Chapter 17: Pensions

Chapter 17: Pensions

Introduction

  • Speaker: Derrick Bonyuet, Clinical Assistant Professor of Accounting, The University of Texas at Austin.

Overview of Pension Plans

  • Definition of Pensions: A pension is a plan that promises fixed retirement benefits which can be defined by a formula or by fixed contributions.

  • Pension Formula Components:   - (a) Years of service.   - (b) Annual compensation.   - (c) Sometimes age.

  • Types of Pension Plans:   - Defined Contribution Pension Plans.   - Defined Benefit Pension Plans.

Accounting for Pension Plans

Defined Contribution Plan

  • Employers promise fixed annual contributions.

  • Example: If an employer contributes 5% of employees’ pay, with an employee earning $110,000, the employer would recognize a pension expense as follows:   - Journal Entry:     - Debit: Pension Expense $3,300 (Calculated as $110,000 × 3%).     - Credit: Cash $3,300.

  • Key Point: No additional liability is created under a Defined Contribution Plan.

Defined Benefit Pension Plan

  • Definition: A Defined Benefit Pension Plan promises fixed retirement benefits based on a formula.

  • Example Calculation:   - For an employee retiring after 30 years of service with a final salary of $100,000, benefits are calculated as:     - Pension Benefit Formula: 1.5% × Years of service × Final year’s salary
        - Calculation:       - $1,500 × 30 years × $100,000 = $45,000.

Uncertainties in Defined Benefit Plans

  • Factors Affecting Obligations:   - Rate of return on plan assets.   - Number of eligible employees for retirement benefits.   - Age at which employees retire.   - Life expectancies of retirees.   - Inflation and future compensation levels.   - Interest rates.

  • Actuary Role:   - Professional hired to estimate uncertainties and obligations under the pension plan.   - Estimates often deviate from actual outcomes.

Key Components of Defined Benefit Plans

  • Employer Obligations:   - Future retirement benefits must be paid.   - Plan assets must be set aside by the employer.   - Periodic expense recognition is required.

  • Pension Gains and Losses:   - When the return on plan assets diverges from expectations.   - When the pension obligation diverges from expectations.

Components of Pension Expense

  • Overview: Components are integrated to present overall pension costs.

  • Key Components:   - Service cost related to employee service during the period.   - Interest accrued on pension liability.   - Return on plan assets, adjusted for variance between actual and expected return.   - Amortized costs of prior service and gains/losses from revisions.

  • Formula:   extPensionExpense=extServiceCost+extInterestCost−extExpectedReturnonPlanAssets+extAmortizedPriorServiceCost+extLosses(orGains)ext{Pension Expense} = ext{Service Cost} + ext{Interest Cost} - ext{Expected Return on Plan Assets} + ext{Amortized Prior Service Cost} + ext{Losses (or Gains)}

  • Elements may be recognized in different periods.

Measurement of Pension Obligation

Three Measures of Pension Obligation

  1. Accumulated Benefit Obligation (ABO):    - Total retirement benefits earned so far, at their discounted present value, based on existing compensation levels.

  2. Vested Benefit Obligation (VBO):    - Portion of ABO that plan participants are entitled to even without continued employment.

  3. Projected Benefit Obligation (PBO):    - Total retirement benefits earned so far, calculated using estimated future salaries.

  • Note: PBO is the same as ABO if future compensation levels are not included in the formula.

Calculating Projected Benefit Obligation (PBO)

Example: Jessica Farrow

  • Situation Summary:   - Employed since 2013, retiring in 2052 (40 years total service).   - Expected retirement salary: $400,000.   - Current salary (2022): $100,000, projected salary increase.   - Discount rate: 6%.

  • Calculation Steps:   1. Calculate retirement benefits earned to date:      - $60,000 ($400,000 × 1.5% × 10 years).   2. Present value of retirement annuity at retirement date (2052):      - Calculated using annuity value formula.   3. Present value of benefits as of the current date (2022):      - Discount future retirement benefits back to present value using 6% over 30 years.

  • Final PBO:   - As of 2022: $119,822.

Subsequent Year Recalculation (2023)

  • Expected Service: Expands to 11 years, salary expected to be $400,000.

  • New retirement benefits: $66,000 per year (calculated).

  • Present value of benefits as of 2023: $139,715 with a new PBO based on updated calculations.

Changes in PBO Balance

Events Affecting PBO

  1. Service Cost: Accrual of additional obligations from services provided.

  2. Interest Cost: Interest accrued on the PBO at the beginning of the year.

  3. Prior Service Cost: Cost associated with amending pension plans retroactively to account for service    rendered preceding the amendment.    - Illustration Example: Amending formula from 1.5% to 1.7%.

  4. Gains/Losses: From re-evaluations and estimates affecting the PBO.

  5. Payment of Retirement Benefits: Reduces the obligation as employees retire.

Concept of Prior Service Cost

  • Updated PBO due to retroactive changes in the pension formula.

  • Involves a recalculation of prior service benefits reflecting the new percentage.

  • Key concept in understanding obligations and liabilities associated with pension plans.

Example Calculation - Prior Service Cost

  • Given changes and liabilities, the previous PBO before and after an amendment may include adjustments based on new service formulas.

Other Problems and Examples

  • Several problems posed to determine PBO, service costs, interest costs, and implications of prior service amendments exhibited practical applications of these concepts. They pertain to:   - Calculating projected benefit obligation in various employment scenarios.   - Estimating pension expenses based on changing financial conditions and amendments to pension plans.   - Understanding the effects of discount rate changes on PBO calculations.