Pensions

1
Pensions

• RCJ Chapter 14

2
Key Issues

• Types of pension plans defined benefit vs.
  defined contribution
• Pension liability PBO, ABO, VBO
• Assumptions discount rate, salary growth rate,
  E(ROA), actuarial
• PENSION assets
• Primary (ongoing) factors
• Journal entries
• Smoothing of transitory gains and losses
• Types of transitory gains and losses
• Additional factors
• Funded status reconciliation
• Minimum liability

• Corridor amortization
• Pension worksheet
• Footnote disclosures
• Correction JE 
• OPEBs

3
Structure of Pension Plan

• firm or employee ? pension fund ? retiree
  
  Cash
  Pay benefits

4
Types of Pension Plans

• 1. Defined contribution
• employee bears risk, no firm liability
• 2. Defined benefit
• firm bears risk and has liability (our focus)

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Ex. Defined Benefit Plan

• workers age 60
• service 30 yrs so far
• retire _at_ 65 (5 more years)
• current salary 50,000
• Pension contract
• X per year final salary
• (X of years of service _at_ retirement)
• Example 35 x 50,000 17,500

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Pension Liabilities

• Pension liability discounted PV of expected
  future cash payments - like any other
  non-current liability (effective interest
  method).
• 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

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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
• Well use PBO, unless otherwise stated.
•  

8
Key Assumptions

• discount rate r
• salary growth rate g (for PBO)
• actuarial (life span, tenure, turnover, etc.)
• EROA (expected rate of return on pension
  assets), see below
• Q Is liability bigger for older or younger
  workers?

What are managements incentives?
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 hell 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 _at_ retirement
• PBO 145,611/(1.10)5 90,413 PV of annuity
  now
• ABO (30 50,000 7.606)/1.105 70,841
• PBO gt ABO due to expected salary growth

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Primary (Ongoing) Factors Affecting PBO

• PBO
• -
• DR CR
• pay benefits Interest cost
• Service cost
• def interest cost r PBO _at_ beginning of year
• (remember effective interest method)
• debt accretion, like zero coupon bond
• def service cost PV of future benefits earned
  this year
• Ex. E14-1, E14-13

11
Ex. Defined Benefit Plan, Continued

• Interest cost 90413.10 9041
• Service cost (1 63,814 7.606)/1.105 3014
• Q how does a higher or lower r affect interest
  cost? 
• Q how does an employees age affect his service
  cost?

E14-1,13
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Pension Assets

• Pension assets FMV of assets (stocks, bonds,
  etc.)
• Funded status (true, economic position)
• Pension assets PBO
• Overfunded assets gt PBO
• Underfunded assets lt PBO
• Severely underfunded assets lt ABO

13
Primary (Ongoing) Factors Affecting Pensions
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

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Primary Journal Entries

• note actual ROA is shown as , but could be
• UNL unexpected net loss (if actual ROA lt
  expected ROA)
• UNG unexpected net gain (if actual ROA gt
  expected ROA)

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Ex. Defined Benefit Plan, Continued

• Assume
• pension assets 100,000
• E(ROA) 10
• actual ROA 15,000
•  
• DR assets 15,000
• CR Pension expense 10,000
• CR UNGain 5,000
• Q How does assumed EROA affect FMV of assets?

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Primary Factors Affecting Pension Expense

• Pension Expense
• -
• DR CR
• Service E(ROA)
• Interest
• Q What is the effect of funding on expense?

17
Ex. Defined Benefit Plan, Continued

• Service 3,014
•  
• Interest 9,041
•  
• E(ROA) (10,000)
• pension expense 2,055
• Ex. E14-12 without amortization and unexpected
  loss

P 14-1, Parts 1-3 in Summary So Far
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Smoothing of Transitory Gains and Losses

• def unrecognized deferred (in footnotes)
• def recognized amortized (into pension expense
  on I/S)
• Transitory gains, losses are CRd (gains) or DRd
  (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
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Smoothing (contd) Intuition

• Loss in DR, Gain in CR
• DR CR
• Loss Unrecognized loss Asset or liab.
• Amortn Exp.(recorded) Unrecognized
  loss
• Gain Asset or liab. Unrecognized gain
• Amortn Unrecognized gain Exp.(recorded)

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Types of Transitory Gains, Losses
note liability gains and losses are also called
actuarial gains and losses Q What happens if
EROA is set too high (higher than true average
ROA)?
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2 Types of Liability Gain/Loss

• Change in assumptions
• Change in contracts
• Intuition What affects r and E(CF)s

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Types of Transitory Gains, Losses (contd)
def UPSC unrecognized prior service cost
(retroactive benefits)
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Ex. Defined Benefit Plan, Continued

• 1. 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 9041
• 2. 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

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Additional Factors Affecting PBO
(? assumptions)
(? contracts)
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Additional Factors Affecting Pension Expense
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Additional Factors Affecting Pension Expense
(contd)

• Loss amortization
• DR Pension expense
• CR UPSC or UNL or UTL 
• Gain amortization
• DR UPSC or UNG or UTA
• CR Pension expense
• UTA, UTL unrecognized transition asset,
  liability
• net position (assets - PBO) _at_ adoption of
  SFAS 87
• remember amortization recognized into expense
• amortization is generally SL over average
  remaining service life of employees

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Ex. Defined Benefit Plan, Continued

• Amortize UPSC over 5 years 9041/5 1808
• DR pension expense 1808
• CR UPSC 1808
• service 3,014
• interest 9,041
• E(ROA) (10,000)
• UPSC Amort. 1,808
• pension expense 3,863
• Ex. E14-13 GM disclosure

E 14-12 w/o Loss
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Funded Status Reconciliation

• Reconcile true vs. recognized position
• assets
• - PBO
• funded status (can be net asset or net
  liability) true position
• UNL (or - UNG)
• UPSC
• 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 liabs make the recognized
  position better than the true position
• unrecognized gains assets make the recognized
  position worse than the true position
• Ex. E14-14, 19

Unrecognized Gains/Losses
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Minimum Liability

• if ABO gt 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) lt (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/S

Ex. E14-2, E14-5
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Corridor (Minimum) Amortization

• UNL or UNG must be amortized only if it gt
  corridor
• corridor 10 of bigger (PBO, assets) _at_BOY
• amortization is down to corridor, not zero 
• if amortn is required one year, it might or
  might not be the next year, and vice versa

Ex. P14-1, sec 1-6 E14-18
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Pension Worksheet - put it all together - relate
to funded status reconciliation
6. reverse DR and CR for a liability gain 8.
reverse DR and CR for amortn of unrecognized
gain 7. reverse DR and CR for souring 9.
reverse DR and CR for amortn from souring Note
recognized asset/liab (prepaid/accrued pension
cost) is net of all unrecognized accounts
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Exercise problems

• E14-3, E14-4, E14-7 E14-17, 20
• P14-2, P14-3
• P14-13

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Footnote Disclosures

• The pension footnote includes
• total pension expense and its components
• reconciliation of BOY vs EOY PBO and asset
  accounts (like t-accounts)
• funded status reconciliation
• assumptions (r, g, EROA)

C 14-2,3
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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/E
• put pension assets and PBO on B/S
• remove accrued or prepaid pension cost from B/S
• 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

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Other Post-Employment Benefits (OPEBs)

• Same accounting as pensions, with minor
  differences
• 1. ABO instead of PBO (OPEBs not tied to salary)
• 2. significance of (TL) transition liability (no
  incentive to fund, so ABO gt assets) firms can
  amortize TL over lt 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 dont increase
  with tenure