Chapter 20: Accounting for Pensions and Postretirement Benefits

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Chapter 20 Accounting for Pensions and
Postretirement Benefits
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Importance of Pension Accounting

• Fiduciary responsibility
• Managements promise to employees
• Potential material unfunded liability
• Significant impact on cash flow
• Negative impact on morale
• Effect on productivity
• Employer accounting vs. Plan
• This chapter employer accounting
• Obligation on BS expense in IS
• Huge portion of US economy
• Plans large investor in equities
• Audit quality issues - Plans

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Flow of Cash among Pension Plan Participants
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Types of Pension Plans

• Plan funding
• Contributory
• Non-contributory
• Funded vs. under/over funded
• Plan types
• Defined contribution
• 401s
• Defined benefit
• Traditional fixed benefit for life
• Qualified plans IRS
• Deductibility of contributions
• Tax free earnings on plan assets

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Defined Contribution Plans

• Employer/employee contribute defined sum to Plan
• Ultimate benefit to employee not known
• Vesting may be required employer contributions
• Actuarial calculations not needed
• Easy to budget for contributions
• DC Plan
• Accumulates assets
• Earns investment income
• Makes distributions to beneficiaries
• Plan assets liabilities belong to employees

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Defined Contribution Plans

• Employers pension expense annual contribution
  needed
• Contributions different from expense
• Contribution lt pension expense liability
• Contribution gt pension expense asset
• Increase in these plan types over last 20 years
• Simple FS disclosures
• Description (covered groups, etc.)
• Contribution basis
• Factors affecting comparability

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Defined Benefit Plans

• Employer/employee contribute changing sum to Plan
• Ultimate benefit to employee known
• Vesting normally required
• Employer vs. employee contributions
• Actuarial calculations essential
• Actuarial assumptions
• Difficult to budget for contributions

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Defined Benefit Plans

• DB Plan
• Accumulates assets
• Earns investment income
• Makes distributions to beneficiaries
• Plan assets liabilities belong to employer
• Employer remains liable for benefit payments
• Employer can recapture excess plan assets
• Benefit settlement employer settles pension
  obligation of employees
• Takeovers often consider funded status of DB Plan

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Benefit and Contribution Plans A Comparison
Contribution Plans
Benefit Plans

• Employer/employee contributions are defined
• Retiree benefits depend on fund performance
  (balance of assets at retirement)
• Retirees bear the investment risk

• Retiree benefits are a fixed amount
• Employer contributions to the plan depend on
  promised benefits to retirees
• Employers bear the investment risk

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Actuaries and Pension Accounting
Pension calculations involve actuarial assumptions
These are estimates
Assumptions involve mortality rates (employees
spouses), employee turnover, future salaries,
rates of return
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Alternative Definitions of Pension Obligation

• Pension obligation
• Deferred obligation to EEs for service
• Measurement alternatives
• Vested benefit obligation
• Current salary levels, vested
• Accumulated benefit obligation
• Current salary levels, vested non vested
• Projected benefit obligation
• Future salary levels, vested non vested

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Alternative Definitions of Pension Obligation

• Measurement alternatives
• Choice affects liability expense
• GAAP projected benefit alternative
• Accumulated benefit allowed in certain cases
• All alternatives use PV of estimated future
  benefits
• Discount rates required to be changed (each
  period) to reflect current interest rates

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Accounting for Pension Obligations

• Capitalization approach
• Fair presentation of ER pension AL
• Economic substance vs. legal form
• Non capitalization approach
• Report difference in required actual
  contribution
• SFAS 87 compromise
• Some significant items not recognized
• Less than ideal conceptual accounting

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Measurement of Pension Cost Components

• Pension expense
• Service cost
• Interest cost
• Actual return on plan assets
• Amortization of unrecognized prior service cost
• Gains losses (actual vs. expected ROR)

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Pension Cost Service Cost Component

• Service cost (increases pension expense)
• Expense caused by the increase in benefits
  payable to employees for services rendered in CY
• Actuarial PV of attributable benefits
• Must use future salaries if Plan does
• Relates to going concern concept
• Benefits/years-of-service actuarial method

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Pension Cost Interest Cost Component

• Interest cost (increases pension expense)
• Interest accrued on pension obligation for CY
• Can use simple or compounded interest
• Assumed discount rate (actuarially determined)
  reflects
• Settlement rate
• Rate to cover benefits payable if all obligations
  settled today
• Look to
• Current annuity rates
• High quality, fixed income investments

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Actual Return on Plan Assets

• Actual return on Plan Assets
• Increase in pension funds/assets from
• Earnings on investments
• Realized unrealized changes in FV of Plan
  assets
• Calculated as
• FV of Plan assets _at_ EOY less FV of Plan assets _at_
  BOY
• Less employer contributions less benefits paid
• NOT a component of pension expense

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Expected Return on Plan Assets

• Expected return on Plan Assets (decreases/increase
  s pension expense)
• Used to determine funding pattern
• Actuarially determined rate market-related
  asset value (i.e. FV)
• Market-related asset value changes in FV
  recognized over not more than 5 years
• Differences in expected actual gain or loss
  on Plan assets (later slide)

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Unrecognized Prior Service Cost

• Prior service cost PSC (increases pension
  expense)
• Employees given credit for past service when plan
  amended or initially adopted
• Affects projected benefit obligation
• Amount actuarially determined
• Not required to recognize effect of change in
  full at time of change
• Amortized over remaining service life of covered
  active employees

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Unrecognized Prior Service Cost

• Amortization of unrecognized PSC (increases
  pension expense)
• Liability accounted for in Plan (off BS)
• Employer records periodic amortization of PSC
• Through annual adjustment of pension expense
• Amortization methods
• Years-of-service method (similar to units of
  production)
• Example page 1030
• Straight line method
• Example page 1030

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Gains and Losses

• Uncontrollable unexpected swings in pension
  expense
• Increase/decrease pension expense
• Sudden/large change in MV of Plan assets
• Changes in actuarial assumptions
• Smoothing techniques used to reduce volatility in
  pension expense
• Plan assets
• Pension liability

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Gains and Losses

• Plan assets
• Difference in actual expected ROR
• Gain actual gt expected
• Increases pension expense
• Loss actual lt expected
• Decreases pension expense
• Accumulate off BS as unrecognized net gain/loss
  combine with prior years

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Gains and Losses

• Pension liability
• Changes in actuarial assumptions
• Liability gains losses
• Gain decrease in liability
• Loss increase in liability
• Accumulate off BS as unrecognized net gain/loss
  combine with prior years
• Same account as plan assets adjustments

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Amortizing Unrecognized Gains and Losses

• Unexpected gains/losses on plan assets pension
  liability should offset
• May grow to large amount
• Corridor amortization
• Amortize unrecognized gains losses when too
  large
• Too large 10 of BOY PBO or market related
  value of plan assets (whichever is larger)
• Corridor 10 and -10
• Within corridor no amortization
• Outside corridor amortize difference over
  remaining service life of active employees

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Amortizing Unrecognized Gains and Losses

• Effect triple smoothing
• Expected ROR
• BOY unamortized gain/loss only amortized if
  outside corridor
• Corridor amortization over remaining service lives

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Prepaid and/or Accrued Pension Cost in Employers
Books

• Prepaid/accrued pension cost is difference
  between
• Total pension cost recognized pension cost
  actually funded
• Pension expense lt funded amount prepaid cost
• Pension expense gt funded amount accrued cost

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Minimum Liability

• Immediate recognition of liability
• Accumulated benefit obligation exceeds FV of plan
  assets
• Net with any recorded pension liability
  (decrease) or prepaid pension (increase) amounts
• Entry
• Debit Intangible Asset Deferred Pension Cost
• Credit Additional Pension Liability

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Minimum Liability

• Immediate recognition of liability
• Exception to intangible asset recognition
  additional liability gt unrecognized prior service
  cost
• Debit Excess of Additional Pension Liability
  Over Unrecognized Prior Service Cost for excess
  amount
• Amount of excess reduces comprehensive income

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Pension DisclosuresNew GAAP

• Financial statements
• Accrued pension cost (LT liability)
• Prepaid pension cost (current asset)
• Excess ABO over FV Plan assets
• Liability total amount of excess
• Intangible asset excess lt unrecognized PSC
• Contra SE account excess gt unrecognized PSC

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Pension DisclosuresNew GAAP

• Footnotes
• Schedule of all major components of pension
  expense.
• Reconciliation of PBO FV Plan assets from BOY
  to EOY
• Funded status amounts recognized or not
  recognized in FS
• Rate used to measure benefit amounts

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Pension DisclosuresNew GAAP

• Footnotes
• Table of Plan assets by investment category
• of FV to total Plan assets
• Narrative description of investment policies
  strategies
• Including target allocation s
• Expected benefit payments next 5 years
  aggregate in 5-year increments
• Best estimate of expected contributions to plan
  in next year

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Pension Disclosures

• Examples
• Financial statements page 1050
• Pension expense page 1046
• Reconciliation page 1051
• Footnotes page 1052

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Pension Reform Act of 1974

• Employee Retirement Income Security Act (ERISA)
• Safeguards employee pension rights
• Mandated plan requirements
• Minimum funding actuarial required
• Participation
• Vesting
• Created Pension Benefit Guaranty Corp. (PBGC)
• Funded by employers
• Administers terminated plans
• Liens assets for certain unfunded liabilities

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Class Exercises

• E20-2 E20-4
• E20-7 E20-8
• E20-13 E20-18