Ch 19: Pension Plan

Pension Plan

An arrangement whereby an employer provides benefits (payments) to retired employees for services in their working years.

• Some companies offer lump sum of money instead of monthly payments

• Pension Fund: Independent From company. company can only plug. Employeer cannot withdraw

• Should be a separate legal and accounting entity

Two most common types:

1. Defined Contribution Plans

2. Defined Benefit Plans

Contributory Pension Plan

Employees voluntarily make payments to increase their benefits

• A retirement plan where employees contribute a portion of their salary

Noncontributory

Employer bears the entire cost.

Qualified Pension Plans

Offer tax benefits. Obligation companies are most scared of.

Defined-Contribution Plan

• At a high risk for the employee

• You know how much goes into the account, but you don’t know exactly how much you’ll have at retirement

• Benefits based on plan value

Defined Benefit Plan

• The plan promises you a specific retirement payment, and the employer figures out how to fund it.

• Risk borne by employer

• Employer contribution varies (determined by actuaries)

Actuaries

make predictions (called actuarial assumptions) of mortality rates, employee turnover, interest and earnings rates, early retirement frequency (all predication can change over time), future salaries, and any other factors necessary to operate a pension plan

• Companies: Audit Pension Every year

• Gov: Cannot move money around like that.

1. What is the pension obligation that a company should report in the financial statements

2. What is the pension expense for the period

1. Figure out for Balance Sheet

2. Figure out for income statement

Pension Obligation

is the deferred compensation obligation it has to its employees for their service under the terms of the pension plan

• Vested: you qualify for pension

• Non-vested: haven’t qualified yet for pension

Vested Benefit Obligation

• Benefits for vested employees only at current salaries

• shows least amount to obligation

• employees keep even if they leave

Accumulated Benefit Obligation

• Includes benefits for vested + non-vested employees at current salaries

Projected Benefit Obligation (FASB’s choice)

• Benefits for vested and non-vested employees at future salaries

• most realistic measure

• used for financial reporting

Plan Assets (PA)

are the investments and cash that actually exist in the pension fund to pay future retirement benefits

Projected Benefit Obligation (PBO)

How much the company is obligated to pay employees in retirement based on work completed to date.

Overfunded Pension

• IF PA> PBO

• Then it is a Pension Asset

  • Pension Asset= PA — PBO

Underfunded Pension

• IF PBO> PA

• Then it is a Pension Liability

  • Pension Liability = PBO — PA

Components of Pension Expense

1. Service Cost for the Year

2. Interest on Liability

3. Actual return on Plan Assets

4. Amortization of prior service cost

5. Gain or Loss

1. Service Cost for the Year

Value of benefits earned by employees this year

Increases Pension Expense

2. Interest on Liability

Interest growth on beginning PBO

Int Expense= settlement rate ( interest rate) X beginning balance PBO

Increases Pension Expense

3. Actual return on Plan Assets

Increase in pension funds from interest, dividends, and realized and unrealized changes in the fair value of plan assets

Actual Return= (PA ending Balance — PA beg Balance) —- (contributions—- Benefits paid)

OR

BB PA X actual rate of Return

• Positive balance will decrease pension expense

• Negative will decrease pension expense

Prior Service Cost (PSC)

Company makes a bigger promise (bigger obligation) to satisfy the work the employee has done. Very big number.

Because of the large amount, you recognize it over time, Amortization Expense.

4. Amortization of prior service cost

Happens when a company improves employee benefits for past service.

1. First the cost shows up in OCI (Other Comprehensive Income)

2. Over time, the company gradually moves this cost into regular pension/benefit expense

This generally increases pension expense

The company owes employees more for past work, but it spreads the cost over several years rather than hitting the income statement all at once.

5. Gain Or Loss

Unpredictability in pension expense can result from sudden and large changes in the fair value of plan assets and by changes in projected benefit obligation

Decreases or increases pension expense

Unexpected swings in pension expense can result from:

1. Sudden and large changes in the fair value of plan assets

2. Changes in actuarial assumptions that affect the amount of the projected benefit obligation:

• Changes in assumptions

  • ex. changes in AI, employees are going down 30%, they would make a sudden change.

Smoothing Unexpected Gains and Losses on Plan Assets

• Companies include the expected return on the plan assets as a component of pension expense, not the actual return in a given year

• Companies record asset gains and asset losses in an account (unexpected return), OCI (G/L), combining them with gains and losses accumulated in prior years

  • Unexpected Return =. Actual Return —— expected Return

  • Expected Return. =. Beg Balance PA. X expected rate of return.

Smoothing Unexpected Gains and Losses on The Pension Liability

• Companies report liability gains and liability losses in OCI (G/L)

• Companies combine the liability gains and losses in the same OCI (G/L) account

• They accumulate the asset and liability gains and losses in AOCI and report on the balance sheet in the stockholders equity section.

Financial Statements

Income Statement:

• Pension Expense

Balance Sheet:

• Pension Asset or Liability

• OCI Gain/Loss (shareholder equity)

• Prior service cost.

Within the Financial Statements

• Recognition of the Net Funded Status of the Plan

• Classification of Pension Asset or Pension Liability

• Aggregation of Pension Plans

• Actuarial Gains and Losses/Prior Service Cost

Financial Statements for Defined Contribution Plans

1. Statement of Net Assets Available for benefits

• This statement is like the assets section of a balance sheet

2. Statement of Changes in Net Assets Available for benefits

• This statement details how the asset balance changed from beginning to the end of the period.

Financial Statements for Defined Benefit Plan

1. Statement of Net Assets Available for benefits

2. Statement of Changes in Net Assets Available for benefits

3. Statement of Accumulated Plan Benefits

• This statement is like the liabilities section of the balance sheet

• Its about vested and non-vested

• Tells us about obligations

4. Statement of Changes in Accumulated Plan Benefits

• This statement details how the liability balance changed from the beginning to the end of the period.