Pensions and
Postretirement Benefits
Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 14
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Learning objectives
1. The rights and obligations in defined contribution and defined
benefit plans.
2. The features of pension plan arrangements.
3. The components of pension expense and their relation to pension
assets and pension liabilities.
4. How GAAP smooths the volatility inherent in pension estimates
and forecasts.
5. The determinants of pension funding.
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Learning objectives:
Concluded
6. How to analyze and use the retirement benefit footnote
disclosures.
7. Other postretirement benefits plan concepts and financial
reporting rules.
8. What research tells us about the usefulness of the detailed
pension and other postretirement benefits disclosures.
9. The key differences in defined benefit plan reporting among
current U.S. GAAP and current IFRS requirements
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Pension plans
Firm (sponsor)
 A pension plan is an agreement
by the firm to provide a series of
payments (called a pension) to
employees when they retire.
Contributions
 The firm makes periodic
contributions to a pension trust.
Pension trust
Benefit
payments
Retired employee
 The pension trust then makes
periodic benefit payments to
retired employees.
 There are two types of pension
plans: defined contribution plans
and defined benefit plans.
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Relationship between sponsor, trust,
and beneficiary.
Figure 14.1
Pension plan entities and relationships
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Pension plans:
Defined contribution and defined benefit plans
Figure 14.2
Assets by plan
type
14-6
Defined benefit pension plans:
Accounting complications
 The plan specifies the benefit formula but not the benefit amount.
 To determine the financial statement effects, the following factors
must be considered:
1. The proportion of the workforce that will remain with the firm long
enough to qualify for benefits under the plan (called vesting).
2. The rate at which employee salaries will rise until retirement.
3. The anticipated life expectancy of employees after retirement.
4. The discount rate used to reflect the present value of future benefits
earned by employees in the current period.
5. What to do when actual experience differs from expectations.
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Defined benefit pension plans:
Five components of pension expense
Service cost (+)
The increase in the discounted present value of the pension
benefits due to an additional year’s employment.
Interest cost (+)
Measures the growth in the pension liability that arises from
the passage of time.
Expected return
on pension assets (-)
Recognized gains
or losses (- or +)
Recognized prior
service cost (- or +)
Dollar return management believes will be earned on
pension investments.
Smoothing device that adjusts for the difference between the
expected and actual return on pension assets.
Smoothing device that adjusts for the costs of retroactive
changes in plan benefits.
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Defined benefit pension plans:
Component 1—Service cost
 Service cost is the increase in the discounted present value of
the pension benefits ultimately payable that is attributable to
an additional year’s employment.
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Defined benefit pension plans:
Component 1—Service cost
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Defined benefit pension plans:
Component 2—Interest cost
The interest cost of
$1,717 is computed by
taking the PBO at the
beginning of the period
(here $24,526) and
multiplying it by the
discount rate (here 7%)
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Defined benefit pension plans:
Component 3—Expected return on plan assets
The 2015 expected return
of $1,717 is computed by
multiplying the beginning
plan assets of $24,526 by
the expected long-term
rate of return assumption
of 7%. For this simplified
example, we assume that
the actual return equals
the expected return
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Defined benefit pension plans:
Relaxing the perfect certainty assumption
 The previous example showed perfect certainty. Unforeseen
pension events arise, examples include:

Higher or lower than anticipated employee turnover.

Higher or lower employee mortality before retirement.

Actual return on plan assets differs from the expected return.

Companies retroactively alter the level of benefits promised under the
plan.
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The Real World: Uncertainty
Introduces Gains and Losses
 GAAP requires that the same interest rate be used for computing both
the service cost and the interest cost components of pensions expense.
However, companies are free to choose some other rate for computing
the expected rate of return on pension plan assets, and most do.
 Uncertainty not only complicates the measurement of service cost and
interest costs but also means that actual outcomes will likely differ from
expectations.
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The Real World: Uncertainty
Introduces Gains and Losses
Figure 14.3
Pension discount rate and expected long-term rate of return on plan assets 2005-2012
14-15
Defined benefit pension plans:
How Component 4 is measured
 If gains and losses do not offset one another over time, the
cumulative off-balance sheet deferred amounts will grow
excessively large.
• Actual versus expected return on plan assets
Cumulative
deferred net
gains or losses
• Actuarial assumptions versus actual experience
• Changes in assumptions (e.g., discount rate)
 The role of Component 4 is to gradually reduce the cumulative
deferred amounts.
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Defined benefit pension plans:
Computing Component 4—Step 1
On January 1, 2014, Dore Corporation has ($1,600,000) in AOCI – actuarial
(gain) loss. The MRV of pension plan assets on that date is $10,000,000, and
the PBO is $8,500,000. The estimated average remaining service period of
active employees is 15 years.
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Defined benefit pension plans:
Computing Component 4—Step 2
On January 1, 2014, Dore Corporation has ($1,600,000) in AOCI – actuarial
(gain) loss. The MRV of pension plan assets on that date is $10,000,000, and
the PBO is $8,500,000. The estimated average remaining service period of
active employees is 15 years.
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Defined benefit pension plans:
Computing Component 4—Step 3
On January 1, 2014, Dore Corporation has ($1,600,000) in AOCI – actuarial
(gain) loss. The MRV of pension plan assets on that date is $10,000,000, and
the PBO is $8,500,000. The estimated average remaining service period of
active employees is 15 years.
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Defined benefit pension plans:
Component 5—Prior service cost


Pension plans are frequently amended to provide increased benefits to
employees.
When benefits are retroactively enhanced, it means prior pension expense was
too low.
Similar to net actuarial losses, new prior service costs increase balance sheet
liabilities and decrease OCI and AOCI.
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Defined benefit pension plans:
Determinants of Pension Funding

Funding decisions are influenced by income
tax laws, protective pension legislation, the
availability of cash, and other incentives.

Firms with high marginal tax rates tend to
overfund their pension plans.

Firms with less stringent capital constraints
and larger union membership tend to have
higher funding ratios.

Firms with more “precarious” debt/equity
ratios tend to have lower funding ratios.
Income tax laws
ERISA
Competing
cash needs
Contracting and
political cost incentives
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Case Study of Pension Recognition
and Disclosure: General Electric
Schedule 1: Components of pension cost: Expected return,
service cost and interest cost
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Case Study of Pension Recognition
and Disclosure: General Electric
Schedule 1: Components of pension cost: Expected return,
service cost and interest cost
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Case Study of Pension Recognition
and Disclosure: General Electric
Schedules 2 and 3: Actuarial and accounting assumptions and
the accumulated benefit obligation (ABO)
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Case Study of Pension Recognition
and Disclosure: General Electric
Schedule 4: Projected benefit obligation (PBO)
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Case Study of Pension Recognition
and Disclosure: General Electric
Schedule 5: Fair Value of Plan Assets
Actual gain on plan assets – Expected return on plan assets (Schedule 1)
$4,854 – $3,768 = $1,086
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Case Study of Pension Recognition
and Disclosure: General Electric
Schedule 6 : Pension Asset (Liability)
$159 - $148 = $11
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Case Study of Pension Recognition
and Disclosure: General Electric
14-28
Pension recognition and disclosure:
Funded status disclosure—Plan assets
Figure 14.6
Causes of
increases and
decreases in plan
assets
14-29
Pension recognition and disclosure:
Funded status disclosure—PBO
Figure 14.7
Causes of
increases and
decreases in PBO
14-30
Pension recognition and disclosure:
Extracting analytical insights
 The funded status reconciliation provides insights about future
pension-related cash flows:
Slightly
overfunded
• Suppose the firm did not contribute cash
to their pensions trust this year.
$
Plan
assets
$
• Will cash contributions be required in
future years?
Pension
benefit
obligation
 Firms are also now required to disclose anticipated pension
benefit payouts for the next five years.
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Defined benefit plans:
Cash-balance plans
 Many U.S. companies are replacing existing pension plans with a
new cash-balance plan.
Employer
Contributes
fixed amount
per year, say
5% of salary
Trustee
Interest earned
at T-bond rate
Pays annuity
benefit to
employee
Employee
 Cash balance plans are attractive to employers, but they are also
controversial.
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Other postretirement benefits
 Many firms promise to provide healthcare and life insurance to
employees (or their spouses) during retirement.
 Under the matching principle, an expense should be recognized over the
period of employment as employees qualify for these OPEBs.
 Pre-Codification SFAS No. 106, most firms used “pay-as-you-go”
accounting.
 The dollar amounts involved can be staggering:
GM’s 1992
adoption of
SFAS No.106
$33.1
billion
OPEB liability
$22.8
billion
Initial OPEB
expense
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Other postretirement benefits:
General Electric footnote—part 1
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Analytical Insights:
Assessing OPEB Liability
Similar to pensions, the OPEB liability is riskier than many
traditional forms of debt. Risk measures are defined as follows:
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Evaluation of Pension and Postretirement
Benefit Financial Reporting
 Pension asset and liability measures in the notes are more closely
associated with stock prices than are the measures recognized on
the balance sheet.
 Both note liabilities (ABO for pensions and APBO for OPEBS) are
negatively correlated with stock prices.
 Investors price the APBO as though it is measured with less
reliability.
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Global Vantage Point
Comparison of IFRS and GAAP Retirement
Benefit Accounting
Difference
GAAP
IFRS
Actuarial Gains and Losses
Follows FASB ASC Subtopic 715-30
IAS 19 requires that the discount
rate be used to compute the
expected return on plan assets.
Prior Service Costs
Recognize new prior services costs
as part of OCI and recycle them into
pension expense over the shorter of
the average remaining work life or
the period covered under the
collective bargaining agreement
Called past service costs under
IFRS. Under IAS – past service
cost is recognized immediately
Balance sheet pension asset
Service cost is part of operating
activities, the finance component
is part of finance costs within profit
and loss, and actuarial gains and
losses is part of OCI
14-37
Summary
 In pension plan contracts, employees exchange current service
for payments to be received during retirement.
 Defined contribution pension plans specify amounts to be
invested for the employee during the employee’s career, and the
employee’s pension will be based on the value of those
investments at retirement.
 In the U.S., most new pension plans are defined contribution
plans.
 The accounting for defined contribution plans is straightforward.
Defined benefit plans specify amounts to be received during
retirement, thereby complicating the underlying economics of the
exchange and the accounting.
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Summary continued
 Under ASC Topic 715, pension expense for defined benefit plans
consists of service cost, interest cost, expected return on plan
assets, and two other “smoothing” components.
 The two smoothing mechanisms avoid year-to-year volatility in
pension expense but make pension accounting exceedingly
complex, because many pension related items are in AOCI.
 Under pre-Codification SFAS 87, the balance sheet asset (liability)
on the balance sheet differed from the actual funded status of the
plan. Current GAAP, requires that the balance sheet asset
(liability) equal the funded status of the plan.
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Summary continued
 Employer funding of defined benefit pension plans is influenced
by tax law, labor law, union membership, and the employer’s
financial needs.
 The reporting rules for other postretirement benefit plans (OPEB)
closely parallel pension accounting rules.
 GAAP requires information about the expected future cash flows,
future amortization amounts, and major classes of investments so
that investors can make cash flow projections, assess risk, and
evaluate return assumptions.
 Academic research suggests that stock prices reflect pension and
OPEB disclosures, but their impact may not be fully valued.
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Summary concluded

Statement readers should be alert for these warning signals of earnings
management:
1. A significant disagreement between any of the various pension and OPEB
rates selected by a firm and the rates chosen by other firms in the industry.
2. A very large difference between the chosen expected rate of return on plan
assets and the discount rate used.
3. An increase in the year-to-year expected rate of return on plan assets that
seems unrelated to changes in market conditions.
4. A decrease in the assumed rate of increase in future compensation levels
that cannot be explained by changing industry or labor market forces.
5. Rate of return assumptions that are inconsistent with prior investment
experience or mix of equity and debt investments.
6. IAS 19 offers guidance that is markedly different from U.S. GAAP
14-41