial
Losses

Interest

Current
Service
Cost

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DEFINED BENEFIT PLAN ASSUMPTIONS

Estimated future benefits, which depend on
- Future compensation increases and levels,
- Length of service,
- Vesting rate and turnover, and
- Life expectancy postretirement.
Discount rate at which to discount future payments and for net
interest calculations.

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DEFINED BENEFIT PLAN ASSUMPTIONS:

EXAMPLE
Assume for a company establishing a DB pension plan, the discount
rate is 6%.
Assume for an employee covered by a DB pension plan:
- Salary in the coming year of 50,000.
- Expected to work 5 more years before retiring.
- Annual compensation increase is 4.75%.
- Will receive benefit for 20 years.
- Benefit based on (Estimated final salary 1.5%) Years of service.
Employees estimated final year salary = 50,000 [(1 + 4.75%) 4] =
60,198.56.

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DEFINED BENEFIT PLAN ASSUMPTIONS:

EXAMPLE
Annual benefit = (Estimated final salary Benefit formula) Years service
Value at retirement date of estimated future benefits = Present value of annual
benefit during retirement period
Annual unit credit = Value at retirement date/Years of service

Today

Retirement
Date

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Retirement
Period End

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DEFINED BENEFIT PLAN ASSUMPTIONS:

EXAMPLE
Annual benefit = (Estimated final salary Benefit formula) Years service =
60,198.56 1.5% 5 = 4,514.89
Value at retirement date of estimated future benefits = Present value of annual
benefit during retirement period
Annual unit credit = Value at retirement date/Years of service

Today

Retirement
Date

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Retirement
Period End

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DEFINED BENEFIT PLAN ASSUMPTIONS:

EXAMPLE
Annual benefit = 4,514.89
Value at retirement date of estimated future benefits = Present value of annual
benefit during retirement period = Present value of annuity of 4,514.89 for 20
years, discounted at 6% = 51,785.46
Annual unit credit = Value at retirement date/Years of service

Today

Retirement
Date

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Retirement
Period End

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DEFINED BENEFIT PLAN ASSUMPTIONS:

EXAMPLE
Annual benefit = 4,514.89
Value at retirement date of estimated future benefits = 51,785.46
Annual unit credit = Value at retirement date/Years of service = 51,785.46/5
years = 10,357.09 per year
Pension obligation increases by an amount equal to the present value of the
annual credit earned in the year

Today

Retirement
Date

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Retirement
Period End

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DEFINED BENEFIT PLAN ASSUMPTIONS:

IMPACT OF CHANGES
Changes in assumptions change the estimated obligation.
Direction of change in assumption that would increase a DB pension
plan obligation:
- Lower discount rate.
- Longer estimated working period before retiring.
- Higher assumed annual compensation increase.
- Longer estimated retirement period (longer life expectancy).

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PENSION AND OTHER POSTEMPLOYMENT

BENEFITS: USING DISCLOSURES
Differences in key assumptions used for pensions and other
postemployment benefits can affect comparisons across companies.
Companies disclose their assumptions about
- discount rates,
- expected compensation increases, and
- expected return on plan assets.
An analyst can compare these assumptions over time and across
companies to assess any conservative or aggressive biases.
In some cases, an analyst can adjust items as reported to create more
comparable data.

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PENSION AND OTHER POSTEMPLOYMENT

BENEFITS: USING DISCLOSURES
In assessing potential conservative or aggressive biases, other fundamental
explanations for differences should be considered.
For example, the assumed discount rates used to estimate pension obligations
- are generally based on the market interest rates of high-quality corporate
fixed-income investments, and
- the investments have a maturity profile similar to the timing of a companys
future pension payments.
Discount rates may thus differ across companies because of
- differences in the regions/countries involved and/or
- differences in the timing of obligations.
An important consideration is whether the assumptions are internally consistent
(e.g., do the companys assumed discount rates and assumed compensation
increases reflect a consistent view of inflation?).

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PENSION AND OTHER POSTEMPLOYMENT

BENEFITS: USING DISCLOSURES
Assumed discount rates used to estimate pension obligations for U.S. plans (percent).

FiatS.p.A.
TheVolvoGroup
GeneralMotors
FordMotorCompany

2009
5.50
4.005.75
5.52
6.50

2008
5.10
5.756.25
6.27
6.25

2007
5.80
5.756.25
6.35
6.25

2006
5.80
5.50
5.90
5.86

2005
5.50
5.75
5.70
5.61

Source: Companies annual reports.

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PENSION AND OTHER POSTEMPLOYMENT

BENEFITS: USING DISCLOSURES
As noted, in some cases, an analyst can adjust items as reported to create
more comparable data or to examine sensitivities.
For example, postemployment health care plans, a type of defined benefit plan,
disclose assumptions about increases in health care costs.
Effect of 1% increase (decrease) in assumed health care cost trend rates on 2009
total accumulated postemployment benefit obligations and periodic expense.

1% Increase

1% Decrease

CNHGlobalN.V.

+$106million(Obligation)
+$8million(Expense)

$90million(Obligation)
$6million(Expense)

CaterpillarInc.

+$220million(Obligation)
+$23million(Expense)

$186million(Obligation)
$20million(Expense)

Source: Companies annual reports.

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PENSION AND OTHER POSTEMPLOYMENT

BENEFITS: USING DISCLOSURES
Example: Adjust items as reported to examine sensitivities.

CaterpillarInc.
($millions)

Reported

Adjustment for 1%
Increase in Health Care
Cost Trend Rate

Totalliabilities

$50,738

+$220

$50,958

Totalequity

$8,823

$220

$8,603

5.75

5.92

Ratioofdebttoequity

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Adjusted

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PENSION PLAN NOTE DISCLOSURES:

EXCERPTS ON FUNDED STATUS

Source: Loral, Registration Document (2011).

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PENSION PLAN NOTE DISCLOSURES:

EXCERPTS ON FUNDED STATUS

Source: Loral, Registration Document (2011).

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PENSION PLAN NOTE DISCLOSURES:

EXCERPTS ON FUNDED STATUS

Source: Colgate-Palmolive Company, Annual Report (2011).

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CASH FLOW INFORMATION ON

DEFINED BENEFIT PLANS
The difference between periodic contributions to a plan and total
pension costs of the period can be viewed as financing activity.
- If periodic contributions to a plan exceed the total pension costs of
the period, the excess is similar to paying loan principal ahead of
scheduled amounts.
- If periodic contributions to a plan are less than the total pension costs
of the period, it can be viewed as a source of financing.
Where the amounts are material, an analyst may choose to adjust the
reported cash flows.

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CASH FLOW INFORMATION: EXAMPLE

Assume a company reported ( millions):
- Total pension cost for period: 437
- Contribution to pension for period: 504
- Cash inflow from operating activities: 6,161
- Cash outflow from financing activities: 1,741
Using an effective tax rate of 28.7%, adjust cash flow from operations
and financing to reflect excess contribution as similar to a repayment
of borrowing.

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CASH FLOW INFORMATION: EXAMPLE

Assume a company reported ( millions):
- Total pension cost for period: 437
- Contribution to pension for period: 504
- Cash inflow from operating activities: 6,161
- Cash outflow from financing activities: 1,741
Using effective tax rate of 28.7%, adjust cash flow from operations and
financing to reflect excess contribution as similar to a repayment of
borrowing.
- After-tax excess contribution: 48
- Increase companys cash outflow from financing activities from
1,741 to 1,789
- Increase companys cash inflow from operations from 6,161 to
6,209
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SHARE-BASED COMPENSATION
Employee compensation packages are structured to fulfill varied
objectives, including satisfying employees needs for liquidity, retaining
employees, and providing incentives to employees.
Common components of employee compensation packages are salary,
bonuses, and share-based compensation.
Share-based compensation (such as stock and stock options)
- Aims to align employees interest with those of the shareholders,
- Requires no current-period cash outlays,
- Is treated as an expense and thus reduces earnings,
- Potentially dilutes EPS (earnings per share), and
- Typically dilutes existing shareholders ownership

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SHARE-BASED COMPENSATION:
STOCK GRANTS
Stock Grants: Stock granted to employees by their employer.
Types of stock grants includes
- Outright,
- Restricted stock grant, and
- Contingent stock grant (also known as performance shares).
Accounting for stock grants compensation expense:
- Amount of expense is based on fair value of the stock on grant date.
- Expense is allocated over the employees service period.

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SHARE-BASED COMPENSATION:
STOCK OPTIONS
Compensation expense is reported at fair value.
The fair value of option grants must be estimated using a valuation model.
Key assumptions and input into option pricing models include
- exercise price,
- stock price volatility,
- estimated life of each award,
- estimated number of options that will be forfeited,
- dividend yield, and
- the risk-free rate of interest.
Some inputs, such as the exercise price, are known at the time of the grant.
Other inputs are highly subjective (e.g., stock price volatility or the expected life
of stock options) and can greatly change the estimated fair value and thus
compensation expense.
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SHARE-BASED COMPENSATION:
STOCK OPTIONS
Day options are granted (usually, the date that
compensation expense is measured).
Date that options can first be
exercised.
Date when employees actually
exercise the options.

Grant
Date

Vesting
Date

Exercise
Date

Expiration
Date

Immediate vesting: Expense is recognized on grant date.

Otherwise, expense is recognized over the service period.

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SUMMARY
Defined contribution pension plans specify (define) only the amount of contribution
to the plan; the eventual amount of the pension benefit to the employee will
depend on the value of an employees plan assets at the time of retirement.
Defined benefit pension plans specify (define) the amount of the pension benefit,
often determined by a plan formula, under which the eventual amount of the
benefit to the employee is a function of length of service and final salary.
The reported obligation and periodic expense for defined benefit pension plans
and other postemployment benefit plans are sensitive to assumptions.
Share-based compensation expense is reported at fair value.
Stock option compensation expense is estimated using a pricing model.
Key inputs into option pricing models include exercise price, stock price volatility,
estimated life of each award, estimated number of options that will be forfeited,
dividend yield, and the risk-free rate of interest. Certain assumptions (stock price
volatility, expected life of stock options) are subjective and can greatly change the
estimated fair value and thus compensation expense.

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