Defined Contribution Plan
plan states fixed amount company should contribute but total depends on how you invest your money
employee bears the risk
During service period: employee can see, control, manage, invest but can’t withdraw
Interim: invest and manage benefits
Retirement: employee accesses and withdraws benefits
Defined Benefit Plan
plan states the future benefits that the employee will receive
company bears the risk
companies contributions depend on actuarial projections
During service period: employer/company makes contributions to Pension Plan Admin (PPA)
Interim: PPA invests/manages plan assets on behalf of company
Retirement: PPA pays benefits to employee
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Pensions
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Defined Contribution Plan
plan states fixed amount company should contribute but total depends on how you invest your money
employee bears the risk
During service period: employee can see, control, manage, invest but can’t withdraw
Interim: invest and manage benefits
Retirement: employee accesses and withdraws benefits
Defined Benefit Plan
plan states the future benefits that the employee will receive
company bears the risk
companies contributions depend on actuarial projections
During service period: employer/company makes contributions to Pension Plan Admin (PPA)
Interim: PPA invests/manages plan assets on behalf of company
Retirement: PPA pays benefits to employee
Role of Actuaries for Pensions
take large amounts of data and make projections out of it that help us estimate future cash outflows
Net Funded Status
the difference between the PBO and PA
Overfunded
PBO < PA
Underfunded
PBO > PA
Fully Funded
PBO = PA
Why fully fund the pension? Who’s in favor?
Incentive for employees to work for the company because increases security on retirement plan
Employees and Labor Unions
Why NOT fully fund/contribute voluntarily to pension? Who’s NOT in favor?
Ties up liquidity
Management - they want to have cash for other opportunities
Creditors - they want the company to be liquid so they get paid back
Suppliers - they want the company to be liquid so they get paid back
Service Cost
Increase PBO, No affect on PA
Increase Pension Expense
Incur Interest
Increase PBO, No affect on PA
Increase Pension Expense
Return on Plan Assets
No affect on PBO, Increases PA
If expect more and receive less = unrealized loss
If expect less and receive more = unrealized gain
Decrease pension expense
Contributions
No affect on PBO, Increase PA
Benefits Paid
Decrease PBO, Decrease PA
OCI and AOCI
items that have a lot of volatility, fluctuate/dramatic changes all the time
Main purpose of OCI/AOCI?
Keep earnings smoothness and predictability
Why are OCI/AOCI NOT included in Net Income?
Because they fluctuate so much they don’t represent a companies regular earnings
These items would make a companies Net Income NOT predictable
Amortization of Prior Service Cost
comes from changes/amendments to the pension plan (always an increase)
total amount is recorded and held in AOCI and increase PBO
gradually expense to pension expense overtime through credit
Journal Entry for Total Plan Amendment
Dr. AOCI - PSC
Cr. PBO
Why do we NOT expense all of Amendment of Prior Service Cost at once?
We don’t want a big spike in pension expense because we want to keep net income smooth
2 other sources of gains/losses
Changes in market value of plan assets → difference between Expected ROPA and Actual ROPA → Actual is More = Unrealized Gain ; Actual is Less = Unrealized Loss
Changes in actuarial assumptions that affect PBO → adjust the PBO but put the changes in AOCI to keep volatility out of pension expense → Actuarial Loss = Increase PBO ; Actuarial Gain = Decrease PBO
Corridor Approach
done at beginning of each period to calc min amortization required for upcoming period
beg balance of PBO or PA (whichever largest) x .10
If less than Beg. AOCI = Min amortization required
If more than Beg. AOCI = No amortization required
How to Calc Min Amount of Amortization
AOCI - Corridor / Remaining Years of Employee Service
Equity Investor incentives for fully funded pension?
aren’t directly affected because they care about net income, since we expense pension expense overtime it dosent affect Net income
might be in favor for funding to appeal to employees to grow the business
How would Pension Policy affect Net Income and Cash Flows?
Net Income - dosent affect
Cash Flows - Increases cash flows which decreases liquidity
What could be an alternative to fully funding a pension to make appeal to all stakeholders?
The company could commit to a certain threshold of funding the pension