Pensions
ACCTG 5120
David Plumlee
1
Important fact…


Accounting we are talking about is for the
company!
The pension fund is actually managed and
accounted for separately


legal and accounting entity of its own…..
We focus on the impact of an
asset/liability/expense for payment of the
pension obligation from the company’s
perspective
page2
Pensions: The Big Picture
Employer
Funding
Payments
Pension Fund Trustee
Invests funds to earn a return and
payout cash to retiree
Retiree
Benefit
Payments
page3
Basic questions
What is employer’s liability/asset (how
should this be reported on the balance
sheet)?
What is the current year’s expense
associated with the plan?
page4
Defined Contribution Plan


Employer contracts for an amount to be
contributed
Example Plan
The company will make a contribution under the plan
equal to a stated percentage of the employee’s current
annual salary. The percentages applied vary according to
age (see attached table). All employees are required to
make a 5% minimum contribution. Ownership of all
contributions is fully vested in the participant.
page5
Defined Contribution Plan
Employee
Employees Company% Wages
< age 45
7.0%$150,000
45 to 49
8.5%
$350,000
50 to retirement
11.5 % $200,000
page6
Company contribution
=$1,500,000* .07 + $3,500,000*.085 +
$2,000,000*.115
=$335,000
page7
Defined Contribution Example
Total Employment Period
Benefit period
page8
Defined Benefit Plan

Employer contracts for future payouts

Example Plan
The company agrees to provide to all employees at age
65, an annual pension benefit computed in accordance
with the “benefit formula.” Ownership of all benefits
becomes fully vested following three years of continuos
employment with the company.
page9
Defined Benefit Example
Total Employment Period
Benefit period
page10
Determining Employer
Contribution
What does the employer need to do?
What is the amount of that liability?
page11
Actuarial Assumptions
Assume for an employee who works for this company:

Benefits are $4,000 per year in retirement for every year
worked

Expected # of years at company = 20 yrs

Employee will live 15 years beyond retirement


Settlement rate is 6%. (The interest rate implicit in the
annuity contract at retirement.)
Expected rate of return 8%. ( The amount that funding will
earn.)
page12
Actuaries Determine Benefits
Actuarial Estimate of Retirement Benefits
= PV of Benefits @ Settlement Rate
Total Employment Period
Current
period
Retirement
page13
Actuaries Determine Benefits
Retirement Benefits =
Remaining Employment Period = 20 years
Current
period
Retirement = 15 years
page14
Actuaries Determine Funding
So, how much should the company fund
this year?
What is that amount in this example?
page15
Actuaries Determine Funding
Remaining Employment Period = 20 years
Current
period
Retirement = 15 years
page16
Defined contribution vs.
benefit plans
Benefit



Employer’s contribution
is based on expected
payout
Contract is for
payments to retired
employees employer
bears risk associated
with plan performance
Great uncertainty
regarding annual
pension expense
Contribution




Employer’s contribution
to the plan is defined
No promises regarding
ultimate pension benefit
Employees bear risk
associated with plan
performance
No uncertainty
regarding annual
pension expense
page17
Accounting for Defined
Contribution Plans
Assume required contribution under terms of
plan for 2003 is $335,000
Case A:
Case B:
Case C:
Employer
Contribution
Funding
Status
$335,000
$300,000
$600,000
fully funded
under funded
over funded
page18
Accounting for Defined
Contribution Plans
Case A:
Case B:
Case C:
page19
Defined BENEFIT Options
Cash basis accounting


wait until employees retire
expense actual payments to retired employees
Modified cash basis accounting


fund plan prior to retirement
expense funding payments
Accrual basis accounting (FAS 87)

expense pension related cost of services
provided in current year by employees
page20
What is the ‘obligation’?

Accumulated benefit obligation (ABO)
Estimate of total retirement benefits based on
current salary levels

Vested benefit obligation
Portion of ABO that is vested

Projected benefit obligation (PBO)
Estimate of total retirement benefits based on future
salary levels
page21
Major Components of a
Pension Plan

PBO
actuarial present value of future pension benefits earned to
date to be paid to employees in the future

Pension plan assets
value of assets set aside to satisfy obligation
**net pension obligation (asset) =PBO-pension assets**

Pension expense
amount charged to income for the period
page22
page23
Important Terms
Benefit payments

pension payments to participants
Funding payments

payments made to the trustee to fund the
plan
Transition adjustment

“catch-up” adjustment that arose when
firms first adopted FAS 87
page24
Important Terms
Current service cost (CSC)

present value of benefits earned during the
current period
Actual return on plan assets

includes dividends, interest income and
capital gains and losses
Expected return on plan assets

anticipated return on plan assets based on
the expected long-term rate of return on
plan assets
page25
Important Terms
Experience gain or loss

difference between actual and expected
return on plan assets
Actuarial gain or loss

a change in the value of the PBO resulting
from a change in actuarial assumptions
Prior service cost (PSC)

cost of retroactive benefits granted in a
plan amendment
page26
Pension Assets
opening balance
+ actual return on plan assets
+ funding payments
- benefit payments to retirees
closing balance
Pension Fund
Trustee
Invests funds to earn a
return and payout cash
to retiree
page27
Projected Benefit Obligation
opening balance
+ current service cost
+ prior service cost
+ interest on obligation
- benefit payments to retirees
+/- changes in assumptions
Employer
(i.e. actuarial gains/losses)
closing balance
page28
Pension Expense
+ current service cost
+ interest on pension obligation
- actual return on plan assets
+/- deferral of experience gain/loss
+/- amortization of unrecognized gain/loss
(including experience and actuarial gains/losses)
+ amortization of unrecognized prior service cost
+/- amortization of transition adjustment
pension expense
page29
Current Service Cost
Actuarial present value of new benefits
earned by employees during current period
Total Employment Period
Current
period
Retirement
PV of additional
retirement benefits
page30
Effect of Service Cost
Assume a $500,000 increase of PBO
due to additional year of service


PBO


Service cost is
starting point
Current service cost
will increase PBO on
an annual basis
Beg Bal.
Current SC
$1,300,000
500,000
Expense


Current service cost
increases
in first year of plan,
same as for PBO
$ 500,000
page31

Prior Service Cost
Credit given to employees for past service


Retroactive benefits




Initiate or amend a plan
really retroactive?
Expectation of future service….
Increases PBO
Amortize PSC for pension expense

Years of service method

prior service cost = $100,000, 5 year amortization
page32
Prior Service Cost
Prior
service
period
Plan
Amendment
PV of benefits due to plan
amendment or adoption
for past periods
Total Employment Period
Current
period
Retirement
page33
Effect of PSC
PBO

Expense
Increases by total
amount in year of
change
Beg Bal.
Current SC
PSC
$1,300,000
500,000
100,000

amortized into over
estimated life of
employees effected,
beginning with year
of change
$ 500,000
20,000
page34
Interest on Pension Obligation


Employee is one year closer to retirement,
which increase present value of benefits
due to the time value of future benefits
Interest on the pension obligation (i.e.
projected benefit obligation) outstanding
during the period
= beginning-of-year balance x settlement rate

Assume settlement rate = 10%
page35
Effect of Interest

Increases PBO
Beg Bal
Current SC
PSC
Interest
$1,300,000
500,000
100,000
130,000

Increases expense
$ 500,000
20,000
130,000
page36
Payments and changes in
assumptions




Benefit payments reduce PBO
Payments have NO EFFECT on pension expense
Assume $30,000 funding payment
Changes in actuarial assumptions



Increase or decrease PBO
Amortized in pension expense (when too big!)
Assume actuarial assumptions change amount
is increase in PBO of $40,000
page37
Effect of payments and
changes in assumptions


Payments decrease
PBO
Changes in actuarial
assumptions change
PBO
Beg Bal
$1,300,000
Current SC
500,000
PSC
100,000
Interest
130,000
Benefit pmt
( 30,000)
Actuarial loss
40,000


No effect
Changes in actuarial
assumptions are
amortized into expense
using corridor approach
$ 500,000
20,000
130,000
00
00*
page38
Return on Plan Assets
Pension Fund
Trustee
Actual return =
interest + dividends + cap. gains - cap. losses
Expected return = actuary’s expected rate of
return x plan assets
Difference is the ‘experience gain or loss’
page39
Details of expected return



Actual return reduces pension expense
with ‘experience’ gains/losses deferred
Net result is EXPECTED return reduces
pension expense
Amortize experience gains/losses when
they gets too large
page40
Return on plan assets



Plan assets = $1,000,000
Actual return at 25%= $250,000
Expected return at 11% = $110,000



unexpected gain (i.e. experience gain)
= 250,000-110,000=140,000
Reduce pension expense by $250,000
Defer experience gain of $140,00 (incr.
Pension exp.)
page41
Effect of return on plan assets

No effect


Beg Bal
$1,300,000
Current SC
500,000
PSC
100,000
Interest
130,000
Benefit pmt
( 30,000)
Actuarial loss
40,000
Actual return
000
Deferred exp gain 000
Reduces expense by
expected return
Actual return less the
deferred ‘experience
gain/loss’
$ 500,000
20,000
130,000
00
00*
(250,000)
140,000
page42
Delayed Recognition Under FAS 87
Impact of following items not fully recognized
when they occur
 experience gains and losses
 actuarial gains and losses (i.e. impact of
changes in assumptions)
 prior service cost
 transition adjustment (IGNORE!!)
page43
With Full Recognition:
expense
+ csc
+ psc
+ interest exp.
- actual return
PBO
balance
+ csc
+ psc
+ interest exp.
- benefits
+/- actuarial
gains and losses
total expense
+/- actuarial
gains and losses
balance
plan assets
balance
+ actual return
- benefits
+ contributions
balance
page44
Effect of Delayed Recognition
Prepaid (accrued) pension reported on
balance sheet may not equal net
pension asset (obligation)

i.e. frequently companies have significant
off-balance sheet pension liabilities or
pension assets
Total pension expense does not equal the
change in the PBO
page45
The Corridor Approach
Minimum amortization





allow gains less losses to accumulate until net amount
deferred exceeds a defined threshold
amortization required when beginning-of-year net gain
or loss exceeds 10% of maximum opening (PBO or fair
value of plan assets)
amortization period is Estimated Average Remaining
Service Life of the active employees expected to
receive benefits
amount amortized is the EXCESS over the
corridor amount.
(beginning net deferred gain/loss - threshold)/EARSL
page46
Corridor Example

Beginning fair value of plan assets = $1,000,000

Beginning of year PBO = $ 1,300,000

Beginning of year deferred gain/loss = $180,000

End of year deferred gain = $320,000

EARSL = 10 years
page47
Corridor Solution

Determine 10% threshold


10% of beginning PBO = $130,000
10% of beginning FV plan assets = $100,000
Amortization amount
Beginning deferred gain/loss = $180,000
Corridor
(10% of PBO)
130,000
Total amort. Amount
$50,000

(This year’s portion $50,000/10=$5,000)
page48
Effect of amortization

No effect
Beg Bal
$1,300,000
Current SC
500,000
PSC
100,000
Interest
130,000
Benefit pmt
( 30,000)
Actuarial loss
40,000
Actual return
000
Deferred exp gain 000
Amortization
000

Increases expense
$ 500,000
20,000
130,000
00
00*
(250,000)
140,000
5,000
page49
What do we record?

Journal entry to record pension expense

as calculated above

Entry to record funding payment

Balance to pension asset/liability
page50
What is not on the balance sheet?

Unrecognized experience gains/losses


Unrecognized prior service cost


Plan assets include actual return not
expected return
PBO includes entire prior service cost not
amortized
Unrecognized actuarial gains/losses

PBO includes all actuarial gains/loss
page51
Minimum liability




Concerns over underfunded plans with
no balance sheet recognition
Requires reporting of ‘minimum liability’
Difference between fair value of plan
assets and ABO
Can only report in a liability, not
additional asset….

(when ABO is less than FV of plan assets)
page52
Recording



Compare minimum liability to balance sheet
and adjust for difference
Debit contra equity account for amount
related to PSC
Debit balance to Intangible Asset-Deferred
Pension Cost

Credit additional pension liability for amount
minimum liability exceeds reported liability/asset
page53
Minimum Liability Example
Assume no minimum liability attributable to PSC.
Intangible Asset - Deferred Pension Cost
Minimum Liability
$XXXX
$XXXX
Assume $ 100,000 attributable to PSC.
Intangible Asset - Deferred
Pension Cost
$(XXXX-$100k)
Contra Equity Account
$100K
Minimum Liability
$XXXX
page54