4. 3-4
Postretirement Benefits
Defined Pension Plan -- Employer-promises
monetary benefits to employees after retirement, e.g.,
monthly stipend until death.
Defined Contribution Plan – Plan specify the amount
of pension contribution that the employer makes to the
plan.
Two kinds of Retirement Plans
11. 3-11
Post Retirement Benefits
Three steps:
• Determine how much is the
annual benefit and for how many
years.
• Determine the PV of the above
payments.
• Determine how many years to
“spread” the cost.
12. 3-12
Postretirement Benefits
Illustration of Pension Accumulation and Disbursement for a Defined
Benefits Plan
Funds required at employees’
retirement:
Present value of 10 payments of
$20,000 per annum with a
discount rate of 8% per annum
$134,200
Annual payments into the
Fund required to accumulate
to $134,200 in 15
years with a discount
rate of 8%per
annum
10 years
Annual benefits of
$20,000 paid to
employee for 10 years
PostretirementPreretirement Retirement
Benefits =
$20,000 per annum
Contributions =
$4,942 per annum
15 years
Step 1
13. 3-13
Determining Future Annual Benefit Cost
Step 1
Need to determine the following
related to each employee:
• Life expectancy
• Employee turnover
• Compensation growth
• Expected rates of return
• Interest rates
15. 3-15
Determining Future Annual Benefit Cost
Who can assist with determining
and calculating the needed
information?
Answer: An Actuary
16. 3-16
Determining Future Annual Benefit Cost
Step 2
How much needs to be “accrued”
at the time of an employee’s
retirement?
17. 3-17
Postretirement Benefits
Illustration of Pension Accumulation and Disbursement for a Defined
Benefits Plan
Funds required at employees’
retirement:
Present value of 10 payments of
$20,000 per annum with a
discount rate of 8% per annum
$134,200
Annual payments into the
Fund required to accumulate
to $134,200 in 15
years with a discount
rate of 8%per
annum
10 years
Annual benefits of
$20,000 paid to
employee for 10 years
PostretirementPreretirement Retirement
Benefits =
$20,000 per annum
Contributions =
$4,942 per annum
15 years
Step 2
18. 3-18
Determining Future Annual Benefit Cost
Step 3
How much is required to be
expensed each year so that the
amount needed to be “accrued” at
the time of an employee’s
retirement is achieved?
How do we determine the number
of years?
19. 3-19
Determining Future Annual Benefit Cost
Step 3
How much is required to be
expensed each year so that the
amount needed to be “accrued” at
the time of an employee’s
retirement is achieved?
Answer – PV of an Annuity
20. 3-20
Determining Future Annual Benefit Cost
Step 3 - continued
How do we determine the number
of years in which to accrue the
expense?
21. 3-21
Determining Future Annual Benefit Cost
Step 3 - continued
How do we determine the number
of years in which to accrue the
expense?
Answer - The estimated remaining
years of employment.
22. 3-22
Postretirement Benefits
Illustration of Pension Accumulation and Disbursement for a Defined
Benefits Plan
Funds required at employees’
retirement:
Present value of 10 payments of
$20,000 per annum with a
discount rate of 8% per annum
$134,200
Annual payments into the
Fund required to accumulate
to $134,200 in 15
years with a discount
rate of 8%per
annum
10 years
Annual benefits of
$20,000 paid to
employee for 10 years
PostretirementPreretirement Retirement
Benefits =
$20,000 per annum
Contributions =
$4,942 per annum
15 years
Step 3
23. 3-23
Postretirement Benefits
Pension Basics
Pension Plan – agreement by the employer to provide pension benefits involving
3entities: employer-who contributes to the plan; employee-who derives benefits; and
pension fund
Pension Fund – account administered by a trustee, independent of employer,
entrusted with responsibility of receiving contributions, investing them in a proper
manner, & disbursing pension benefits to employees
Vesting – specifies employee’s right to pension benefits regardless of whether
employee remains with the company or not; usually conferred after employee has
served some minimum period with the employer
Pension Plan Categories
Defined benefit – a plan specifying amount of pension benefits that employer promises
to provide retirees; employer bears risk of pension fund performance
Defined contribution – a plan specifying amount of pension contributions that
employers make to the pension plan; employee bears risk of pension fund performance
Focus of Pension Analysis
Defined benefit plans constitutes the major share of pension plans and are
the focus of analysis given their implications to future company
performance and financial position
24. 3-24
Managing Pension Plan
Company’s prefer defined contribution
plans since the amount of expense can
be modified each year and the expense
amount can easily be determined.
The expense amount of a defined benefit
plan is much more difficult to determine
and the amount in future period can
fluctuate significantly.
25. 3-25
Managing Pension Plan
CFO desired goals:
• Steady earnings.
• Limited disclosure
• Footnote only if possible
• Least impact on earnings
• Least fluctuation in earnings
• Least recorded amount of a
liability
26. 3-26
Recognized Pension Cost
The recognized pension cost included in net income (i.e., the net periodic
pension cost) is a smoothed version (smoothing process, defers volatile,
one-time items) of the actual economic pension cost for the period.
Expected return on plan assets is recognized in reported pension
expense.
Difference between the actual and expected return is deferred. These
deferred amounts are gradually recognized through a process of
amortization.
Thus, net periodic pension cost includes service cost, interest cost,
expected return on plan assets and amortization of deferred items.
Articulation of Balance Sheet and Income Statement Effects
The net deferral for the period is included in other comprehensive income
for the period
The cumulative net deferral is included in accumulated other
comprehensive income, a component of shareholders’ equity.
Postretirement Benefits
Pension Accounting Requirements
27. 3-27
Pension Costs
Recurring:
• Service cost
• Interest cost
• Expected return on assets
Changes in assumptions and economics:
• Actual return on assets different than
expected.
• Prior service cost (additional benefits)
• Actuarial gain / losses due to change in
assumptions
28. 3-28
Pension Plan Example
Why is interest cost a portion of
pension expense?
Why is return on plan assets
considered a negative expense?
29. 3-29
Pension Plan Example
Why is interest cost a portion of
pension expense?
To compensate for the liability
amount being discounted.
Why is return on plan assets
considered a negative expense?
The earnings from plan assets is a
source of funding the plan.
30. 3-30
Pension Plan Example
What would be the company’s pension
expense given the following:
• Service cost is $125,000
• Interest cost is $ 25,000
• Expected return on assets $50,000
31. 3-31
Pension Plan Example
What would be the company’s pension
expense given the following:
• Service cost is 125,000
• Interest cost is 25,000
• Expected ROA (50,000)
• Total expense $100,000
32. 3-32
Pension Costs
Recurring:
• Service cost
• Interest cost
• Expected return on assets
Changes in assumptions and economics:
• Actual return on assets different than
expected.
• Prior service cost (additional benefits)
• Actuarial gain / losses due to change in
assumptions
33. 3-33
Impact on Plan Expense
What is the impact on the plan if we
have any of the following:
• Change in discount rate
• Change in expected return on assets
• Change in compensation growth rate
34. 3-34
Impact on Plan Expense
Change in discount rate
Higher rate lower liability
Change in expected return on assets
Higher return lower cost
Change in compensation growth rate
Increase in rate higher liability
35. 3-35
Impact on Plan Expense
What is the impact on the plan if we have
any of the following:
• Additional pension benefits
• Increase in life expectancy
• Increase in expected employee turnover
36. 3-36
Impact on Plan Expense
Additional pension benefits
Increase liability and future expense
Increase in life expectancy
Increase liability and future expense
Increase in expected employee turnover
Decrease liability and future expense
37. 3-37
Expected vs Actual Return on Plan Assets
How would you account for the following change?
Plan assets $1,000,000
Expected return 8%
Expected earnings $80,000 (Reduction of pension expense)
Actual return 3%
Actual earnings $30,000
Average life of plan assets 10 years
38. 3-38
Expected vs Actual Return on Plan
Assets
Accounting Entries:
Year 1
Cash $30,000
Expected return $80,000 (Reduction of current pension expense)
Deferred asset $50,000
(An amount that will be amortized in future periods that will increase
pension expense.)
Year 2
Amortization of deferred asset $5,000 (Expense)
Deferred asset $5,000
39. 3-39
Change in Actuarial Assumptions
How would you account for the following change?
Increase in life expectancy $40,000
Higher employee turnover $20,000
Increase in expected compensation $30,000
Lower expected discount rate $100,000
Average remain years of service for employee - 15 years
40. 3-40
Change in Actuarial Assumptions
How would you account for the following change?
Year 1
Deferred assets $150,000
Projected benefit obligations $150,000
Year 2
Amortization of deferred asset $10,000 (Expense)
Deferred assets $10,000
41. 3-41
Postretirement Benefits
Economic pension cost -- net cost arising from changes in net economic position (or funded
status) for a period; includes both recurring and nonrecurring components along with return on
plan assets.
Recurring pension costs consist of two components:
Service cost – actuarial present value of pension benefit earned by employees
Interest Cost – increase in projected benefit obligation arising when pension
payments are one period closer to being made; computed by multiplying
beginning-period PBO by the discount rate
Return on plan assets:
Actual return on plan assets – pension plan’s earnings, consisting
of investment income—capital appreciation and dividend and interest
received, less management fees; plus realized and unrealized
appreciation (or minus depreciation) of other plan assets; Used to offset cost
to arrive at a net economic pension cost.
Nonrecurring pension costs consist of two components:
Actuarial Gain or Loss – change in PBO that occurs when one or more
actuarial assumptions are revised in estimating PBO
Prior Service Cost – effect of changes in pension plan rules on PBO
Economic Pension Cost
42. 3-42
Evaluation of the following assumptions:
Compensation increases 5.5% per year
(Average for the last ten years)
Employee turnover 7.2% per year
(Average for the last five years)
Expected asset yield 7.5% per year
(Average for the last twenty years)
Expected discount rate 8.0% per year
(Average for the last twenty years)
48. 3-48
Expected Return on Assets
What is a reasonable rate of return on
assets with the following mix?
Short term bonds 45%
Long term bonds 25%
Equities 30%
50. 3-50
Postretirement Benefits
Accumulated benefit obligation (ABO) – actuarial present value of future pension
benefits payable to employees at retirement based on their current compensation and
service to-date
Project benefit obligation (PBO) – actuarial estimate of future pension benefits payable to
employees on retirement based on expected future compensation and service to-date
Plan Assets – The funds contributed to the plan are called plan assets because these are
invested in capital markets
Funded Status of the Plan – Difference between the value of the plan assets and the PBO
which represents the net economic position of the plan
** Note: Plan is overfunded (underfunded) when value of plan assets exceeds (is less
than) PBO***
Alternative Definitions of Pension Obligation
Relation between Plan Assets and Funded Status
51. 3-51
Postretirement Benefits
Pension benefits -- Employer-promises monetary
benefits to employees after retirement, e.g., monthly
stipend until death
Other Postretirement Employee Benefits (OPEB)
-- Employer-provided non-pension (usually
nonmonetary) benefits after retirement, e.g., health care
and life insurance
Two kinds of Postretirement
Benefits
52. 3-52
Postretirement Benefits
Pension Accounting Requirements
Recognized Status on the Balance Sheet
Recognizes the funded status of the pension plans on the
balance sheet.
Pension assets and obligations are netted against each other
(as funded status) rather than separately reported both as an
asset and a corresponding liability.
Companies do not report the funded status of pension plans
as a separate line item on the balance sheet, instead, it is
embedded in various assets and liabilities.
54. 3-54
Postretirement Benefits
(similar to pension accounting)
(1) Other Pension Employee Benefits (“OPEB”) costs are recognized when incurred
rather than when actually paid out.
(2) Assets of the OPEB plan are offset against the OPEB obligation, and returns from
these assets are offset against OPEB costs.
(3) Actuarial gains and losses, prior service costs, and the excess of actual return
over expected return on plan assets are deferred and subsequently amortized.
Features of OPEB Accounting
55. 3-55
Analyzing Postretirement Benefits
Five-step procedure for analyzing postretirement benefits:
(1)Determine and reconcile the reported and economic benefit cost
and liability (or asset).
(2)Make necessary adjustments to financial statements.
(3)Evaluate actuarial assumptions (discount rate, expected return,
growth rate) and their effects on financial statements.
(4)Examine pension risk exposure (arises to the extent to which
plan assets have a different risk profile than the pension
obligation).
(5)Consider the cash flow implications of postretirement
benefit plans.
Postretirement Benefits
