PENSIONS
PENSION PLAN CHARACTERISTICS


Contributory Plan
– Employer and employee contribute.
– Employees keep their contributions.
– Vesting determines employee right to employer
contributions.
Defined CONTRIBUTION Plan – Villanova faculty
– Specific contributions are promised by the employer.
(“Match” $2 for $1 up to 5%)
– Specific benefits are NOT promised.
– Benefits are a function of the management of the plan
assets. Risk/Reward borne by Employee
– Pension expense = Cash contributions by employer.
PENSION PLAN CHARACTERISTICS

Defined BENEFIT PLAN (Hydromaint)
– Specific benefit payments are promised by the employer.
(e.g., at retirement get $2,000 per mo.)
– Much More complex accounting.

Funded Pension Plan
– Fully funded: Plan Assets = PV of “ABO” (Accumulated
Benefit Obligation—using EXISTING compensation
levels)
– Partially funded: Plan Assets < PV of ABO
» Need not be fully funded; plan only needs to have enough assets to
meet current payment obligations.
» ERISA, tax laws, cash flow impact determines
“funding’
– Pension Expense = GAAP (FASB #87)
DEFINED BENEFIT PLANS
Pension Expense on Income Statement composed of:
1) Service Cost – “earned” by employees this period
(present value of increase in amount paid at
retirement for work done this period)
2) Interest cost accrued on Beg. of Year Pension Liability - the “PBO” (Projected Benefit Obligation—using
EXPECTED future compensation levels)
3) “PSC” (Prior Service Cost) amortization – attributed
to employee service before plan amendment
4) Plan Asset return – “expected” return on plan assets
5) Gain/loss amortization – adjust expected plan asset
return for difference between expected and actual
AND for other gains and losses due to changes in
estimate that affect PBO (e.g., life expectancy, discount
rate, actual age of employees at retirement, employee
turnover). These gains and losses are only amortized IF
net gain or loss > 10% of plan assets or PBO whichever is
larger.
EXAMPLE PLAN ASSUMPTIONS

Employee Data
– Hired on 1/1/20x1, Expected to retire on 12/31/20x5, and
expected to die on 12/31/20x7.
– Earns $10,000 per year from 20x1 to 20x3 and expected to
earn $20,000 per year from 20x4 to 20x5.

Plan Data (adopted 1/1/20x3)
– Benefits = number of years worked x 1% x highest salary
– Discount rate is 5%. (Use present value because will not
be paying out money until the future)
– Current service cost is fully funded at the end of each year.
– Expected rate of return to be earned on plan assets is 10%.
– PSC (Prior Service Cost) -- Pension credit given for work
years prior to plan adoption date. This PSC is given at
time plan adopted on 1/1/20X3.
– 1/10th of PSC “voluntarily” funded 1/1/20x3;
– 3 year amortization of PSC to Pension Expense.
Calculate Prior Service Cost
at Plan Adoption Date (1/1/20X3)
1/1/x1
1/1/x3
20x1
20x2
Hire
Employee
12/31/x3
20x3
Adopt
Plan
Solve for PV at retirement date
Compute PV of retirement benefits at
date granted by the plan
20x4
Balance
Sheet
Date
Number of service years (20x1 & 20x2)
Highest salary level expected
Pension Benefit annually at retirement
Calculate PBO:
Compute PV of employee's pension benefit
until death, at the date of retirement
12/31/x5
20x5
20x6
Employee
Retires
12/31/x7
20x7
Employee
Dies
2
$20,000
$400 (Begins on 1/1/x6 when employee retires) 1st $400 paid to retiree on 1/1/20x6.
Years =
discount rate=
pmt =
PV =
2
(20x6 and 20x7)
5.00%
$400
$780.95 (Annuity Due)
Years =
discount rate=
FV
PV
3
(20x3 through 20x5)
5.00%
$780.95
$674.62 (Regular PV, no annuity due)
Solve for PV at plan adoption date
This is the PBO. It also happens to be the
prior service cost (PSC) at the plan adoption date.
Projected Benefit
Obligation (PBO) is
the present value of
benefits for
employee service
prior to a particular
date based on
expected future
salary levels.
Calculate Service Cost for 20x3
(First Year of the Plan)
1/1/x1
1/1/x3
20x1
20x2
Hire
Employee
12/31/x3
20x3
Adopt
Plan
12/31/x5
20x4
20x5
Balance
Sheet
Date
12/31/x7
20x6
20x7
Employee
Retires
Employee
Dies
Number of service years
Highest salary level expected
Pension Benefit @ 1%
1
$20,000
$200
PSC is
$674.62
Compute PV of increase in pension benefit
at the date of retirement
Solve for PV at retirement date
Compute PV of the increase in retirement
benefit for additional service year
Solve for PV of increase in benefit
Years =
discount rate=
pmt =
PV =
Years =
discount rate=
FV =
PV =
2
(20x6 and 20x7)
5.00%
$200
$390.48 (Annuity Due)
2
(x4 and x5)
5.00%
$390.48
$354.17 (Regular PV, no annuity due)
Service Cost is
the increase in
PBO due to
work performed
in the current
year (20x3).
Calculate Pension Benefit Obligation
(PBO) at 12/31/x3 (Current Year End)
1/1/x1
1/1/x3
20x1
20x2
Hire
Employee
12/31/x3
20x3
Adopt
Plan
12/31/x5
20x4
20x5
Balance
Sheet
Date
20x6
Employee
Retires
Total Number of service years earned by 12/31/20x3
Highest salary level
Pension Benefit @1%
12/31/x7
20x7
Employee
Dies
3 years
$20,000
$600
PSC is
$674.61
Service Cost is $354.17
Compute PV of retirement benefit
at 12/31/20x3
Solve for PV at retirement date
Compute PV of retirement benefits
at 12/31/20x3
Solve for PV of total retirement benefits
This is the PBO at 12/31/20x3.
Years
discount rate=
pmt =
PV =
Years =
discount rate =
FV =
PV =
2
(20x6 and 20x7)
5.00%
$600
$1,171.43 (Annuity Due)
2
Prior Service Cost (PBO @ 1/1/20x3)
Interest on PBO at 5% discount rate
Current year (20x3) Service Cost
"Proof" of 12/31/20x3 PBO
(20x4 and 20x5)
5.00%
$1,171.43
$1,062.52 (Regular PV, no annuity due)
674.62
33.73
354.17
1,062.52
PBO vs. ABO

Projected Benefit Obligation (PBO)
– PV of benefits, based on expected future salary
levels

Accumulated Benefit Obligation (AB0)
– PV of benefits, based on existing compensation
levels (Need ABO vs. Plan Assets at end of year
to determine IF need an entry to show
“Minimum Liability” on Balance Sheet)
Financial Statement Effects
Pension Plan FUNDING to Trustee by Employer
1/10 Prior service cost funded 1/1/X3
Service cost funded on 12/31/x3
$67.46
$354.17
Employer Journal Entries
Accrued Pension Liability
Cash
To record funding of plan on 1/1/x3.
Trustee Account Record
(No Direct Entry on Employer's "Books")
Initial funding at 1/1/x3 by employer
Annual return on assets held by trustee
Funding by employer at 12/31/x3
Funds held by trustee at 12/31/x3
67.46
6.75
354.17
428.38
Accrued Pension Liability
Cash
To record funding of plan on 12/31/20x3
Pension Expense
Accrued Pension Liability
To record pension expense for x3.
Pension Expense Calculation for 20x3
Service Cost for 20x3
Interest on PBO:
$674.62 PBO 1/1/x3 x 5%
Amortization of Prior Service Cost:
$674.62 PSC / 3 years
Less: 10% Return on plan assets
Total pension expense
354.17
33.73
224.87
(6.75)
606.03
Still would
need to
check for
“Minimum
Liability”
67.46
67.46
354.17
354.17
606.03
606.03
Accrued Pension
Liability
67.46
354.17
606.03
184.40
RECENT DEVELOPMENTS

SFAS No. 132 --Employers’ Disclosures
about Pensions and Other Postretirement
Benefits.
– Standardizes disclosures for pensions and
other post-retirement benefit plans.
– Required disclosures:
» Change in PBO.
» Change in Plan Assets.
» Assumptions for discount rate, expected return
on plan assets, and compensation increases.
» Components of pension expense (net periodic
pension cost).
Recent additional pension disclosures
– Investment strategies & targets
– Plan asset allocations—equities, fixed assets,
real estate, and other
– Expected pension benefits to be paid out to
retirees – each of next 5 years and total
estimate for next 10 years
– Estimated cash contribution to plan trustee
for next year
Pension Note Disclosures for 20x3
Change in benefit obligation
Benefit obligation at beginning of year
Service cost
Interest cost
Adopton of plan
Benefit obligation at end of year
Change in plan assets
Fair value of plan assets at
beginning of year
Actual return on plan assets
Employer contributions
Fair value of plan assets at end of year
Underfunded status (FMV of Plan Assets < PBO)
Unrecognized prior service cost
Accrued Pension Liab.
$-0354.17
33.73
674.62
1,062.52
$-06.75
421.63
428.38
(634.14)
449.74
(184.40)
Weighted-average assumptions as of 12/31/20x3
Discount rate
Expected return on plan assets
5.00%
10.00%
Components of net periodic benefit cost
Service cost
Interest cost
Expected return on plan assets
Amortization of prior service costs
Net periodic benefit cost
354.17
33.73
(6.75)
224.87
606.03