PENSIONS AND OTHER POSTRETIREMENT BENEFITS

1. Chapter 17 PENSIONS AND OTHER POSTRETIREMENT BENEFITS

2. Nature of Pension Plans • For a pension plan to qualify for special tax treatment it must meet the following requirements: • Cover at least 70% of employees. • Cannot discriminate in favor of highly compensated employees. • Must be funded in advance of retirement through an irrevocable trust fund. • Benefits must vest after a specified period of service. • Complies with timing and amount of contributions. Pension plans provide income to individuals during their retirement years. This is accomplished by setting aside funds during an employee’s working years so that at retirement, the accumulated funds plus earnings from investing those funds are available to replace wages.

3. Defined contribution pension plans promise fixed annual contributions to a pension fund (say, 10% of the employees' pay). The employee chooses (from designated options) where funds are invested – usually stocks or fixed-income securities. Retirement pay depends on the size of the fund at retirement. Types of Pension Plans

4. Types of Pension Plans Defined benefit pension plans promise fixed retirement benefits defined by a designated formula. Typically, the pension formula bases retirement pay on the employees' (a) years of service, (b) annual compensation [often final pay or an average for the last few years], and sometimes (c) age. Employers are responsible for ensuring that sufficient funds are available to provide promised benefits.

5. Defined Contribution Pension Plans Plan Characteristics Employer deposits an agreed-upon amount into an employee-directed investment fund. Employee bears all risk of pension fund performance. Contributions are defined by agreement.

6. Defined Contribution Pension Plans Accounting for these plans is quite simple. Let’s assume that the annual contribution is to be 3% of an employee’s salary. If an employee earned $110,000 during the year, the company would make the following entry:

7. Defined Benefit Pension Plans Plan Characteristics Employer is committed to specified retirement benefits. Employer bears all risk of pension fund performance. Retirement benefits are based on a formula that considers years of service, compensation level, and age.

8. A pension formula might define annual retirement benefits as: 1 1/2 % x Years of service x Final year’s salary By this formula, the annual benefits to an employee who retires after 30 years of service, with a final salary of $100,000, would be: 1 1/2 % x 30 years x $100,000 = $45,000 Defined Benefit Pension Plan

9. The Pension Obligation Accumulated benefit obligation (ABO) The actuary’s estimate of the total retirement benefits (at their discounted present value) earned so far by employees, applying the pension formula using existing compensation levels. Vested benefit obligation (VBO) The portion of the accumulated benefit obligation that plan participants are entitled to receive regardless of their continued employment. Projected benefit obligation (PBO) The actuary’s estimate of the total retirement benefit (at their discounted present value) earned so far by employees, applying the pension formula using estimated future compensation levels. (If the pension formula does not include future compensation levels, the PBO and the ABO are the same. © 2008 The McGraw-Hill Companies, Inc.

10. Projected Benefit Obligation The PBO is a more meaningful measurement because it includes a projection of what the salary might be at retirement. Jessica Farrow was hired by Global Communications in 1998. She is eligible to participate in the company's defined benefit pension plan. The benefit formula is: Annual salary in year of retirement × Number of years of service × 1.5% Annual retirement benefits Farrow is expected to retire in 2037 after 40 years of service. Her retirement period is expected to be 20 years. At the end of 2007, 10 years after being hired, her salary is $100,000. The interest rate is 6%. The company’s actuary projects Farrow’s salary to be $400,000 at retirement.

11. Projected Benefit Obligation • Step 1. Use the pension formula to determine the retirement benefits earned to date. • $400,000 • × 10 • × 1.5% • $ 60,000 per year • Step 2. Find the present value of the retirement benefits as of the retirement date. • The present value (n=20, i=6%,) of the retirement annuity at the retirement date is $688,195 ($60,000 × 11.46992). • Step 3. Find the present value of the retirement benefits as of the current date. • The present value (n=30, i=6%,) of the retirement benefits at 2007 is $119,822 ($688,195 × .17411). This is the PBO.

12. Projected Benefit Obligation • If the actuary’s estimate of the final salary hasn’t changed, the PBO a year later at the end of 2008 would be $139,715. • Step 1. Use the pension formula to determine the retirement benefits earned to date. • $400,000 • × 11 • × 1.5% • $ 66,000 per year • Step 2. Find the present value of the retirement benefits as of the retirement date. • The present value (n=20, i=6%,) of the retirement annuity at the retirement date is $757,015 ($66,000 × 11.46992). • Step 3. Find the present value of the retirement benefits as of the current date. • The present value (n=29, i=6%,) of the retirement benefits at 2008 is $139,715 ($757,015 × .18456). This is the PBO.

13. Changes in the PBO

14. Changes in the PBO Service cost is the increase in the PBO attributable to employee service performed during the period.

15. Changes in the PBO Interest cost is the interest on the PBO during the period.

16. Changes in the PBO Prior service costis the increase in the PBO from using a new, more generous pension formula to determine the pension obligation for prior years.

17. Changes in the PBO Loss or gain on PBOresults from revising estimates used to determine the PBO.

18. Changes in the PBO Retiree benefits paid are payments to retired employees.

19. Changes in the PBO

20. Global Communications funds its defined benefit pension plan by contributing the year’s service cost plus a portion of the prior service cost each year. Cash of $48 million was contributed to the pension fund in 2009. Plan assets at the beginning of 2009 were valued at $300 million. The expected rate of return on the investment of those assets was 9%, but the actual return in 2009 was 10%. Retirement benefits of $38 million were paid at the end of 2009 to retired employees. The plan assets at the end of 2009 will be: Pension Plan Assets

21. OVERFUNDED Market value of plan assets exceeds the actuarial present value of all benefits earned by participants. Funded Status of the Pension Plan UNDERFUNDED Market value of plan assets is below the actuarial present value of all benefits earned by participants.

22. This amount is reported in the balance sheet as a Pension Liability or Pension Asset. Funded Status of Pension Plan Projected Benefit Obligation (PBO) - Plan Assets at Fair Value Underfunded / Overfunded Status

23. Pension Expense – An Overview

24. Actuaries have determined that Global Communications has service cost of $41,000,000 in 2009. Pension Expense

25. Interest cost is calculated as: PBOBeg × Discount rate Global had PBO of $400,000,000 on 1/1/09. The actuary uses a discount rate of 6%. Interest Cost 2009 Interest Cost: PBO 1/1/09 $400,000,000 × 6% = $24,000,000

26. Return on Plan Assets The plan trustee reports that plan assets were $300,000,000 on 1/1/09. The trustee uses an expected return of 9% and the actual return is 10%.

27. In 2008, Global Communications amended the pension plan, increasing the PBO at that time. For all plan participants, the prior service cost was $60 million at 1/1/08. The average remaining service life of the active employee group is 15 years. Amortization of Prior Service Cost $60,000,000 PSC ÷ 15 = $4,000,000 per year

28. Gains and Losses

29. Corridor Amount PBO at the beginning of the period. The corridor amount is 10% of the greater of . . . Or Fair value of plan assets at the beginning of the period.

30. Net unrecognized gain or loss at beginning of year Corridor amount ־ Average remaining service period of activeemployees expected to receive benefits under the plan Gains and Losses If the beginning net unrecognized gain or loss exceeds the corridor amount, amortization is recognized using the following formula . . .

31. Gains and Losses $15,000,000 ÷ 15 years = $1,000,000

32. Recording Gains and Losses For 2009, the actual return on plan assets exceeded the expected return by $3 million. In addition, there was a $23 million loss from changes made by the actuary when it revised its estimate of future salary levels causing its PBO estimate to increase. Global would make the following journal entry to record the gain and loss: OCI = Other comprehensive income

33. Recording the Pension Expense

34. Pension Expense Spreadsheet

35. Postretirement Benefits Other Than Pensions Net Cost of Benefits Estimated medical costs in each year of retirement Retiree share of cost Medicare payments Less: Estimated net cost of benefits Equals:

36. Expected Postretirement Benefit Obligation (EPBO) – The actuary's estimate of the totalpostretirement benefits (at their discounted present value) expected to be received by plan participants. Accumulated Postretirement Benefit Obligation (APBO) – The portion of the EPBO attributed to employee service to date. Other Postretirement Benefits

37. Attribution The process of assigning the cost of benefits to the years during which those benefits are assumed to be earned by employees.

38. Postretirement Benefit Expense

39. 30,0002,000 15 average service years = Appendix 17: Service Method of Allocating Prior Service Cost The allocation approach that reflects the declining service pattern of employees is called the service method. The method requires that the total number of service years for all employees be calculated. This calculation is usually done by the actuary. Assume Global Communications has 2,000 employees and the company’s actuary determined that the total number of service years of these employees is 30,000. We would calculate the following amortization fraction:

40. End of Chapter 17