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. OPEB’s 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
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
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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
We’ll 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 management’s 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 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
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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 employee’s 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 Pension expense CR PBO
Funding (contributions)
benefits ROA
Assets
PBO Assets(actual ROA)* UNL
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 E(ROA) pension expense 3,014 9,041 (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 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
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Smoothing (cont’d): Intuition
Loss in DR, Gain in CR
DR CR
Asset or liab. Unrecognized loss Unrecognized loss
Loss:
Amort’n: Exp.(recorded)
Gain:
Asset or liab.
Unrecognized gain
Amort’n: Unrecognized gain
Exp.(recorded)
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Types of Transitory Gains, Losses
DR
asset gain: actual ROA > expected ROA
asset loss: actual ROA < expected ROA
CR
Pension expense UNG
Pension expense
Assets
Assets UNL
* assets are DR’d (or CR’d) for actual ROA; pension expense is CR’d for expected ROA; difference is UNG or UNL (see slide #15)
liability loss (due to assumption r%, g%, etc.) liability gain (due to assumption r%, g%, etc.)
UNL PBO
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 (cont’d)
DR
Change in pension contract: sweetening Change in pension contract: souring UPSC PBO
CR
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
CR (-)
Interest cost
Primary factors Service cost
Liability gain Additional factors Souring Liability loss ( assumptions) Sweetening ( contracts)
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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 (cont’d)
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 3,014
interest
E(ROA) UPSC Amort. pension expense
9,041
(10,000) 1,808 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 & liab’s 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 amort’n 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 amort’n #EOY net loss CR *BOY net gain (* for current year amort’n test) Current year gain loss amort’n (amort’n only if required) #EOY net gain (# for next year’s amort’n 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 Amortization of UPSC (from sweetening)9 Summary JE; only recognized (on FS) JE DR DR DR CR CR or DR DR DR CR CR DR DR CR Cash pp’d/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 CR DR DR UPSC
6. reverse DR and CR for a liability gain 7. reverse DR and CR for souring
8. reverse DR and CR for amort’n of unrecognized gain 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
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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 (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
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