Chapter 17
PENSIONS AND OTHER
POSTRETIREMENT
BENEFITS
McGraw-Hill /Irwin
© 2009 The McGraw-Hill Companies, Inc.
Slide 2
Nature of Pension Plans
For a pension plan to qualify for special tax
treatment
must meet
the to
following
1. Pension
plans itprovide
income
requirements:
individuals during
their retirement years.
1. 2.Cover
70% of employees.
Thisat
is least
accomplished
by setting aside
fundsdiscriminate
during an employee’s
2. Cannot
in favor ofworking
highly
years so thatemployees.
at retirement, the
compensated
accumulated
plus earnings
from
3. Must
be funded funds
in advance
of retirement
investing
those fundstrust
are available
to
through
an irrevocable
fund.
replacemust
wages.
4. Benefits
vest after a specified period of
service.
5. Complies with timing and amount of
contributions.
17-2
Slide 3
Types of Pension Plans
Defined contribution pension plans promise fixed
annual contributions to a pension fund (say, 10% of
the employees' pay). The employee chooses (from
designated options) where funds are invested –
usually stocks or fixed-income securities. Retirement
pay depends on the size of the fund at retirement.
17-3
Slide 4
Types of Pension Plans
Defined benefit pension plans promise fixed retirement
benefits defined by a designated formula. Typically,
the pension formula bases retirement pay on the
employees' (a) years of service, (b) annual
compensation [often final pay or an average for the
last few years], and sometimes (c) age. Employers
are responsible for ensuring that sufficient funds are
available to provide promised benefits.
17-4
Slide 5
Defined Contribution Pension Plans
Plan Characteristics
Contributions
are defined by
agreement.
Employer
deposits an
agreed-upon
amount into an
employeedirected
investment
fund.
Employee
bears all risk
of pension
fund
performance.
17-5
Slide 6
Defined Contribution Pension Plans
Accounting for these plans is quite simple. Let’s assume
that the annual contribution is to be 3% of an employee’s
salary. If an employee earned $110,000 during the year,
the company would make the following entry:
Date
Description
Pension expense
Cash
Debit
Credit
3,300
3,300
($110,000 × 3% = $3,300)
17-6
Slide 7
Defined Benefit Pension Plans
Plan Characteristics
Employer is
committed to
specified
retirement
benefits.
Retirement
benefits are
based on a
formula that
considers years
of service,
compensation
level, and age.
Employer
bears all risk
of pension
fund
performance.
17-7
Slide 8
Defined Benefit Pension Plan
A pension formula might define annual retirement
benefits as:
1 1/2 % x Years of service x Final year’s salary
By this formula, the annual benefits to an
employee who retires after 30 years of service,
with a final salary of $100,000, would be:
1 1/2 % x 30 years x $100,000 = $45,000
17-8
Slide 9
The Pension Obligation
1. Accumulated benefit obligation (ABO) The actuary’s
estimate of the total retirement benefits (at their discounted
present value) earned so far by employees, applying the
pension formula using existing compensation levels.
2. Vested benefit obligation (VBO) The portion of the
accumulated benefit obligation that plan participants are
entitled to receive regardless of their continued
employment.
3. Projected benefit obligation (PBO) The actuary’s estimate
of the total retirement benefit (at their discounted present
value) earned so far by employees, applying the pension
formula using estimated future compensation levels. (If
the pension formula does not include future compensation
levels, the PBO and the ABO are the same.© 2008 The McGraw-Hill Companies, Inc.
17-9
Slide 10
Projected Benefit Obligation
The PBO is a more meaningful measurement
because it includes a projection of what the salary
might be at retirement.
Jessica Farrow was hired by Global Communications in 1998. She
is eligible to participate in the company's defined benefit pension
plan. The benefit formula is:
Annual salary in year of retirement
× Number of years of service
× 1.5%
Annual retirement benefits
Farrow is expected to retire in 2037 after 40 years of service. Her
retirement period is expected to be 20 years. At the end of 2007,
10 years after being hired, her salary is $100,000. The interest
rate is 6%. The company’s actuary projects Farrow’s salary to be
$400,000 at retirement.
17-10
Slide 11
Projected Benefit Obligation
Step 1. Use the pension formula to determine the retirement
benefits earned to date.
$400,000
×
10
×
1.5%
$ 60,000 per year
Step 2. Find the present value of the retirement benefits as of the
retirement date.
The present value (n=20, i=6%,) of the retirement annuity at
the retirement date is $688,195 ($60,000 × 11.46992).
Step 3. Find the present value of the retirement benefits as of the
current date.
The present value (n=30, i=6%,) of the retirement benefits at
2007 is $119,822 ($688,195 × .17411). This is the PBO.
17-11
Slide 12
Projected Benefit Obligation
If the actuary’s estimate of the final salary hasn’t changed,
the PBO a year later at the end of 2008 would be $139,715.
Step 1. Use the pension formula to determine the retirement
benefits earned to date.
$400,000
×
11
×
1.5%
$ 66,000 per year
Step 2. Find the present value of the retirement benefits as of the
retirement date.
The present value (n=20, i=6%,) of the retirement annuity at
the retirement date is $757,015 ($66,000 × 11.46992).
Step 3. Find the present value of the retirement benefits as of the
current date.
The present value (n=29, i=6%,) of the retirement benefits at
2008 is $139,715 ($757,015 × .18456). This is the PBO.
17-12
Slide 13
Changes in the PBO
The PBO changes as a result of:
Cause
Effect
Frequency
Service Cost
+
Interest Cost
+
Prior Service
Cost
Loss or Gain on
PBO
Retiree Benefits
Paid
+
+ or -
Each period
Each period (except the first period
of the plan)
Only if the plan is amended (or
initiated) that period
Whenever revisions are made in the
pension liability estimate
Each period (unless no employees
have yet retired under the plan)
17-13
Slide 14
Changes in the PBO
The PBO changes as a result of:
Cause
Effect
Frequency
Service Cost
+
Each period
Each period (except the first period
Service
Interest
Cost cost
+ is the increase in the PBO
of the plan)
attributable to employee
service performed
Prior Service
Only if the plan is amended (or
+
during
the period.
Cost
initiated) that period
Loss or Gain on
Whenever revisions are made in the
+ or PBO
pension liability estimate
Retiree Benefits
Each period (unless no employees
Paid
have yet retired under the plan)
17-14
Slide 15
Changes in the PBO
The PBO changes as a result of:
Cause
Effect
Frequency
Service Cost
Interest Cost
Prior
Service
Interest
cost
Cost
Loss or Gain on
PBO
Retiree Benefits
Paid
+
Each period
Each period (except the first period
+
of the plan)
Only if the
amended
(or
is+the interest
onplan
theisPBO
during
initiated) that period
the period.
Whenever revisions are made in the
+ or pension liability estimate
Each period (unless no employees
have yet retired under the plan)
17-15
Slide 16
Changes in the PBO
The PBO changes as a result of:
Cause
Effect
Frequency
Service Cost
+
Each period
Each period (except the first period
Interest Cost
+
of the plan)
Prior Service
Only if the plan is amended (or
+
Cost
initiated) that period
Loss
Gain oncost is theWhenever
are from
madeusing
in the
Priororservice
increase revisions
in the PBO
+ or PBO
pension
liability
estimate the
a new,
more generous pension
formula
to determine
Retiree Benefits
Each period
(unless
no employees
pension- obligation
for prior
years.
Paid
have yet retired under the plan)
17-16
Slide 17
Changes in the PBO
The PBO changes as a result of:
Cause
Effect
Frequency
Service Cost
+
Each period
Each period (except the first period
Interest Cost
+
of the plan)
Prior Service
Only if the plan is amended (or
+
Cost
initiated) that period
Loss or Gain on
Whenever revisions are made in the
+ or PBO
pension liability estimate
Retiree
Benefits
Each results
period (unless
employees
Loss
or gain -on PBO
from no
revising
Paid
have yet retired under the plan)
estimates used to determine the PBO.
17-17
Slide 18
Changes in the PBO
The PBO changes as a result of:
Cause
Effect
Frequency
Service Cost
+
Interest Cost
+
Prior Service
Cost
Loss or Gain on
PBO
Retiree Benefits
Paid
+
+ or -
Each period
Each period (except the first period
of the plan)
Only if the plan is amended (or
initiated) that period
Whenever revisions are made in the
pension liability estimate
Each period (unless no employees
have yet retired under the plan)
Retiree benefits paid are payments to
retired employees.
17-18
Slide 19
Changes in the PBO
The changes in the PBO for Global Communications during 2009 were as follows:
($ in millions)*
PBO at the beginning of 2009+ (amount assumed)
Service cost, 2009 (amount assumed)
Interest cost: $400  6%
Loss (gain) on PBO (amount assumed)
Less: Retiree benefits paid (amount assumed)
PBO at the end of 2009
$
$
400
41
24
23
(38)
450
*Of course, these expanded amounts are not simply the amounts for Jessica Farrow
multiplied by 2,000 employees because her years of service, expected retirement date,
and salary are not necessarily representative of other employees. Also, the expanded
amounts take into account expected employee turnover and current retirees.
+
Includes the prior service cost that increased the PBO when the plan was amended in
2008.
17-19
Slide 20
Pension Plan Assets
Global Communications funds its defined benefit pension
plan by contributing the year’s service cost plus a portion of
the prior service cost each year. Cash of $48 million was
contributed to the pension fund in 2009.
Plan assets at the beginning of 2009 were valued at $300
million. The expected rate of return on the investment of
those assets was 9%, but the actual return in 2009 was
10%. Retirement benefits of $38 million were paid at the
end of 2009 to retired employees. The plan assets at the
end of 2009 will be:
Plan assets at the beginning of 2009
Return on plan assets (10% x $300 million)
Cash contributions
Less: Retiree benefits paid
Plan assets at the end of 2009
$
$
300,000,000
30,000,000
48,000,000
(38,000,000)
340,000,000
17-20
Slide 21
Funded Status of the Pension Plan
OVERFUNDED
Market value of plan
assets exceeds the
actuarial present value
of all benefits earned by
participants.
UNDERFUNDED
Market value of plan
assets is below the
actuarial present value
of all benefits earned by
participants.
17-21
Slide 22
Funded Status of Pension Plan
Projected Benefit Obligation (PBO)
- Plan Assets at Fair Value
Underfunded / Overfunded Status
This amount is reported in the
balance sheet as a Pension
Liability or Pension Asset.
17-22
Slide 23
Pension Expense – An Overview
Components of Pension Expense
+
Service cost ascribed to employee service this period
+
Interest accrued on pension liability
Expected return on the plan assets
+
Amortized portion of prior service cost
+ or - Amortization of net loss or net gain
=
Pension expense
17-23
Slide 24
Pension Expense
Actuaries have determined that Global
Communications has service cost of
$41,000,000 in 2009.
Global's 2009 Pension Expense
Service cost
Interest cost
Expected return on the plan assets
Amortization of prior service cost
Amortization of net loss
Pension expense
($ in millions)
$ 41
$
41
17-24
Slide 25
Interest Cost
Interest cost is calculated as:
PBOBeg × Discount rate
Global had PBO of $400,000,000 on 1/1/09. The
actuary uses a discount rate of 6%.
Global's 2009 Pension Expense
Service cost
Interest cost
Expected return on the plan assets
Amortization of prior service cost
Amortization of net loss
Pension expense
($ in millions)
$ 41
24
$
65
2009 Interest Cost: PBO 1/1/09 $400,000,000 × 6% = $24,000,000
17-25
Slide 26
Return on Plan Assets
The plan trustee reports that plan assets were
$300,000,000 on 1/1/09. The trustee uses an expected
return of 9% and the actual return is 10%.
Beginning value of plan assets
Rate of return
Return on plan assets
Beginning value of plan assets $
Adjustment (10% - 9%)
Adjusted for gain on plan assets
Expected return on plan assets
$
300,000,000
10%
30,000,000
300,000,000
1%
Global's 2009 Pension Expense
Service cost
Interest cost
Expected return on the plan assets
Amortization of prior service cost
Amortization of net loss
Pension expense
$
3,000,000
27,000,000
($ in millions)
$ 41
24
(27)
$
38
17-26
Slide 27
Amortization of Prior Service Cost
In 2008, Global Communications amended the pension plan,
increasing the PBO at that time. For all plan participants,
the prior service cost was $60 million at 1/1/08. The
average remaining service life of the active employee
group is 15 years.
$60,000,000 PSC ÷ 15 = $4,000,000 per year
Global's 2009 Pension Expense
Service cost
Interest cost
Expected return on the plan assets
Amortization of prior service cost
Amortization of net loss
Pension expense
($ in millions)
$ 41
24
(27)
4
$
42
17-27
Slide 28
Gains and Losses
Projected Benefits Return on Plan
Obligation
Assets
Higher than
Expected
Low er than
Expected
Loss
Gain
Gain
Loss
17-28
Slide 29
Corridor Amount
The corridor
amount is 10% of
the greater of . . .
PBO at the
beginning of the
period.
Or
Fair value of plan
assets at the
beginning of the
period.
17-29
Slide 30
Gains and Losses
If the beginning net unrecognized gain or loss
exceeds the corridor amount, amortization is
recognized using the following formula . . .
Net unrecognized gain or loss
Corridor
‫־‬
at beginning of year
amount
Average remaining service period of active
employees expected to receive benefits under the plan
17-30
Slide 31
Gains and Losses
2009 Net Loss Amortization ($ in millions)
PBO
$
400
Fair value of plan assets
300
Net loss for 2009
55
Average service life
15
Net loss
Corridor amount ($400 x 10%)
Excess at the beginning of the year
$
$
55
40
15
$15,000,000 ÷ 15 years = $1,000,000
17-31
Slide 32
Recording Gains and Losses
For 2009, the actual return on plan assets exceeded the expected
return by $3 million. In addition, there was a $23 million loss from
changes made by the actuary when it revised its estimate of future
salary levels causing its PBO estimate to increase. Global would
make the following journal entry to record the gain and loss:
Date
Description
Dec 31 Loss-OCI
Debit
Credit
23
PBO
Plan assets
Gain-OCI
23
3
3
OCI = Other comprehensive income
17-32
Slide 33
Recording the Pension Expense
Global's 2009 Pension Expense
($ in millions)
Service cost
$ 41
Interest cost
24
Expected return on the plan assets
(27)
Amortization of prior service cost (calculated later)
4
Amortization of net loss (calculated later)
1
Pension expense
$ 43
Date
Description
Dec 31 Pension expense
Plan assets
PBO ($41 + $24)
Debit
Credit
43
27
65
Amortization of PSC-OCI
4
Amortization of net loss-OCI
1
17-33
Slide 34
Pension Expense Spreadsheet
Income
Statement
AOCI
($ in millions)
Note: ( )s indicates credits
debits otherwise
Balance, Jan. 1, 2009
Sevice cost
Interest cost
Expected return on assets
Adjust for : Gain on assets
Amortization of:
Prior service cost - AOCI
Net loss - AOCI
Loss on PBO
Prior service cost - AOCI
Contributions to fund
Retiree benefits paid
Balance, Dec. 31, 2009
Plan
PBO
Assets
(400)
300
Prior
Service
Cost
56
Net
Loss
55
(41)
(24)
Cash
41
24
(27)
27
3
(1)
23
4
1
-
38
48
(38)
(450)
340
(48)
52
74
Net Pension
(Liability)/
Asset
(100)
(41)
(24)
27
3
(3)
(4)
(23)
-
Pension
Expense
Asset
Asset or
Liability
43
(23)
48
(110)
17-34
Slide 35
Postretirement Benefits Other Than
Pensions
Net Cost of Benefits
Estimated medical
costs in each
year of retirement
Less:
Equals:
Retiree
share of
cost
Medicare
payments
Estimated net
cost of benefits
17-35
Slide 36
Other Postretirement Benefits
1. Expected Postretirement Benefit Obligation
(EPBO) – The actuary's estimate of the total
postretirement benefits (at their discounted
present value) expected to be received by
plan participants.
2. Accumulated Postretirement Benefit
Obligation (APBO) – The portion of the EPBO
attributed to employee service to date.
17-36
Slide 37
Attribution
The process of assigning the cost of
benefits to the years during which
those benefits are assumed to be
earned by employees.
17-37
Slide 38
Postretirement Benefit Expense
Component
Service Cost
Interest Cost
Expected Return on Plan Assets
Prior Service Cost
Losses or Gains
Postretirement Benefit Expense
Portion of the EPBO attributed to
the current period.
Increase in APBO due to the
passage of time.
Earnings on plan investments, if
plan is funded.
Amortization of compensation cost
from amending the plan. Often a
negative amount.
Amortization of unexpected
changes in either the obligation or
plan assets.
17-38
Slide 39
Appendix 17: Service Method of Allocating
Prior Service Cost
The allocation approach that reflects the declining
service pattern of employees is called the service
method. The method requires that the total number
of service years for all employees be calculated.
This calculation is usually done by the actuary.
Assume Global Communications has 2,000 employees
and the company’s actuary determined that the total
number of service years of these employees is 30,000.
We would calculate the following amortization fraction:
30,000
2,000
= 15 average service years
17-39
End of Chapter 17
McGraw-Hill /Irwin
© 2009 The McGraw-Hill Companies, Inc.