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  1. 1. Pensions RCJ Chapter 14
  2. 2. Key Issues1. Types of pension plans: defined benefit vs. defined contribution2. Pension liability: PBO, ABO, VBO3. Assumptions: discount rate%, salary growth rate%, E(ROA)%, actuarial4. PENSION assets5. Primary (ongoing) factors6. Journal entries7. Smoothing of transitory gains and losses 12. Corridor amortization8. Types of transitory gains and losses 13. Pension worksheet9. Additional factors 14. Footnote disclosures10. Funded status reconciliation 15. Correction JE  16. OPEB’s11. Minimum liability Paul Zarowin 2
  3. 3. Structure of Pension Planfirm or employee  pension fund  retiree Cash Pay benefits Paul Zarowin 3
  4. 4. Types of Pension Plans1. Defined contribution: employee bears risk, no firm liability2. Defined benefit: firm bears risk and has liability (our focus) Paul Zarowin 4
  5. 5. Ex. Defined Benefit Plan worker’s age = 60 service = 30 yrs so far retire @ 65 (5 more years) current salary = $50,000Pension contract: X% per year * final salary (X = # of years of service @ retirement) Example: 35% x $50,000 = $17,500 Paul Zarowin 5
  6. 6. Pension LiabilitiesPension liability : discounted PV of expected future cashpayments - like any other non-current liability (effective interestmethod).compare to other non-current liabilities: r% E(CF) Bonds known known Leases known? known Pensions ? ?Both discount rate and expected cash flows are subjective Paul Zarowin 6
  7. 7. 3 Definitions of Liabilities PBO = PV of expected payments, given expected future salaries ABO= PV of expected payments, given current salaries VBO =PV of vested portion of expected payments, given current salaries PBO ≥ ABO ≥ VBO Which definition is appropriate for which case? 1. valuing a going concern 2. Takeover 3. Firm in bankruptcy We’ll use PBO, unless otherwise stated.  Paul Zarowin 7
  8. 8. Key Assumptions discount rate = r% What are salary growth rate = g% (for PBO) management’s incentives? actuarial (life span, tenure, turnover, etc.) EROA% (expected rate of return on pension assets), see belowQ: Is liability bigger for older or younger workers? Paul Zarowin 8
  9. 9. Ex. Defined Benefit Plan, Continued Assumptions  Expected salary growth rate = 5%  Discount rate = 10%   Life expectancy = 80 years (15 years in retirement) Expected final salary = 50,000 * (1.05)5 = 63,814 30% * 63,814 = 19,144 = amount he’ll receive per year in retirement (based on service so far) PV of annuity factor, 10%, 15 yrs = 7.606 19,144 * 7.606 = 145,611 = PV @ retirementPBO = 145,611/(1.10)5 = 90,413 = PV of annuity nowABO = (30% * 50,000 * 7.606)/1.105 = 70,841PBO > ABO due to expected salary growth Paul Zarowin 9
  10. 10. Primary (Ongoing) Factors Affecting PBO PBO - + DR CR pay benefits Interest cost Service costdef: interest cost = r% * PBO @ beginning of year(remember: effective interest method)[debt accretion, like zero coupon bond]def: service cost = PV of future benefits earned this yearEx. E14-1, E14-13 Paul Zarowin 10
  11. 11. Ex. Defined Benefit Plan, ContinuedInterest cost = 90413*.10 = 9041Service cost = (1% * 63,814 * 7.606)/1.105 = 3014Q: how does a higher or lower r% affect interest cost? Q: how does an employee’s age affect his service cost? E14-1,13 Paul Zarowin 11
  12. 12. Pension Assets Pension assets: FMV of assets (stocks, bonds, etc.) Funded status (true, economic position): Pension assets – PBO  Overfunded: assets > PBO  Underfunded: assets < PBO  Severely underfunded: assets < ABO Paul Zarowin 12
  13. 13. Primary (Ongoing) Factors AffectingPensions Assets Assets + - DR CR Funding (contribution) Pay benefits (ROA)Return on assets## note: this is actual ROA; ROA is shown as +, but could be –Ex. E14-6, E14-13 Paul Zarowin 13
  14. 14. Primary Journal Entries DR CRservice, interest Pension expense PBOFunding Assets Cash(contributions)benefits PBO AssetsROA Assets(actual Pension Expense ROA)* (expected ROA= EROA %*beginning assets) UNL or UNG* note: actual ROA is shown as +, but could be –UNL = unexpected net loss (if actual ROA < expected ROA)UNG = unexpected net gain (if actual ROA > expected ROA) Paul Zarowin 14
  15. 15. Ex. Defined Benefit Plan, ContinuedAssume: pension assets = 100,000 E(ROA)% = 10% actual ROA = 15,000  DR assets 15,000 CR Pension expense 10,000 CR UNGain 5,000Q: How does assumed EROA% affect FMV of assets? Paul Zarowin 15
  16. 16. Primary Factors Affecting PensionExpense Pension Expense + - DR CR Service E(ROA) InterestQ: What is the effect of funding on expense? Paul Zarowin 16
  17. 17. Ex. Defined Benefit Plan, ContinuedService 3,014 Interest 9,041 E(ROA) (10,000)pension expense 2,055Ex. E14-12 without amortization and unexpected lossP 14-1, Parts 1-3 in Summary So Far Paul Zarowin 17
  18. 18. Smoothing of Transitory Gains and Lossesdef: unrecognized = deferred (in footnotes)def: recognized = amortized (into pension expense on I/S) Transitory gains, losses are CR’d (gains) or DR’d (losses) to unrecognized (footnote) accounts, rather than recognized as gain or loss on I/S. The unrecognized balances are amortized onto I/S. This smooths NI and keeps assets and PBO off of B/S.Full Exp For E14-13 Paul Zarowin 18
  19. 19. Smoothing (cont’d): Intuition Loss in DR, Gain in CR DR CRLoss: Unrecognized loss Asset or liab.Amort’n: Exp.(recorded) Unrecognized lossGain: Asset or liab. Unrecognized gainAmort’n: Unrecognized gain Exp.(recorded) Paul Zarowin 19
  20. 20. Types of Transitory Gains,Losses DR CRasset gain: actual ROA > expected ROA Assets Pension expense UNGasset loss: actual ROA < expected ROA Assets Pension expense UNL* assets are DR’d (or CR’d) for actual ROA; pension expense is CR’d for expected ROA;difference is UNG or UNL (see slide #15)liability loss (due to ∆ assumption r%, g%, etc.) UNL PBOliability gain (due to ∆ assumption r%, g%, etc.) PBO UNGnote: asset and liability gains and losses are all aggregated into one UNG/Laccountnote: liability gains and losses are also called actuarial gains and lossesQ: What happens if EROA% is set too high (higher than true averageROA%)? 20
  21. 21. 2 Types of Liability Gain/Loss1. Change in assumptions2. Change in contractsIntuition: What affects r% and E(CF)’s Paul Zarowin 21
  22. 22. Types of Transitory Gains, Losses(cont’d) DR CRChange in pension contract: sweetening UPSC PBOChange in pension contract: souring PBO UPSCdef: UPSC = unrecognized prior service cost (retroactive benefits) Paul Zarowin 22
  23. 23. Ex. Defined Benefit Plan, Continued1. assume benefits are sweetened to pay 1.1% * final salary per year (increased by 10%) increase in PBO = 10% * 90,413 = 9041 DR UPSC 9041 CR PBO 90412. assume salary growth rate is increased to 6% (final salary = 66,912), so PBO = 94,802 and increase in PBO = 4389 (94,802 – 90,413) DR UNLoss 4389 CR PBO 4389 Paul Zarowin 23
  24. 24. Additional Factors Affecting PBO PBO DR (+) CR (-) Pay benefits Interest cost Primary factors Service cost Liability gain Liability loss (∆ assumptions) Additional factors Souring Sweetening (∆ contracts) Paul Zarowin 24
  25. 25. Additional Factors Affecting PensionExpense Expense DR (+) CR (-) Interest cost E(ROA)Primary factors Service cost lossAdditional factors Gain amortization amortization Paul Zarowin 25
  26. 26. Additional Factors Affecting Pension Expense(cont’d)Loss amortization: DR Pension expense CR UPSC or UNL or UTL Gain amortization: DR UPSC or UNG or UTA CR Pension expenseUTA, UTL = unrecognized transition asset, liability = net position (assets - PBO) @ adoption of SFAS #87 remember: amortization = recognized into expense amortization is generally SL over average remaining service life of employees Paul Zarowin 26
  27. 27. Ex. Defined Benefit Plan, ContinuedAmortize UPSC over 5 years: 9041/5 = 1808 DR pension expense 1808 CR UPSC 1808service 3,014interest 9,041E(ROA) (10,000)UPSC Amort. 1,808pension expense 3,863Ex. E14-13 GM disclosureE 14-12 w/o Loss Paul Zarowin 27
  28. 28. Funded Status ReconciliationReconcile true vs. recognized position assets - PBO funded status (can be net asset or net liability): ‘true position’ + UNL (or - UNG) Unrecognized + UPSC Gains/Losses + UTL (or - UTA) recognized (on B/S) position: prepaid pension cost (asset) or deferred pension cost (liab) note: funded status (true economic position) vs. recognized position unrecognized losses & liab’s make the recognized position better than the true position unrecognized gains & assets make the recognized position worse than the true positionEx. E14-14, 19 Paul Zarowin 28
  29. 29. Minimum Liability if ABO > assets the pension plan is considered ‘severely underfunded’ and a liab. ≥ (ABO - assets) must be recognized. if recognized position is asset (prepaid cost) or liab (accrued cost) < (ABO-assets), additional entry is needed to bring recognized position to minimum level: DR Intangible asset* CR Additional liability * should be DR to a loss account additional liab can be shown separately or aggregated with accrued pension cost on B/SEx. E14-2, E14-5 Paul Zarowin 29
  30. 30. Corridor (Minimum) Amortization  UNL or UNG must be amortized only if it > “corridor”  corridor = 10% of bigger (PBO, assets) @BOY  amortization is down to corridor, not zero   if amort’n is required one year, it might or might not be the next year, and vice versa UNG/L DR CR *BOY net loss *BOY net gain (* for current year amort’n test) Current year loss Current year gain gain amort’n loss amort’n (amort’n only if required) #EOY net loss #EOY net gain (# for next year’s amort’n test)Ex. P14-1, sec 1-6 E14-18 30
  31. 31. Pension Worksheet - put it all together - relate to funded status reconciliation Recognized (on FS) bal. Unrecognized (footnote) balances Pen. exp Cash pp’d/acc cost Pen Pen UNGL UPSC Ass LiabService cost DR CRInterest cost DR CRROA CR DR plugFunding (contribution) CR DRBenefits CR DRliability loss6 CR DRSweetening7 CR DRAmortization UNL8 DR CRAmortization of UPSC DR CR(from sweetening)9 Summary JE; only DR CR CR or DR recognized (on FS) for a liability gain6. reverse DR and CR JE 8. reverse DR and CR for amort’n of unrecognized gain7. reverse DR and CR for souring 9. reverse DR and CR for amort’n from souringNote: recognized asset/liab (prepaid/accrued pension cost) is net of all unrecognized accounts
  32. 32. Exercise problems E14-3, E14-4, E14-7 E14-17, 20 P14-2, P14-3 P14-13 Paul Zarowin 32
  33. 33. Footnote DisclosuresThe pension footnote includes:1. total pension expense and its components2. reconciliation of BOY vs EOY PBO and asset accounts (like t-accounts)3. funded status reconciliation4. assumptions (r%, g%, EROA%) C 14-2,3 Paul Zarowin 33
  34. 34. Correction JE(to put assets and liabs on B/S) using information in pension footnote, put pension assets and liab on B/S; replace recognized position with true position DR CR pension assets PBO accrued pension cost or Prepaid pension cost R/E or R/E1. put pension assets and PBO on B/S2. remove accrued or prepaid pension cost from B/S3. plug: DR or CR R/E = cumulative unrecognized gains/losses (sum of UNGL, UPSC, UTAL)note: DR or CR to R/E rather than current year gain or loss Paul Zarowin 34
  35. 35. Other Post-Employment Benefits (OPEB’s)Same accounting as pensions, with minor differences1. ABO instead of PBO (OPEB’s not tied to salary)2. significance of (TL) transition liability (no incentive to fund, so ABO > assets) firms can: amortize TL over <= 20 years DR OPEB expense CR Accrued OPEB cost or take loss as change in accounting principle (below the line): DR loss due to change in acct principle CR Accrued OPEB cost ? most firms chose latter: why? 3. service cost is accrued (earned) over short (vesting) period, since benefits don’t increase with tenure Paul Zarowin 35