Pensions – Costs and
Obligations
Lesson 7
Story
Starting in year 2008, I want to take
two years off to do some research and
write a book. Based on my calculations
I will need $3,500 per month for living,
travel, and research expenses during
those two years.
I conservatively estimate that I can
invest money to earn 6% for the entire
7 year period.
Problems
1. How much money will I need at the
beginning of year 2008?
2. How much must I contribute at the
beginning of each of the next five
years to reach my goal?
1. How much will I need at the
beginning of year 2008?
December 31
2009
January 1
2008
0
1
2
3
3,500
3,500
3,500
3,500
21
3,500
22
3,500
23
3,500
PV
PV = (3,500 x P/AD, 0.5%*, 24) = $79,364
* 6% compounded monthly / 12 months = 0.5% per month
24
2. How much must I contribute at
the beginning of each year?
December 31
2007
January 1
2003
0
13,282
Pmt
1
13,282
Pmt
2
13,282
Pmt
3
13,282
Pmt
4
5
13,282
Pmt
FV = 79,364
79,364
Pmt 
 13,282
( F / AD,6%,5)
The Plan
PLAN
Year
2003
2004
2005
2006
2007
Opening
January 1
+ Deposit =
Balance
Balance
$
$ 13,282
$ 13,282
$ 14,079
$ 13,282
$ 27,361
$ 29,003
$ 13,282
$ 42,285
$ 44,822
$ 13,282
$ 58,104
$ 61,590
$ 13,282
$ 74,872
Interest at
6%
$
797
$ 1,642
$ 2,537
$ 3,486
$ 4,492
December 31
Balance
$
14,079
$
29,003
$
44,822
$
61,590
$
79,364
Actual Experience
ACTUAL
ACTUAL
2003
2003
2004
2004
2005
2005
2006
2006
2007
2007
Opening
January
Opening
January 11 Interest
Interest
++ Deposit
Deposit ==
Balance
Balance
Rate
Balance
Balance
Rate
$
--$
$$
13,282
13,282 5.0%
5.0%
$ 13,282
13,282
$$ 13,282
13,282
5.0%
$
$
$$ 13,946
13,946
13,282
27,228 7.5%
7.5%
13,946
$ 13,282
13,282
$$ 27,228
27,228
7.5%
$
$$ 29,270
29,270
13,014 *** $
42,285 6.0%
6.0%
29,270
$ 13,014
13,014
$$ 42,285
42,285
6.0%
$
$
$$ 44,822
44,822
13,282
58,104 4.0%
4.0%
44,822
$ 13,282
13,282
$$ 58,104
58,104
4.0%
$
$$ 60,428
60,428
15,157 **
** $
75,585 5.0%
5.0%
60,428
$ 15,157
15,157
**
$$ 75,585
75,585
5.0%
** $13,282 -- 268
268 == 13,014
13,014
**
P/F,5%,1)==75,585
75,585
** PV(79,364
PV(79,364 xx P/F,5%,1)
75,585 - 60428
60428 == 15,157
15,157
Interest
Interest
$
$$
$
$$
$
$$
$
$$
$
$$
664
664
664
2,042
2,042
2,042
2,537
2,537
2,537
2,324
2,324
2,324
3,779
3,779
3,779
December
31
December 31
Balance
$
13,946
13,946
$$
13,946
$
29,270
29,270
$$
29,270
$
44,822
$
44,822
$
44,822
$
60,428
60,428
$$
60,428
$
79,364
$
79,364
$
79,364
Target
Target
Balance
Balance
$$$ 14,079
14,079
14,079
$$$ 29,003
29,003
29,003
$$$ 44,822
44,822
44,822
$$$ 61,590
61,590
61,590
$$$ 79,364
79,364
79,364
Surplus
(Deficit)
$$ (133)
(133)
(133)
$$
268
268
$$
-$$ (1,162)
(1,162)
(1,162)
$$
(0)
(0)
Lesson 7
Pension costs and obligations
This lesson deals with pensions — long-term obligations to
employees — and the pension fund assets segregated to
service such obligations. Generally, a financial statement
element related to pensions is disclosed as a long-term
liability or a long-term asset. The standards for measuring
pension costs and obligations and establishing disclosure are
critically evaluated.
Lesson 7
What is a pension plan?
A pension plan consists of:
segregated assets, held by a trustee and
invested over the long-term, and
an actuarially-determined long-term liability
to employees for pension entitlements
earned.
Lesson 7
What is a defined contribution plan?
Defined contribution plans define the
annual contributions employers must
make.
Pensions paid depend on contributions
plus earnings.
Accounting is straightforward: payments
made are expensed.
Lesson 7
What is a defined benefit plan?
Defined benefit plans define the
eventual benefits (pensions) paid to
employees.
Employers must make payments that,
over time, will fund the pensions to be
paid to employees.
Lesson 7
How are payments to defined plans
determined?
Actuaries develop estimates of future
retirement benefit payments to be paid
to an employee according to the
pension plan formula.
The company’s pension plan obligation
is measured using actuarial cost
methods to establish funding.
Lesson 7
Actuarial cost methods:
Level funding method: equal annual
payments, project final pay, project total
years of service.
Projected benefit method: increasing annual
payments, project final pay only.
Accumulated benefit funding method:
increasing annual payments, project nothing.
Lesson 7
Important acronyms:
•
•
•
•
•
•
•
Actuarial present value (APV)
Current service cost (CSC)
Past service cost (PaSC)
Prior service cost (PrSC)
Expected period to full eligibility (EPFE)
Average remaining service period (ARSP)
Pension benefit obligation (PBO)
Lesson 7
Definitions
Current service cost is the actuarial present
value of the cost of pension entitlements
earned in the current period.
Past service cost is the actuarial present value
of pension entitlements granted for work in
periods prior to a new pension plan.
Prior service cost is the APV of pension
entitlements granted for work in periods
before an improvement to an existing plan.
Memory Hooks
PaSc
d
o
p
t
i
o
n
all time
PrSC
e
c
e
n
t
revision
Lesson 7
How is pension expense measured?
Pension expense must be measured using the
projected benefits method.
Pension expense is the sum of:
current service cost
interest cost
return on plan assets (a reduction)
amortization of PaSC
amortization of PrSC
actuarial gains or losses, if needed
Lesson 7
Amortization periods:
PaSC: EPFE.
PrSC: EPFE or period until next amendment
expected.
Actuarial G/L: If within 10% corridor, no
amortization is needed. If over 10% corridor,
excess amount must be amortized over the
average remaining service period (ARSP). These
are minimums; the company can include all or
amortize greater amounts.
10% corridor: 10% of larger of pension assets or
PBO at the beginning of the year.
Lesson 7
What does the journal entry look like?
Debit pension expense, as calculated
Credit cash, as paid
Difference is to deferred balance sheet
account
Lesson 7
What disclosure is required in the
financial statements?
The value of pension fund assets (held by the
trustee) and the actuary’s estimate of the
pension liability to employees must be
disclosed.
Considerable note disclosure is required for
important accounting policies and
measurements used for pension accounting.
The cash flow statement reflects cash paid in
the operations section.
Lesson 7
What does the balance sheet account
include?
The balance sheet pension asset or
liability is equal to the difference
between pension assets and the
actuary’s estimate of pension liability
plus or minus the unrecognized
(unamortized) portions of past and prior
service costs, actuarial/experience gains
or losses.