CHAPTER 14
EMPLOYEE COMPENSATION:
POSTEMPLOYMENT AND SHARE-BASED
Presenter’s name
Presenter’s title
dd Month yyyy
TYPES OF POSTEMPLOYMENT BENEFITS:
PENSION PLANS
Amount of
Future benefit to
Employee
Contribution
from Employer
Defined
contribution
(DC)
pension plan
Depends on
investment
performance of
plan assets
Amount (if any)
is defined in
each period
Defined
benefit (DB)
pension plan
Defined based
on plan’s
formula
Depends on
current period
estimate and
investment
performance of
plan assets
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TYPES OF POSTEMPLOYMENT BENEFITS:
PENSION PLANS & EMPLOYER’S OBLIGATION
Type of Benefit
Defined
contribution
Defined benefit
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Amount of
Future benefit to
Employee
Depends
Defined
Contribution
from Employer
Employer’s
Prefunding of Its
Future
Obligation
Defined
N/A
Depends
Typically
prefunded;
regulatory
requirements.
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TYPES OF POSTEMPLOYMENT BENEFITS:
OTHER
Type of Benefit
Other
postemployment
benefits (e.g.,
retirees’ health
care)
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Employer’s
Amount of
Prefunding of its
Future benefit
Contribution
Future
to Employee
from Employer
Obligation
Eventual benefits
are specified.
Depends on plan The amount of
specifications
the future
Typically not
prefunded.
and type of
obligation must
benefit.
be estimated in
the current
period.
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MEASURING A DEFINED BENEFIT
PENSION OBLIGATION
• Pension obligation is measured as the present value of estimated
future payments to employees for benefits earned to date.
• Measured without deducting any plan assets.
• Requires company to make actuarial assumptions:
- Estimated future benefits.
- The discount rate at which to discount future payments.
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MEASURING NET PENSION LIABILITY
(OR ASSET) FOR DB OBLIGATIONS
• Pension obligation is measured without deducting any plan assets.
• The net pension deficit (or surplus) deducts fair value of plan assets.
Present value of the DB obligation – Fair value of the plan assets
= Funded status
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NET PENSION LIABILITY (OR ASSET)
• Underfunded
- Pension obligation exceeds pension plan assets.
- Liability equal to the net pension obligation is reported.
• Overfunded
- Pension plan assets exceed the pension obligation.
- Asset equal to the overfunded pension obligation is reported,
subject to limitations.
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COMPONENTS OF A COMPANY’S DEFINED
BENEFIT PENSION EXPENSE
Return on
Plan Assets
Actuarial
Losses
Past
Service
Cost
Interest
Current
Service
Cost
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DEFINED BENEFIT PLAN ASSUMPTIONS
• Estimated future benefits, which depend on
- Future compensation increases and levels,
- Length of service,
- Vesting rate and turnover, and
- Life expectancy postretirement.
• Discount rate at which to discount future payments and for net
interest calculations.
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DEFINED BENEFIT PLAN ASSUMPTIONS:
EXAMPLE
• Assume for a company establishing a DB pension plan, the discount
rate is 6%.
• Assume for an employee covered by a DB pension plan:
- Salary in the coming year of €50,000.
- Expected to work 5 more years before retiring.
- Annual compensation increase is 4.75%.
- Will receive benefit for 20 years.
- Benefit based on (Estimated final salary × 1.5%) × Years of service.
• Employee’s estimated final year salary = €50,000 × [(1 + 4.75%)4] =
€60,198.56.
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DEFINED BENEFIT PLAN ASSUMPTIONS:
EXAMPLE
• Annual benefit = (Estimated final salary × Benefit formula) × Years service
• Value at retirement date of estimated future benefits = Present value of annual
benefit during retirement period
• Annual unit credit = Value at retirement date/Years of service
Today
Retirement
Date
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Retirement
Period End
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DEFINED BENEFIT PLAN ASSUMPTIONS:
EXAMPLE
• Annual benefit = (Estimated final salary × Benefit formula) × Years service =
€60,198.56 × 1.5% × 5 = €4,514.89
• Value at retirement date of estimated future benefits = Present value of annual
benefit during retirement period
• Annual unit credit = Value at retirement date/Years of service
Today
Retirement
Date
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Retirement
Period End
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DEFINED BENEFIT PLAN ASSUMPTIONS:
EXAMPLE
• Annual benefit = €4,514.89
• Value at retirement date of estimated future benefits = Present value of annual
benefit during retirement period = Present value of annuity of €4,514.89 for 20
years, discounted at 6% = €51,785.46
• Annual unit credit = Value at retirement date/Years of service
Today
Retirement
Date
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Retirement
Period End
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DEFINED BENEFIT PLAN ASSUMPTIONS:
EXAMPLE
• Annual benefit = €4,514.89
• Value at retirement date of estimated future benefits = €51,785.46
• Annual unit credit = Value at retirement date/Years of service = €51,785.46/5
years = €10,357.09 per year
• Pension obligation increases by an amount equal to the present value of the
annual credit earned in the year
Today
Retirement
Date
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Retirement
Period End
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DEFINED BENEFIT PLAN ASSUMPTIONS:
IMPACT OF CHANGES
• Changes in assumptions change the estimated obligation.
• Direction of change in assumption that would increase a DB pension
plan obligation:
- Lower discount rate.
- Longer estimated working period before retiring.
- Higher assumed annual compensation increase.
- Longer estimated retirement period (longer life expectancy).
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PENSION AND OTHER POSTEMPLOYMENT
BENEFITS: USING DISCLOSURES
• Differences in key assumptions used for pensions and other
postemployment benefits can affect comparisons across companies.
• Companies disclose their assumptions about
- discount rates,
- expected compensation increases, and
- expected return on plan assets.
• An analyst can compare these assumptions over time and across
companies to assess any conservative or aggressive biases.
• In some cases, an analyst can adjust items as reported to create more
comparable data.
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PENSION AND OTHER POSTEMPLOYMENT
BENEFITS: USING DISCLOSURES
• In assessing potential conservative or aggressive biases, other fundamental
explanations for differences should be considered.
• For example, the assumed discount rates used to estimate pension obligations
- are generally based on the market interest rates of high-quality corporate
fixed-income investments, and
- the investments have a maturity profile similar to the timing of a company’s
future pension payments.
• Discount rates may thus differ across companies because of
- differences in the regions/countries involved and/or
- differences in the timing of obligations.
• An important consideration is whether the assumptions are internally
consistent (e.g., do the company’s assumed discount rates and assumed
compensation increases reflect a consistent view of inflation?).
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PENSION AND OTHER POSTEMPLOYMENT
BENEFITS: USING DISCLOSURES
Assumed discount rates used to estimate pension obligations for U.S. plans (percent).
Fiat S.p.A.
The Volvo Group
General Motors
Ford Motor Company
2009
5.50
4.00−5.75
5.52
6.50
2008
5.10
5.75−6.25
6.27
6.25
2007
5.80
5.75−6.25
6.35
6.25
2006
5.80
5.50
5.90
5.86
2005
5.50
5.75
5.70
5.61
Source: Companies’ annual reports.
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PENSION AND OTHER POSTEMPLOYMENT
BENEFITS: USING DISCLOSURES
• As noted, in some cases, an analyst can adjust items as reported to create
more comparable data or to examine sensitivities.
• For example, postemployment health care plans, a type of defined benefit plan,
disclose assumptions about increases in health care costs.
Effect of 1% increase (decrease) in assumed health care cost trend rates on 2009
total accumulated postemployment benefit obligations and periodic expense.
1% Increase
1% Decrease
CNH Global N.V.
+ $106 million (Obligation)
+ $8 million (Expense)
– $90 million (Obligation)
– $6 million (Expense)
Caterpillar Inc.
+ $220 million (Obligation)
+ $23 million (Expense)
– $186 million (Obligation)
– $20 million (Expense)
Source: Companies’ annual reports.
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PENSION AND OTHER POSTEMPLOYMENT
BENEFITS: USING DISCLOSURES
Example: Adjust items as reported to examine sensitivities.
Caterpillar Inc.
($ millions)
Reported
Adjustment for 1%
Increase in Health Care
Cost Trend Rate
Total liabilities
$50,738
+ $220
$50,958
Total equity
$8,823
– $220
$8,603
Ratio of debt to equity
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5.75
Adjusted
5.92
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PENSION PLAN NOTE DISCLOSURES:
EXCERPTS ON FUNDED STATUS
Source: L’oréal, Registration Document (2011).
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PENSION PLAN NOTE DISCLOSURES:
EXCERPTS ON FUNDED STATUS
Source: L’oréal, Registration Document (2011).
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PENSION PLAN NOTE DISCLOSURES:
EXCERPTS ON FUNDED STATUS
Source: Colgate-Palmolive Company, Annual Report (2011).
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CASH FLOW INFORMATION ON
DEFINED BENEFIT PLANS
• The difference between periodic contributions to a plan and total
pension costs of the period can be viewed as financing activity.
- If periodic contributions to a plan exceed the total pension costs of
the period, the excess is similar to paying loan principal ahead of
scheduled amounts.
- If periodic contributions to a plan are less than the total pension costs
of the period, it can be viewed as a source of financing.
• Where the amounts are material, an analyst may choose to adjust the
reported cash flows.
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CASH FLOW INFORMATION: EXAMPLE
• Assume a company reported (₤ millions):
- Total pension cost for period: ₤437
- Contribution to pension for period: ₤504
- Cash inflow from operating activities: ₤6,161
- Cash outflow from financing activities: ₤1,741
• Using an effective tax rate of 28.7%, adjust cash flow from operations
and financing to reflect excess contribution as similar to a repayment
of borrowing.
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CASH FLOW INFORMATION: EXAMPLE
• Assume a company reported (₤ millions):
- Total pension cost for period: ₤437
- Contribution to pension for period: ₤504
- Cash inflow from operating activities: ₤6,161
- Cash outflow from financing activities: ₤1,741
• Using effective tax rate of 28.7%, adjust cash flow from operations
and financing to reflect excess contribution as similar to a repayment
of borrowing.
- After-tax excess contribution: ₤48
- Increase company’s cash outflow from financing activities from
₤1,741 to ₤1,789
- Increase company’s cash inflow from operations from ₤6,161 to
₤6,209
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SHARE-BASED COMPENSATION
• Employee compensation packages are structured to fulfill varied
objectives, including satisfying employees’ needs for liquidity, retaining
employees, and providing incentives to employees.
• Common components of employee compensation packages are salary,
bonuses, and share-based compensation.
• Share-based compensation (such as stock and stock options)
- Aims to align employees’ interest with those of the shareholders,
- Requires no current-period cash outlays,
- Is treated as an expense and thus reduces earnings,
- Potentially dilutes EPS (earnings per share), and
- Typically dilutes existing shareholders’ ownership
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SHARE-BASED COMPENSATION:
STOCK GRANTS
• Stock Grants: Stock granted to employees by their employer.
• Types of stock grants includes
- Outright,
- Restricted stock grant, and
- Contingent stock grant (also known as performance shares).
• Accounting for stock grants’ compensation expense:
- Amount of expense is based on fair value of the stock on grant date.
- Expense is allocated over the employee’s service period.
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SHARE-BASED COMPENSATION:
STOCK OPTIONS
• Compensation expense is reported at fair value.
• The fair value of option grants must be estimated using a valuation model.
• Key assumptions and input into option pricing models include
- exercise price,
- stock price volatility,
- estimated life of each award,
- estimated number of options that will be forfeited,
- dividend yield, and
- the risk-free rate of interest.
• Some inputs, such as the exercise price, are known at the time of the grant.
• Other inputs are highly subjective (e.g., stock price volatility or the expected life
of stock options) and can greatly change the estimated fair value and thus
compensation expense.
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SHARE-BASED COMPENSATION:
STOCK OPTIONS
Day options are granted (usually, the date that
compensation expense is measured).
Date that options can first be
exercised.
Date when employees actually
exercise the options.
Grant
Date
Vesting
Date
Exercise
Date
Expiration
Date
• Immediate vesting: Expense is recognized on grant date.
• Otherwise, expense is recognized over the service period.
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SUMMARY
• Defined contribution pension plans specify (define) only the amount of
contribution to the plan; the eventual amount of the pension benefit to the
employee will depend on the value of an employee’s plan assets at the time of
retirement.
• Defined benefit pension plans specify (define) the amount of the pension
benefit, often determined by a plan formula, under which the eventual amount
of the benefit to the employee is a function of length of service and final salary.
• The reported obligation and periodic expense for defined benefit pension plans
and other postemployment benefit plans are sensitive to assumptions.
• Share-based compensation expense is reported at fair value.
• Stock option compensation expense is estimated using a pricing model.
• Key inputs into option pricing models include exercise price, stock price
volatility, estimated life of each award, estimated number of options that will be
forfeited, dividend yield, and the risk-free rate of interest. Certain assumptions
(stock price volatility, expected life of stock options) are subjective and can
greatly change the estimated fair value and thus compensation expense.
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