Pensions

RCJ Chapter 14
Paul Zarowin 2
Key Issues
1. Types of pension plans: defined benefit vs. defined contribution
2. Pension liability: PBO, ABO, VBO
3. Assumptions: discount rate%, salary growth rate%, E(ROA)%, actuarial
4. PENSION assets
5. Primary (ongoing) factors
6. Journal entries
7. Smoothing of transitory gains and losses
8. Types of transitory gains and losses
9. Additional factors
10. Funded status reconciliation
11. Minimum liability


12. Corridor amortization
13. Pension worksheet
14. Footnote disclosures
15. Correction JE
16. OPEBs

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Structure of Pension Plan

firm or employee pension fund retiree
Cash Pay benefits

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Types of Pension Plans
1. Defined contribution:
employee bears risk, no firm liability

2. Defined benefit:
firm bears risk and has liability (our focus)

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Ex. Defined Benefit Plan
workers age = 60
service = 30 yrs so far
retire @ 65 (5 more years)
current salary = $50,000
Pension contract:
X% per year * final salary
(X = # of years of service @ retirement)
Example: 35% x $50,000 = $17,500

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Pension Liabilities
Pension liability: discounted PV of expected future cash payments
- like any other non-current liability (effective interest method).
compare to other non-current liabilities:
r% E(CF)
Bonds known known
Leases known? known
Pensions ? ?

Both discount rate and expected cash flows are subjective
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3 Definitions of Liabilities
PBO = PV of expected payments, given expected future salaries
ABO= PV of expected payments, given current salaries
VBO =PV of vested portion of expected payments, given current
salaries
PBO ABO VBO

Which definition is appropriate for which case?
1. valuing a going concern
2. Takeover
3. Firm in bankruptcy

Well use PBO, unless otherwise stated.



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Key Assumptions
discount rate = r%
salary growth rate = g% (for PBO)
actuarial (life span, tenure, turnover, etc.)
EROA% (expected rate of return on pension assets),
see below


Q: Is liability bigger for older or younger workers?
What are
managements
incentives?
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Ex. Defined Benefit Plan, Continued
Assumptions
Expected salary growth rate = 5%
Discount rate = 10%
Life expectancy = 80 years (15 years in retirement)

Expected final salary = 50,000 * (1.05)
5
= 63,814
30% * 63,814 = 19,144 = amount hell receive per year in
retirement (based on service so far)
PV of annuity factor, 10%, 15 yrs = 7.606
19,144 * 7.606 = 145,611 = PV @ retirement

PBO = 145,611/(1.10)
5
= 90,413 = PV of annuity now
ABO = (30% * 50,000 * 7.606)/1.10
5
= 70,841
PBO > ABO due to expected salary growth

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Primary (Ongoing) Factors Affecting PBO
PBO
- +
DR CR
pay benefits Interest cost
Service cost

def: interest cost = r% * PBO @ beginning of year
(remember: effective interest method)
[debt accretion, like zero coupon bond]

def: service cost = PV of future benefits earned this year

Ex. E14-1, E14-13
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Ex. Defined Benefit Plan, Continued
Interest cost = 90413*.10 = 9041
Service cost = (1% * 63,814 * 7.606)/1.10
5
= 3014

Q: how does a higher or lower r% affect interest cost?
Q: how does an employees age affect his service cost?
E14-1,13
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Pension Assets
Pension assets: FMV of assets (stocks, bonds, etc.)

Funded status (true, economic position):
Pension assets PBO
Overfunded: assets > PBO
Underfunded: assets < PBO
Severely underfunded: assets < ABO

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Primary (Ongoing) Factors Affecting
Pensions Assets
Assets
+ -
DR CR
Funding (contribution) Pay benefits
(ROA)Return on assets
#

# note: this is actual ROA; ROA is shown as +, but could be


Ex. E14-6, E14-13


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Primary Journal Entries
* note: actual ROA is shown as +, but could be
UNL = unexpected net loss (if actual ROA < expected ROA)
UNG = unexpected net gain (if actual ROA > expected ROA)


DR CR
service, interest Pension expense PBO
Funding
(contributions)
Assets Cash

benefits PBO Assets
ROA

Assets(actual
ROA)
*


Pension Expense
(expected ROA=
EROA%*beginning assets)
UNL or UNG
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Ex. Defined Benefit Plan, Continued
Assume:
pension assets = 100,000
E(ROA)% = 10%
actual ROA = 15,000

DR assets 15,000
CR Pension expense 10,000
CR UNGain 5,000

Q: How does assumed EROA% affect FMV of assets?

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Primary Factors Affecting Pension
Expense
Pension Expense
+ -
DR CR
Service E(ROA)
Interest


Q: What is the effect of funding on expense?
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Ex. Defined Benefit Plan, Continued
Service 3,014

Interest 9,041

E(ROA) (10,000)
pension expense 2,055


Ex. E14-12 without amortization and unexpected loss
P 14-1, Parts 1-3 in Summary So Far
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Smoothing of Transitory Gains and Losses
def: unrecognized = deferred (in footnotes)
def: recognized = amortized (into pension expense on I/S)

Transitory gains, losses are CRd (gains) or DRd (losses)
to unrecognized (footnote) accounts, rather than
recognized as gain or loss on I/S. The unrecognized
balances are amortized onto I/S. This smooths NI and
keeps assets and PBO off of B/S.

Full Exp For E14-13
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Smoothing (contd): Intuition
Loss in DR, Gain in CR
DR CR
Loss: Unrecognized loss Asset or liab.

Amortn: Exp.(recorded) Unrecognized loss


Gain: Asset or liab. Unrecognized gain

Amortn: Unrecognized gain Exp.(recorded)


20
Types of Transitory Gains, Losses
DR CR
asset gain: actual ROA > expected ROA Assets Pension expense
UNG
asset loss: actual ROA < expected ROA Assets
UNL
Pension expense
* assets are DRd (or CRd) for actual ROA; pension expense is CRd for expected ROA;
difference is UNG or UNL (see slide #15)
liability loss (due to assumption r%, g%, etc.) UNL PBO
liability gain (due to assumption r%, g%, etc.) PBO UNG
note: asset and liability gains and losses are all aggregated into one UNG/L
account
note: liability gains and losses are also called actuarial gains and losses
Q: What happens if EROA% is set too high (higher than true average
ROA%)?

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2 Types of Liability Gain/Loss
1. Change in assumptions
2. Change in contracts

Intuition: What affects r% and E(CF)s
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Types of Transitory Gains, Losses (contd)
DR CR
Change in pension contract: sweetening UPSC PBO
Change in pension contract: souring PBO UPSC



def: UPSC = unrecognized prior service cost (retroactive benefits)
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Ex. Defined Benefit Plan, Continued
1. assume benefits are sweetened to pay 1.1% * final
salary per year (increased by 10%)
increase in PBO = 10% * 90,413 = 9041
DR UPSC 9041
CR PBO 9041
2. assume salary growth rate is increased to 6% (final
salary = 66,912), so PBO = 94,802 and increase in
PBO = 4389 (94,802 90,413)
DR UNLoss 4389
CR PBO 4389

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Additional Factors Affecting PBO
PBO
DR (+) CR (-)
Primary factors
Pay benefits Interest cost
Service cost
Additional
factors
Liability gain Liability loss
Souring Sweetening
( assumptions)
( contracts)
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Additional Factors Affecting Pension
Expense
Expense
DR (+) CR (-)
Primary factors
Interest cost E(ROA)
Service cost
Additional factors loss amortization Gain amortization
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Additional Factors Affecting Pension Expense (contd)
Loss amortization:
DR Pension expense
CR UPSC or UNL or UTL
Gain amortization:
DR UPSC or UNG or UTA
CR Pension expense
UTA, UTL = unrecognized transition asset, liability =
net position (assets - PBO) @ adoption of SFAS #87
remember: amortization = recognized into expense
amortization is generally SL over average remaining service life of
employees

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Ex. Defined Benefit Plan, Continued
Amortize UPSC over 5 years: 9041/5 = 1808
DR pension expense 1808
CR UPSC 1808

service 3,014
interest 9,041
E(ROA) (10,000)
UPSC Amort. 1,808
pension expense 3,863

Ex. E14-13 GM disclosure
E 14-12 w/o Loss
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Funded Status Reconciliation
Reconcile true vs. recognized position
assets
- PBO
funded status (can be net asset or net liability): true position
+ UNL (or - UNG)
+ UPSC
+ UTL (or - UTA)
recognized (on B/S) position: prepaid pension cost (asset) or
deferred pension cost (liab)
note: funded status (true economic position) vs. recognized position
unrecognized losses & liabs make the recognized position better
than the true position
unrecognized gains & assets make the recognized position worse
than the true position
Ex. E14-14, 19

Unrecognized
Gains/Losses
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Minimum Liability
if ABO > assets the pension plan is considered severely
underfunded and a liab. (ABO - assets) must be
recognized.
if recognized position is asset (prepaid cost) or liab
(accrued cost) < (ABO-assets), additional entry is needed
to bring recognized position to minimum level:
DR Intangible asset*
CR Additional liability
* should be DR to a loss account
additional liab can be shown separately or aggregated with
accrued pension cost on B/S
Ex. E14-2, E14-5
30
Corridor (Minimum) Amortization
UNL or UNG must be amortized only if it > corridor
corridor = 10% of bigger (PBO, assets) @BOY
amortization is down to corridor, not zero
if amortn is required one year, it might or might not be the
next year, and vice versa



UNG/L
DR CR
*BOY net loss *BOY net gain (* for current year amortn test)
Current year loss Current year gain
gain amortn loss amortn (amortn only if required)
#EOY net loss #EOY net gain (# for next years amortn test)

Ex. P14-1, sec 1-6 E14-18
Pension Worksheet - put it all
together - relate to funded status reconciliation
Recognized (on FS) bal. Unrecognized (footnote) balances
Pen. exp Cash ppd/acc cost Pen Ass Pen Liab UNGL UPSC
Service cost DR CR
Interest cost DR CR
ROA CR DR plug
Funding (contribution) CR DR
Benefits CR DR
liability loss
6
CR DR
Sweetening
7
CR DR
Amortization UNL
8
DR CR
Amortization of UPSC
(from sweetening)
9

DR CR
Summary JE; only
recognized (on FS) JE
DR CR CR or DR
6. reverse DR and CR for a liability gain 8. reverse DR and CR for amortn of unrecognized gain
7. reverse DR and CR for souring 9. reverse DR and CR for amortn from souring
Note: recognized asset/liab (prepaid/accrued pension cost) is net of all unrecognized accounts

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Exercise problems
E14-3, E14-4, E14-7 E14-17, 20
P14-2, P14-3
P14-13
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Footnote Disclosures
The pension footnote includes:
1. total pension expense and its components
2. reconciliation of BOY vs EOY PBO and asset
accounts (like t-accounts)
3. funded status reconciliation
4. assumptions (r%, g%, EROA%)

C 14-2,3
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Correction JE
(to put assets and liabs on B/S)
using information in pension footnote, put pension assets and liab
on B/S; replace recognized position with true position

DR CR
pension assets PBO
accrued pension cost or Prepaid pension cost
R/E or R/E

1. put pension assets and PBO on B/S
2. remove accrued or prepaid pension cost from B/S
3. plug: DR or CR R/E = cumulative unrecognized gains/losses (sum of
UNGL, UPSC, UTAL)
note: DR or CR to R/E rather than current year gain or loss

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Other Post-Employment Benefits (OPEBs)
Same accounting as pensions, with minor differences
1. ABO instead of PBO (OPEBs not tied to salary)
2. significance of (TL) transition liability (no incentive to fund, so
ABO > assets) firms can: amortize TL over <= 20 years
DR OPEB expense
CR Accrued OPEB cost
or take loss as change in accounting principle (below the line):
DR loss due to change in acct principle
CR Accrued OPEB cost
most firms chose latter: why?
3. service cost is accrued (earned) over short (vesting) period,
since benefits dont increase with tenure