Chapter 17 Pension Notes

Pension Plans and Other Postretirement Benefits

The Nature of Pension Plans

• Pension plans offer retirement security, boost productivity, lower turnover, meet union demands, and aid employers in the labor market.

Types of Pension Plans

Defined Contribution Pension Plans

• These plans promise specific annual contributions to a pension fund.

• Example: An employer might contribute 5% of an employee's salary.

Defined Benefit Pension Plans

• These plans promise fixed retirement benefits based on a formula.

• The pension formula considers:

  • Years of service.

  • Annual compensation.

  • Sometimes, age.

Defined Benefit Plan vs. Defined Contribution Plan

• Companies are shifting from defined benefit to defined contribution plans because:

  1. Government regulations increase the administrative burden and cost of defined benefit plans.

  2. Employers are less willing to bear the risks associated with defined benefit plans.

     • With defined contribution plans, the employer's obligation ends upon making contributions.

  3. Employers are moving away from "buying long-term loyalty" (defined benefit) towards attracting new talent (defined contribution).

Comparison of Defined Contribution and Defined Benefit Plans

Defined Contribution Pension Plans

• These promise defined periodic contributions to a pension fund without further commitment on benefit amounts at retirement.

• Variations include:

  • Money purchase plan: Employers contribute a fixed percentage of salaries.

  • Thrift plan.

  • Savings plan.

  • 401(k) plan: Permits voluntary contributions by employees.

  • Contributory plan: Employees contribute in addition to employer contributions.

• Plans linking contributions to company performance are known as profit-sharing plans or incentive savings plans.

Defined Contribution Plan Example: Microsoft Corporation

• Microsoft's savings plans in the U.S. qualify under Section 401(k) of the Internal Revenue Code, with international savings plans as well.

• Eligible U.S. employees can contribute a portion of their salary, subject to limitations.

• The company matches a portion of employee contributions.

• Employer-funded retirement benefits totaled $1.6$ billion, $1.4$ billion, and $1.2$ billion in fiscal years 2023, 2022, and 2021, respectively, and were expensed as contributed.

Accounting for a Defined Contribution Plan

• Suppose a plan promises an annual contribution of 3% of an employee’s salary.

• If an employee's salary is $110,000$, the employer recognizes pension expense of $(110,000 imes 3\%) = 3,300$.

• Journal Entry:

  • Debit: Pension expense $3,300$

  • Credit: Cash $3,300$

• The company discloses the nature and effect of changes impacting comparability. The employee bears the risk of uncertain investment returns.

Defined Benefit Pension Plans

• These plans involve uncertainties:

  • Rate of return on plan assets.

  • Number of employees eligible for benefits.

  • Age at which employees retire.

  • Life expectancies of retirees.

  • Inflation, future compensation levels, and interest rates.

• They promise fixed retirement benefits defined by a pension formula.

• Example: An employee retires after 30 years with a final salary of $100,000$. Annual benefits are calculated as $1.5\% imes 30 imes 100,000 = 45,000$.

  • $1.5\% imes \text{Years of service} imes \text{Final year’s salary}$

Defined Benefit Pension Plan: Concept Check

• Investment risk is borne by the employer (correct answer).

Key Elements of a Defined Benefit Pension Plan

• Employer's obligation to pay future retirement benefits.

• Plan assets set aside to pay these benefits.

• Periodic expense of having the pension plan.

Components of Pension Expense — Overview

• Components of Pension Expense:

  • Service cost.

  • Interest on the pension liability.

  • Return on plan assets (adjusted for any difference between actual and expected return).

  • Amortized portion of prior service cost.

  • Amortized portion of losses or gains from revisions in the pension liability or from investing plan assets.

  • $\text{Pension expense} = \text{Service cost} + \text{Interest cost} - \text{Return on plan assets} + \text{Amortized prior service cost} + \text{Amortized losses/gains}$

Ways to Measure the Pension Obligation

1. Accumulated Benefit Obligation (ABO):

   • Estimate of total retirement benefits earned so far, discounted to present value, using current compensation levels.

2. Vested Benefit Obligation (VBO):

   • Portion of the ABO that plan participants are entitled to receive regardless of continued employment.

3. Projected Benefit Obligation (PBO):

   • Estimate of total retirement benefits earned so far, discounted to present value, using estimated future compensation levels.

   • If the pension formula doesn't include future compensation, PBO and ABO are the same.

Alternative Measures of Pension Obligation

• Vested benefit obligation: Present value of vested benefits at present pay levels.

• Accumulated benefit obligation: Includes vested benefit obligation + present value of non-vested benefits at present pay levels.

• Projected benefit obligation: Includes accumulated benefit obligation + present value of additional benefits related to projected pay increases.

Accumulated Benefit Obligation (ABO)

• An estimate of the discounted present value of retirement benefits earned so far, using the plan’s pension formula and existing compensation levels.

Vested Benefit Obligation

• Vested benefits are those employees have the right to receive even if they cease employment today.

• Benefits must vest:

  • Fully within five years.

  • Or, 20% within three years, with another 20% vesting each subsequent year until fully vested after seven years.

• The vested benefit obligation is a subset of the accumulated benefit obligation.

Pension Benefit Guaranty Corporation (PBGC)

• Established by the Employee Retirement Income Security Act (ERISA).

• Imposes liens on corporate assets for unfunded pension liabilities and administers terminated pension plans.

• Financed by premiums from employers.

• Guarantees basic vested benefits when pension liabilities exceed assets for terminated plans.

Projected Benefit Obligation (PBO)

• Estimates retirement benefits using the pension formula and projected future salary.

• Less objective, but more relevant.

• Used to report amounts in the balance sheet and income statement.

Projected Benefit Obligation: Concept Check

• The PBO is best described as the present value of benefits accrued to date based on future salary levels (correct answer).

Projected Benefit Obligation Example

• Kali Farrow was hired by Global Communications at the beginning of 2016.

• The company has a defined benefit pension plan that specifies annual retirement benefits equal to:

  • $1.5\% imes \text{Service years} imes \text{Final year’s salary}$

• Farrow is expected to retire in 2055 after 40 years of service.

• The retirement period is expected to be 20 years.

• At the end of 2025, 10 years after being hired, Farrow’s salary is $100,000$.

• The interest rate is 6%.

• The actuary projects Farrow’s salary to be $400,000$ at retirement.

Calculating the Projected Benefit Obligation

1. Use the pension formula (including a projection of future salary levels) to determine the retirement benefits earned to date.

2. Find the present value of the retirement benefits as of the retirement date (end of 2055).

3. Find the present value of retirement benefits as of the current date (end of 2025).

Projected Benefit Obligation Calculation

1. Actuary estimates employee has earned retirement benefits of:

   • 1.5\% imes 10 \text{ years} imes $400,000 = $60,000 \text{ per year}

2. Present value of the retirement annuity at the retirement date is:

   • $60,000 imes 11.46992 = $688,195

3. Present value of retirement benefits at 2025 is:

   • $688,195 imes 0.17411 = $119,822 \text{ (PBO)}

Projected Benefit Obligation in 2026

• If the actuary's estimate of the final salary hasn't changed, the PBO a year later at the end of 2026 would be $139,715$.

1. Actuary estimates employee has earned retirement benefits of:

   • 1.5\% imes 11 \text{ years} imes $400,000 = $66,000 \text{ per year}

2. Present value of the retirement annuity at the retirement date is:

   • $66,000 imes 11.46992 = $757,015

3. Present value of retirement benefits at 2026 is:

   • $757,015 imes 0.18456 = $139,715 \text{ (PBO)}

Five Events That Might Cause Change in PBO Balance

1. Service cost:

   • Each year’s service adds to the obligation to pay benefits.

   • Increase in the projected benefit obligation attributable to employee service performed during the period.

2. Interest cost:

   • Interest accrues on PBO balance each year.

   • Calculated as the assumed discount rate multiplied by the projected benefit obligation at the beginning of the year.

3. Prior service cost:

   • When a pension plan is amended, credit often is given for employee service rendered in prior years. The cost of doing so is called prior service cost.

   • Example: Global Communications revised the pension formula, increasing the salary percentage from 1.5% to 1.7%.

     • $1.7\% imes \text{Service years} imes \text{Final year’s salary}$

4. Gain or loss on the PBO:

   • Decrease or increase in estimates of the PBO because of periodic re-evaluation of uncertainties.

   • Possible estimate changes that would affect the PBO:

     • Change in life expectancies.

     • Expectation that retirement will occur earlier than previously thought.

     • Change in the assumed discount rate.

5. Payment of retirement benefits.

   • Obligation is reduced as benefits actually are paid to retired employees.

Components of Change in the PBO

Expanded PBO Example

• The changes in the PBO for Global Communications during 2027 were as follows:

• (Figures in millions)

  • PBO at the beginning of 2027: $400$

  • Service cost, 2027: $41$

  • Interest cost: $(400 imes 6\%) = 24$

  • Loss (gain) on PBO: $23$

  • Less: Retiree benefits paid: $(38)$

  • PBO at the end of 2027: $450$

Computing PBO: Concept Check

• M-Howard Inc. has a defined benefit pension plan. On December 31, the company received the PBO report from the actuary.

• Information included:

  • Ending PBO: $110,000$

  • Benefits paid to retirees: $10,000$

  • Interest cost: $7,200$

  • Discount rate applied by the actuary: 8%.

• What was the beginning PBO?

  • PBO 1/1: $\text{?}$

  • Service cost: $xxx$

  • Interest cost ($\text{?} imes 8\%)$: $7,200$

  • Loss (gain): $xxx$

  • Prior service cost: $xxx$

  • Benefits paid: $(10,000)$

  • PBO 12/31: $110,000$

  • PBO, 1/1 = \frac{7,200}{8\%} = $90,000

Pension Plan Assets

• Resources with which a company will satisfy the retirement benefit obligation.

• Details of the pension plan asset balance must be reported in the disclosure notes to the financial statements.

How Plan Assets Change

• Global Communications contributes each year’s service cost plus a portion of the prior service cost to its pension fund.

  • Cash of $48$ million was contributed at the end of 2027.

  • Plan assets at the beginning of 2027 were $300$ million.

  • The expected rate of return was 9%, but the actual return in 2027 was 10%.

  • Retirement benefits of $38$ million were paid.

  • Global’s PBO at the end of 2027 is $450$ million.

• What is the value of the company’s pension plan assets at the end of 2027?

  • Plan assets at the beginning of 2027: $300$

  • Actual return on plan assets ($10\% imes 300$): $30$

  • Cash contributions: $48$

  • Less: Retiree benefits paid: $(38)$

  • Plan assets at the end of 2027: $340$

Underfunded Pension Plan

• An underfunded pension plan means the PBO exceeds the plan assets.

• The Employee Retirement Income Security Act (ERISA) of 1974 established minimum funding standards to protect plan participants.

• Factors that impact a plan’s funded status include:

  • Amending the plan.

  • Revising estimates.

  • Investment performance of the plan’s assets.

  • Interest rates.

Determining Actual Return on Plan Assets

• Information regarding the defined benefit pension plan of Corey Services included the following for 2027 (in millions):

  • Plan assets, January 1: $70$

  • Plan assets, December 31: $105$

  • Retiree benefits paid (end of year): $17$

  • Employer contributions to the pension plan (end of year): $42$

• The correct answer is a: $10$ million.

  • Beginning balance: $70$

  • Actual return: $10$

  • Contributions: $42$

  • Retiree benefits paid: $(17)$

  • Ending balance: $105$

Determining Employer Contributions

• Information regarding the defined benefit pension plan of Chumlee Company included the following for 2027 (in millions):

  • Plan assets, January 1: $350$

  • Plan assets, December 31: $525$

  • Retiree benefits paid (end of year): $85$

  • Return on plan assets: $50$

• The correct answer is c: $210$ million

  • Beginning balance: $350$

  • Actual return: $50$

  • Contributions: $210$

  • Retiree benefits paid: $(85)$

  • Ending balance: $525$

Reporting the Funded Status of the Pension Plan

• Firms report the net difference between plan assets and PBO, referred to as the “funded status” of the plan.

• A company must report in its balance sheet a liability for the underfunded (or asset for the overfunded) status of its postretirement plans.

Components of the Periodic Pension Expense

• Changes in the PBO:

  • Service Cost: Increase in the employer's obligation attributed to employee service during the current period.

  • Interest Cost: Interest accrued on the obligation during the current period (balance at the beginning of the period multiplied by the interest rate).

  • Prior Service Cost: Increase in the employer's obligation due to giving credit to employees for years of service provided before the pension plan is amended.

  • Losses or (Gains) on the PBO: Increases or (decreases) in the estimate of the PBO from revisions in underlying assumptions.

  • Less: Payments to retirees.

• Changes in Plan Assets:

  • Expected Return on the Plan Assets: Estimated long-term return from changes in the value of plan assets, due to dividends, interest, and market price changes.

  • Gains or (Losses) on the Plan Assets: Return on plan assets lower or (higher) than expected.

  • Cash Contributions: Payments into the fund by the employer.

  • Less: Payments to retirees.

    • Pension Expense:

    • Included Currently: Service cost, interest cost, (expected return on the plan assets).

    • Delayed Recognition: Amortized portion of prior service cost, net loss or (gain).

Pension Expense Calculation

• Reports from the actuary and the trustee of plan assets indicate the following changes during 2027 in the PBO and plan assets of Global Communications (in millions).

  • Beginning of 2027: $400$

  • Service cost: $41$

  • Interest cost $6\%$

  • Gain on PBO: $23$

  • Retiree benefits paid: $(38)$

  • End of 2027: $450$

• Plan Assets

  • Beginning of 2027: $300$

  • Actual return on plan assets is $30$

  • Cash contributions: $48$

  • Retiree benefits paid (38)

  • End of 2027: $340$
    Calculation:

• Service cost: 41

• Interest cost (6%*400): 24

• Expected return on the plan assets (30 actual, less 3 gain): (27)

• Amortization of prior service cost (calculated later): $4$

• Amortization of Netloss: $1$

• pension expense: 43

  1. Service cost: $41$ million, increase in the projected benefit obligation attributable to employee service.

  2. Interest cost: Calculated as the discount rate times by the projected benefit obligation at the beginning of the year

  3. Return on plan Assets: Generated from the pension fund investments in stocks. We need to differentiate between its two modes: the actual return and the expected return

     • Adjustment for Gain or loss

     • The actual return should first be adjusted for any differences between that return and the amount that had been expected (gain or loss)

     • Any loss or gain is not included in pension expense right away

     1. Amortization of prior service cost: 60 million divided by 15 year; Amortized over the average remaining service life of the active employee group

Gains and Losses

• Gains and losses are reported as OCI in the statement of comprehensive income as they occur.

• If a net gain or net loss exceeds the corridor, the excess is not charged to pension expense all at once.

Determining Net loss Amortization

• Net loss exceeded previous gains ($55$) by $opprox )$% $15$. 10% of $400$ is $40$. Remaining service period divides by $15$ to arrive at total ammortized to $2027$ pension expenditure

  • Net Loss AoCI (in millions)

    • prior service cost at the begging of $2027$: $45$

    • less amortization: $(1)$

    • plus: loss on PBO: $23$

    • Less: total loss AoCI: ($3$)million

    • Total net loss: ($74$) million

Global records a total loss-oCI

To record the full pension cost

US GAAP vs IFRS

Under US GAAP- Uses the same rate for both the interest cost on the defined benefit obligation and the interest income on the plan assets.
Reported as other comprehensive income when they first arise, but are not subsequently reclassified to pension expense. Instead, those amounts remain in the balance sheet as accumulated other comprehensive income.
While under IFRS, uses different rates for the interest cost on the defined benefit obligation and the return on the plan assets
Reported as other comprehensive income when they occur, and are gradually amortized or reclassified out of OCI and into pension expense, when the accumulated net gain or net loss exceeds the “corridor.”

Determining Pension expense:

Entries to record pension cost:

Computing pension expenses check

Prior service cost of $20$ million. Service and interest costs where $10$ million and $4$ million.

Remaining service is $10$, actual return on assets are $4$ million although they expected to be $6$ million which is $2$ million less

Under gaap company reports service cost separately from components the rest of the operating costs and non-expenses

Prior Service Cost- IFRS

Prior service cost is combined with the current service cost and reported within the income statement.

While under GAAP prior service cost is reported as a separate component of other comprehensive income.

Changes to recording funds and payments

Global increase (adds) - asset funding: 48-million dollars and pays $38$ million to current retired workers

Recording balances of Plan Assets
400-in balance 23 from loss: plus, service (41 million and intertest rate -24 )million then benefits -30 total ends to arrive A Balance of $450$ Million

in relation to global

Balance, Gain, and funding are at a funded state of around $IIO$ million dollars

| | Dollars in -million(D) | |
| :--------------------------------------- | :---------------------- | :---| | | |
| Net Income | XX | XXX | Total change in equity (besides Owners) | |
| plus,other - full Comprehensive (OC)income | | | change in equity |
| Net gain -AFS investment - unrealized | x | d | |
| pension loss Due - revise PO | | (-23)illionD |
| Return on - plan assets EX | x | | |
| amortization of losses | | 1 million D | |

Balance-and taxes

gain and losses are recorded with their effect on a balance and balance sheet

Achieved with tax allocated in or out
a o C I is always - net- tax

Pension Spreadsheet

Recording the change in Accounts over a period:

Reverting from US gaap -to AI-FRS standards 2027

the prior service should revert from being on the AOCO in to being in operating expenses

FIRM reports a
settlement, curtailment pension -or to reduce exposure
employers are
TERMINIATIN, and elect reducing future benefits -the CURTAILMENT
-a company

1. Distribute the plan assets or for current empyees roll over- and provide lump sumpayments

2. Transfer the pension -insurance
   Any legal obligation to provide futyre retirement benefits is then PERMANETLY settled upon receiving plan assets

   .a loss is recorded, when the settlement is recorded

Companies use * Curtailment *by, significantly reducing or elimanating benefit (payout) for future empyees

thesis may mean that they, (1) FREEE new Employees (which doesnt require anything spectical in account) or (2) - all services

Freezing ALL future benefits (stoping any service or increase) of service . A CURTAILMENT may occur here

IFRS -COMPONETS OF NET PENSION COST

*Accounting for pensions and benefits *
(iasNo. to this post-employment standard)

There is three (3) parts that seperate cost :

1. The cost off Service

2. the Cost (financing) the cost.

3. * Gains from occasional re-meaure

Each component contains- what (included) - how to recognizing (either in balance/Incom statements)

Proffit loss

/

/

• service :Cost -2027 ($41$) million
  Past sevice cost (0): million
  total service =
  Interest cost (6% X 400-- 300
  *The tax-expense and return + investment returns on the plan and other pension standards in place *
  Therefore the US GAAP- mainly relays heavily on record-keeping and balance where under- IFRS - record as a financial state

PostReterminet Benifits*

includes: medicine and health coverage -denatl coverage and and legal help
Aka