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
8. Types of transitory gains and losses 13. Pension worksheet
9. Additional factors 14. Footnote disclosures
10. Funded status reconciliation 15. Correction JE
16. OPEB’s
11. Minimum liability
Paul Zarowin 2
Structure of Pension Plan
firm or employee pension fund retiree
Cash Pay benefits
Paul Zarowin 3
Types of Pension Plans
1. Defined contribution:
employee bears risk, no firm liability
2. Defined benefit:
firm bears risk and has liability (our focus)
Paul Zarowin 4
Ex. Defined Benefit Plan
worker’s 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
Paul Zarowin 5
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% E(CF)
Bonds known known
Leases known? known
Pensions ? ?
Both discount rate and expected cash flows are subjective
Paul Zarowin 6
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
We’ll use PBO, unless otherwise stated.
Paul Zarowin 7
Key Assumptions
discount rate = r% What are
salary growth rate = g% (for PBO) management’s
incentives?
actuarial (life span, tenure, turnover, etc.)
EROA% (expected rate of return on pension assets),
see below
Q: Is liability bigger for older or younger workers?
Paul Zarowin 8
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 he’ll 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
Paul Zarowin 9
Primary (Ongoing) Factors Affecting PBO
PBO
- +
DR CR
pay benefits 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
Paul Zarowin 10
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 employee’s age affect his service cost?
E14-1,13
Paul Zarowin 11
Pension Assets
Pension assets: FMV of assets (stocks, bonds, etc.)
Funded status (true, economic position):
Pension assets – PBO
Overfunded: assets > PBO
Underfunded: assets expected ROA)
Paul Zarowin 14
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?
Paul Zarowin 15
Primary Factors Affecting Pension
Expense
Pension Expense
+ -
DR CR
Service E(ROA)
Interest
Q: What is the effect of funding on expense?
Paul Zarowin 16
Ex. Defined Benefit Plan, Continued
Service 3,014
Interest 9,041
E(ROA) (10,000)
pension expense 2,055
Ex. E14-12 without amortization and unexpected loss
P 14-1, Parts 1-3 in Summary So Far
Paul Zarowin 17
Smoothing of Transitory Gains and Losses
def: unrecognized = deferred (in footnotes)
def: recognized = amortized (into pension expense on I/S)
Transitory gains, losses are CR’d (gains) or DR’d (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
Paul Zarowin 18
Smoothing (cont’d): Intuition
Loss in DR, Gain in CR
DR CR
Loss: Unrecognized loss Asset or liab.
Amort’n: Exp.(recorded) Unrecognized loss
Gain: Asset or liab. Unrecognized gain
Amort’n: Unrecognized gain Exp.(recorded)
Paul Zarowin 19
Types of Transitory Gains, Losses
DR CR
asset gain: actual ROA > expected ROA Assets Pension expense
UNG
asset loss: actual ROA 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) “corridor”
corridor = 10% of bigger (PBO, assets) @BOY
amortization is down to corridor, not zero
if amort’n is required one year, it might or might not be the
next year, and vice versa
UNG/L
DR CR
*BOY net loss *BOY net gain (* for current year amort’n test)
Current year loss Current year gain
gain amort’n loss amort’n (amort’n only if required)
#EOY net loss #EOY net gain (# for next year’s amort’n test)
Ex. P14-1, sec 1-6 E14-18 30
Pension Worksheet - put it all
together - relate to funded status reconciliation
Recognized (on FS) bal. Unrecognized (footnote) balances
Pen. exp Cash pp’d/acc cost Pen Ass Pen Liab UNGL UPSC
Service cost DR CR
Interest cost DR CR
ROA CR DR plug
Funding (contribution) CR DR
Benefits CR DR
liability loss6 CR DR
Sweetening7 CR DR
Amortization UNL8 DR CR
Amortization of UPSC
DR CR
(from sweetening)9
Summary JE; only
DR CR CR or DR
recognized (on FS) JE
6. reverse DR and CR for a liability gain 8. reverse DR and CR for amort’n of unrecognized gain
7. reverse DR and CR for souring 9. reverse DR and CR for amort’n 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
Paul Zarowin 32
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
Paul Zarowin 33
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 CR
pension assets PBO
accrued pension cost or Prepaid pension cost
R/E or R/E
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
Paul Zarowin 34
Other Post-Employment Benefits (OPEB’s)
Same accounting as pensions, with minor differences
1. ABO instead of PBO (OPEB’s 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 don’t increase with tenure
Paul Zarowin 35