Topic 8: Pensions and Postretirement Benefits-1

Pension Plan: arrangement whereby an employer provides benefits (payments) to retired employees for services they performed during their working years.

· Becoming less common (no major companies added pension plans in the last decade)

Three ‘players’:

Pension plans are ‘funded’ when the employer makes payments to a funding agency

Contributary pension funds: Employees bear part of the cost of the stated benefits or voluntarily make contributions to increase their benefits

Noncontributary pension funds: Employer bears the entire cost of contributing to the fund

Qualified pension plans: allow employer to deduct contributions into the fund and earnings from the fund to be tax exempt

NOTE: a pension fund is a separate legal and accounting entity!

· Maintains its own books

· Prepares its own financial statements

This chapter accounting for pension funds from the employer’s perspective (not the fund’s)

Defined Contribution Plan: Employer agrees to contribute a certain amount to a pension trust each period based on a formula (factoring in age, length of service, employer profit, employee compensation level, etc.)

· No promises made about ultimate benefits paid to employees

· Common example: 401(k) plan

· Benefits employees receive from defined contribution plans are the result of:

· Contributions

· Trust income (from investment decisions)

· Forfeitures of funds (early termination of other employees)

· Independent trustee assumes ownership of pension assets, determines investment decisions, and oversees any distributions

· SIMPLE ACCOUNTING

· Employer contributions owed per period (based on formulas) = ‘pension expense’

During 2018, Sweeto Burrito contributes $40,000 on behalf of its employees to a defined contribution pension plan. What journal entry should the company record?

Defined Benefit Plan: Employer outlines the benefits that employees will receive when they retire (function of years of service and compensation level in the years approaching retirement)

· Ideally, company meets defined benefit commitments based on time value of money calculations to determine contributions required Any problems with this approach?

*Legal requirements dictate minimum funding, participation, and vesting (Pension Reform Act of 1974)

· Employer is the beneficiary of a defined benefit trust and then uses those funds to pay defined benefits

· What if the fund runs short?

Employer still responsible to pay benefits (from company assets)

· What if the fund generates excess returns?

Employer can recapture excess returns by…

1. Reducing future funding

2. Reverting funds to the company

Difficulties with defined benefit plans:

· Expense ≠ contribution amount (contributions may be too high / low)

· Liability? Depends on future outcomes (e.g., pension fund returns)

Actuaries: help ensure pension plans are appropriate for employees using probability rates (actuarial assumptions – taken as given in this class)

ACCOUNTING FOR PENSIONS

Two main challenges: (1) What is the pension obligation (liability) that should be reported, and (2) what is the pension expense each period?

Pension Liability Calculation (three possible approaches, all discounted to present value):

1. Based on vested benefits, i.e., what employees would receive based on service already provided and current salary levels (smallest)

· Vested benefit obligation

2. Based on both vested and nonvested benefits based on current salaries (middle)

· Accumulated benefit obligation

3. Based on both vested and nonvested benefits using future salaries (largest)

· Projected benefit obligation

* U.S. GAAP must use Option 3 (Projected Benefit Obligation) *

The actual pension liability on the balance sheet is calculated based on plan assets compared to the projected benefit obligation.

· Overfunded plan assets > projected benefit obligation pension asset

· Underfunded plan assets < projected benefit obligation pension liability

Coker Company has a projected benefit obligation (PBO) of $300,000, and the fair value of its plan assets is $210,000. Does Coker have a pension asset or a pension liability? Liability

· In 2007, S&P 500 companies had a net pension asset of $47.2 billion

· By 2011, they had a net pension liability of $358.4 billion

PENSION EXPENSE CALCULATION: Expensed on an accrual basis (compensation for current work performed)

· Changes in the PBO and the plan assets drive the amount of pension expense recorded

Basic Pension Expense Components:

· Service Cost: increase in projected benefit obligation due to services rendered during the current period (i.e., present value of new benefits earned by employees)

· Actuaries calculate the additional pension obligation due to current service and then discount the new obligation to its present value

· Actuaries must consider future compensation levels when calculating this amount

· Interest on the liability: as time passes, the discounted PBO accrues ‘interest’

· Interest rate: reflects rate at which companies could ‘settle’ pension benefits (i.e., rate at which investment needs to grow to settle future obligations)

· Returns on plan assets: interest, dividends, and increases in the fair value of fund assets should be subtracted from current period pension expense; losses added to expense

· Pension fund assets investments in stock, bonds, real estate, etc. that provide returns and (hopefully) grow in value

· Actual returns reduce the cost of providing pension benefits

· Actual return = increase in pension fund from interest, dividends, and realized/unrealized changes in the fair value of plan assets

· Other Items (discussed later):

· Amortization of Prior Service Cost

· Gains and losses from changes in actuarial assumptions, etc.

USING A PENSION WORKSHEET

On 1/1/14 Zarle Corp. provides the following information related to its pension plan for 2014:

* See Pension Worksheet (Zarle 2014) *

Journal Entry

Balance Sheet

Amortization of Prior Service Cost: If pension plan initiations/amendments provide pension benefits for prior service, the cost for those years is amortized over the remaining service years

· Initially recorded as an adjustment to OCI based on the increase in the Pension Benefit Obligations at amendment (or initiation) date

· Allocation: ‘prior service cost’ ÷ ‘total # of service years’ = ‘cost per service year’

Assume that on 1/1/2015 Zarle Corp. amends its pension plan such that 170 of its older employees are granted $80,000 of benefits for prior service performed. Zarle’s expects these employees to retire as follows (all on December 31):

Zarle calculates total service years provided per year, as follows:

Cost per service year = $80,000 ÷ 500 = $160 per service year

How much ‘prior service cost’ should Zarle amortize each year from 2015 to 2019?

Assume the following additional information pertains to Zarle’s pension in 2015:

Complete Zarle’s pension worksheet for 2015 and record any necessary journal entries

* See Pension Worksheet (Zarle 2015) *

If the OCI amount is confusing, think of the entry this way:

Gain or Loss: Impact can be extensive

· Sudden and large changes regarding the fair value of plan assets (e.g., bull markets)

· Changes in actuarial assumptions resulting in new projected benefit obligations

Often, large gains / losses from pensions result from volatility and will be reversed in the future

· E.g., abnormally large stock market gains large pension gains

The FASB developed rules for pension gains/losses to smooth out pension expense volatility

1. Expected returns (not actual returns) are a component of pension expense

· Market Value of Plan Assets × Expected Rate of Return = Expected Return

· Expected Return – Actual Return = [Unexpected] Asset Loss (Gain)

· Unexpected asset gains/losses reported as Other Comprehensive Income

2. Change in Actuarial Assumptions can result in [Unexpected] liability gains and losses

· Includes changes in mortality rate, retirement rate, turnover rate, disability rate, etc.

· Reported as Other Comprehensive Income (netted against Asset Gains and Losses)

Continuing with Zarle Company, the following facts apply to the pension plan for 2016:

* See Pension Worksheet (Zarle 2016) *

Corridor Amortization (performed at beginning of each year)

If AOCI from Pension Gains and Losses grows ‘too large’ ( >10% of the larger of Beginning PBO or Beginning Plan Assets), the excess amount is amortized as part of pension expense

The following pension information relates to Soft-White Company for 2014-2016:

Soft White recorded actuarial (liability) losses of $400,000 in 2014 and $300,000 in 2015. The average remaining service life of all active employees is 5.5 years in both 2015 and 2016. Assuming these are the only asset/liability gains or losses Soft White has experienced, what amount should be amortized going forward?

2015: 400,000 – 280,000 = 120,000 ÷ 5.5 = $21,818 (additional pension expense)

2016: $400,000 - $21,818 + $300,000 = $678,182 - $290,000 = $388,182 ÷ 5.5 = $70,579

WHY ARE WE DOING THIS???

· Rationale:

· Many asset/liability gains/losses will eventually offset part of OCI

· If gains/losses become so large that they are unlikely to offset, they should be recognized as part of pension expense

· To avoid large single-year adjustments, we amortize them over time

*** Try it on your own ***

The following information is provided by the actuaries for “I Love Deferred Taxes” Corp. with respect to its defined benefit pension plan. ILDT began 2017 with no prior gains and losses for its pension (i.e., AOCI G/L of zero).

Assuming that covered employees at ILDT have an average of 14 service years remaining in both 2017 through 2020, what amount (if any) of gain/loss amortization should occur for the company in 2017 through 2020? What effect will that amortization have on the company’s (1) OCI, and (2) net income in each year?

· 2018: Amortization decreases OCI and increases net income

· 2019: Amortization increases OCI and decreases net income

COMPREHENSIVE EXAMPLE

The following pension information for Zarle Company relates to 2017:

Use a pension worksheet to determine the required pension journal entry for 2017 as well as how Zarle will report its pension on its balance sheet for the year ended 12/31/2017.

* See Pension Worksheet (Zarle 2017) *

Corridor Test for 2017

Partial Balance Sheet – Zarle – 2017

Pension Liability 98,900

REPORTING PENSION PLANS IN FINANCIAL STATEMENTS

What to report:

· Overfunded (underfunded) pension asset (liability) for defined benefit pension plans

· LONG TERM

· Benefits owed to recipients and not yet paid are current

· Multiple pension plans for a single company are netted into one line if they are all overfunded or all underfunded.

· If some are underfunded, some are overfunded, must be separated into 2 accounts

· Pension Expense: reported on the income statement

· Initial Prior Service Cost / Actuarial Gains and Losses: reported as OCI

· When prior service cost is amortized, it becomes part of pension expense

Earnings Without / With Pension Effects

Earnings without pension effects 2010 2011 2012 2013 2014 2015 10000 12000 11000 13000 12000 14000 Earnings with pension effects 2010 2011 2012 2013 2014 2015 4000 17500 4500 18000 5000 18500

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