Pensions and Postretirement Benefits Revsine/Collins/Johnson: Chapter 14.

Pensions and Postretirement

Benefits

Revsine/Collins/Johnson: Chapter 14

2RCJ: Chapter 14 © 2005

Learning objectives

1. The difference between defined contribution and defined benefit pension plans.

2. What the components of pension expense are and their relation to pension assets and to the pension liability.

3. The requirements for funding pension plans, computing the return on plan assets, and the role of the plan trustee.

4. How GAAP smoothes the volatility inherent in pension estimates and forecasts.

5. The determinants of the pension funding decision.


Learning objectives:Concluded

6. How to analyze and use the funded status footnote and the reconciliation of pension asset and liability accounts.

7. When a minimum balance sheet pension liability must be recognized.

8. The financial reporting rules for other postretirement benefits.

9. What research tells us about the usefulness of the detailed pension and other postretirement benefits disclosures.


Pension plans

A pension plan is an agreement by the firm to provide a series of payments (called a pension) to employees when they retire.

The firm makes periodic contributions to a pension trust.

The pension trust then makes periodic benefit payments to retired employees.

As we shall see, there are two types of pension plans: defined contribution plans and defined benefit plans.

Firm (sponsor)

Pension trust

Retired employee

Contributions

Benefit payments


Pension plans:Defined contribution

Defined contribution plans specify the amount of cash that the employer puts into the plan.

No explicit promise is made about the size of the periodic payments the employee will receive on retirement.

Employees shoulder

investment risk


Pension plans:Defined benefit

Defined benefit plans specify the formula for determining the amount that will be paid out to the employee after retirement.

Determining how much should be charged to pension expense each year and how much cash must be contributed to the fund is complex.

Employers shoulder

investment risk


Pension plans:Defined contribution and defined benefit plans


Defined benefit pension plans:Accounting complications

The plan specifies the benefit formula but not the benefit amount.

To determine the periodic pension expense, the following factors must be estimated:1. The proportion of the workforce the will remain with the firm long

enough to qualify for benefits under the plan (called vesting).

2. The rate at which employee salaries will rise until retirement.

3. The anticipated life span of employees after retirement.

4. The rate of return that will be earned on pension investments.

5. The discount rate used to reflect the present value of future benefits earned by employees in the current period.


Defined benefit pension plans:Evolution of GAAP

SFAS No. 87 specifies the measurement and disclosure requirements for defined benefit pension plans.

The disclosure aspects of SFAS No. 87 were amended in 1998 and again in 2003 as SFAS No. 132.

SFAS No. 87 was designed to avoid volatility in pension expense, but the result is arguably the most technically complicated financial reporting pronouncement ever issued.


Defined benefit pension plans:Six components of pension expense

Service cost (+)

Interest cost (+)

Expected returnon pension assets (-)

Recognized gainsor losses (- or +)

Amortization ofunrecognized transition

asset or obligation (- or +)

Recognized priorservice cost (- or +)

The increase in the discounted present value of the pension benefits due to an additional year’s employment.

Measures the growth in the pension liability that arises from the passage of time.

Dollar return management believes will be earned on pension investments.

Smoothing device that adjusts for the difference between the expected and actual return on pension assets.

Smoothing device that adjusts for the initial SFAS No. 87 disparity between pension assets and liabilities.

Smoothing device that adjusts for the costs of retroactive changes in plan benefits.


Defined benefit pension plans:A simple example

2005 2006 2007

Wildcat adopts pension plan

Cate retires Lump-sum benefit of $20,000 is

paid


Defined benefit pension plans:Component 1—Service cost

Service cost is the increase in the discounted present value of the pension benefits ultimately payable that is attributable to an additional year’s employment.

2005 2006 2007

Service cost $10,000

$8,734

Benefit earned2.07)$10,000/(1PV

DR Pension expense $8,734

CR Cash $8,734

Here’s the December 31, 2005 journal entry:


Defined benefit pension plans:Component 1—Service cost for 2006

2005 2006 2007

Service cost $10,000

$9,346

Additional benefit earned.07)$10,000/(1PV


Defined benefit pension plans:Component 2—Interest cost for 2006

The interest cost component of pension expense arises from the passage of time.

2005 2006 2007

$8,734 benefit liability

$9,346 benefit liability

Interest cost

$611 = $8,734 x 0.07

Discount rateBenefit liability


Defined benefit pension plans:Component 3—Expected return on plan assets

This component of pension expense reflects the long-term expected return earned on pension investments.

2005 2006 2007

$8,734 cash contribution

to trust

Increased value of plan

assets

Expected return on plan

assets

$611 = $8,734 x 0.07

Expected rate of returnPlan assets


The journal entry for 2006 is:

Defined benefit pension plans:Pension expense for 2006

DR Pension expense $9,346

CR Cash $9,346

Component 1

Component 2

Component 3


Defined benefit pension plans:Relaxing the perfect certainty assumption

In our example, perfect certainty meant:

Date of retirement was known in advance

Amount of the pension was also known in advance

Discount rates and earnings rates were equal and could be perfectly forecast

Under these circumstances, pension expense is equal to service cost in every period.

Accounting complications arise when:

Higher or lower than anticipated employee turnover.

Higher or lower employee mortality before retirement.

Actual return on plan assets differs from the expected return.

Companies retroactively alter the level of benefits promised under the plan.


Defined benefit pension plans:Pension plan entities and relationships


Defined benefit pension plans:Discount rate uncertainty

SFAS No. 87 requires that firms use a settlement rate as the assumed discount rate in their pension expense calculation.


Defined benefit pension plans:Rates vary across firms

Expected Rate of Return

Settlement Rate


Defined benefit pension plans:Compensation increase rates vary across firms

Compensation Increase Rates 1997-2002


Defined benefit pension plans:Component 4—Recognized gains and losses

The actual return on plan assets can differ considerably from the expected return in any year.

This volatility in asset returns would—in the absence of SFAS No. 87—translate directly into net income volatility.

Volatility in actual return


Defined benefit pension plans:SFAS No. 87 and Component 4

To avert the net income volatility, SFAS No. 87 allows firms to reduce pension expense by the expected return on plan assets rather than by the actual return:

Firms first select a target return that they expect to earn on plan assets in the long run.

Any difference between this expected return and the actual return earned in a given year is assigned to an off-balance sheet device called unrecognized gain or loss.


Defined benefit pension plans:Actual and expected return at GE


Defined benefit pension plans:Excerpts from GE’s pension footnotes

Volatile actual returns

Smooth expected returns


Defined benefit pension plans:How volatility is eliminated


If gains and losses do not offset one another over time, the cumulative off-balance sheet deferred amounts will grow excessively large.

The role of Component 4 is to gradually reduce the cumulative deferred amounts.

Defined benefit pension plans:How Component 4 is measured

Cumulativeunrecognized

gains and losses

• Actual versus expected return on plan assets

• Actuarial assumptions versus actual experience

• Changes in assumptions (e.g., discount rate)


Defined benefit pension plans:Computing Component 4—Step 1

Step 1 : Compute the 10% threshold

Threshold equals 10% of MRAV or PBO, whichever is larger. Here the threshold is $1 million.



Step 2 : Determine whether the threshold is triggered

Because CUGOL exceeds the threshold amount, the threshold is triggered.



Step 3 : Compute the current year component 4 amortization

So, pension expense will be reduced by $40,000 in the current year.


When firms first adopted SFAS No. 87, they were required to determine the transition funding status of the plan:

This transition asset or liability is then amortized over the remaining service period of employees who are expected to receive benefits under the plan.

Defined benefit pension plans:Component 5—Transition amounts

$$

Transition liability

Plan assets Pension liability

$

Transition assets

Plan assets Pension liability

$


Pension plans are frequently amended to provide increased benefits to employees.

When benefits are retroactively enhanced, it means prior pension expense was too low.

Defined benefit pension plans:Component 6—Prior service cost


Defined benefit pension plans:Relative magnitude of expense components


Here are the pension expense components for Adess Corp.:

If the entire amount of pension expense is funded by payments to the plan trustee, the entry is:

Defined benefit pension plans:Journal entries illustrated

DR Pension expense $50,000 CR Cash $50,000

DR Pension expense $50,000 CR Cash $44,000 CR Unfunded accrued pension cost 6,000

If Adess decides to fund $44,000 that year:


Defined benefit pension plans:The pension funding decision

Funding decisions are influenced by income tax laws, protective pension legislation, the availability of cash, and other incentives.

Income tax laws

ERISA

Competingcash needs

Contracting andpolitical cost incentives

Firms with high marginal tax rates tend to overfund their pension plans.

Firms with less stringent capital constraints and larger union membership tend to have higher funding ratios.

Firms with more “precarious” debt/equity ratios tend to have lower funding ratios.


The pension footnote:General Electric—Part 1

Used in later journal entry

GE has pension income rather than pension expense.





Used in later

journal entry

Pension assets are larger than GE’s pension obligation



Used in later journal entry




The pension footnote:Funded status disclosure—Plan assets

Causes of Increases and Decreases in Plan Assets


The pension footnote:Funded status disclosure—PBO

Causes of Increases and Decreases in Projected Benefit Obligations (PBO)


The pension footnote:Reconciling funded status to balance sheet

General Electric Company


The pension footnote:GE’s journal entry

Change in account balance from Ex 14.8

“Effect on operations” from

Ex 14.8

Employer contribution

Change in account balance from Ex 14.8


The pension footnote:Extracting analytical insights

The funded status reconciliation provides insights about future pension-related cash flows:

Firms are also now required to disclose anticipated pension benefit payouts for the next five years.

$

Slightly overfunded

Plan assets

Pension benefit

obligation

$

• Suppose the firm did not contribute cash to their pensions trust this year.

• Will cash contributions be required in futures years?


The pension footnote:Extracting analytical insights (concluded)

Pension assets and liabilities are quite sensitive to changes in interest rates:

Changes in various pension rate assumptions also affect pension expense.

Assumed rate of Compensation increase

Spread between the discount rate and rate of Compensation increase

Service cost


Defined benefit plans:Cash-balance plans

Many U.S. companies are replacing existing pension plans with a new cash-balance plan.

Cash balance plans are attractive to employers, but they are also controversial.

Employer

Employee

Trustee

Contributes fixed amount per year, say 5% of salary

Pays annuity benefit to employee

Interest earned at T-bond rate


Defined benefit plans:Minimum balance sheet liability

Firms are required to report a minimum balance sheet liability whenever the accumulated benefit obligation (ABO) exceeds the fair value of plan assets (FVPA).

The journal entry would be:

DR Intangible asset $2,000,000

CR Minimum pension liability $2,000,000

Minimum balance sheet liability


Defined benefit plans:Minimum liability—complication 1

Suppose the company already had an “accrued pension liability” of $400,000 on its books. In this case, the computation is:

The journal entry would then be:



$2,000,000 - $400,000 =


Defined benefit plans:Minimum liability—complication 2

Assume the unrecognized prior service cost is only $1.5 million:

The journal entry would be:


DR Accumulated comprehensive loss 500,000


Cannot exceed amount of UPSC


Defined benefit plans:AMR’s minimum balance sheet liability

DR Intangible asset $330

DR Accumulated comprehensive loss 1,293

CR Minimum pension liability $1,623

= ABO - FVPA

UPSC = $330


Defined benefit plans:Funded status and operating cash flow


Other postretirement benefits

Many firms promise to provide healthcare and life insurance to employees (or their spouses) during retirement.

Under the matching principle, an expense should be recognized over the period of employment as employees qualify for these OPEBs.

Prior to SFAS No. 106 in 1992, most firms used “pay-as-you-go” accounting.

The dollar amount’s involved can be staggering:

$22.083 billion

$33.116 billion

OPEB liability Initial OPEB expense

GM’s 1992 adoption of

SFAS No.106


Other postretirement benefits:General Electric footnote—part 1










Other postretirement benefits:Initial SFAS No. 106 adoption

The Two Permitted SFAS No.106 Alternative Adoption Methods


Other postretirement benefits:Funded status reconciliation


Other postretirement benefits:Initial SFAS No. 106 adoption at GE


Are pension and OPEB disclosures useful?


An alternative view:Pension “expense” becomes pension “income”


An alternative view:Adjusted operating income at GE


Pension and OPEB accounting:Reliability and valuation relevance

Pension asset and liability measures in the footnotes are more closely associated with stock prices than are the measures recognized on the balance sheet.

Both footnote liabilities (ABO for pensions and APBO for OPEBS) are negatively correlated with stock prices.

Investors price the APBO as though it is measured with less reliability.


Summary

Under SFAS No. 87 and 132, pension expense consists of service cost, interest cost, expected return on plan assets and three other components.

The three other components are smoothing mechanisms that avoid year-to-year volatility in pension expense.

Because some pension items are “off-balance sheet,” the FASB requires firms to disclose the funded status of the plan and to reconcile funded status to reported balance sheet amounts.

An understanding of the funded status disclosure helps readers better forecast future operating cash flows.


Summary continued

The reporting rules for postretirement benefit plans (OPEB) closely parallel the pension accounting rules.

Prior to SFAS No. 106, only a few companies funded OPEB obligations. Consequently, significant off-balance OPEB liabilities exist for many firms.

Research evidence suggests that the equity valuation impact of these estimated OPEB obligations is less than dollar-for-dollar due to the potential uncertainty and measurement error associated with the estimates.


Summary concluded

Statement readers should be alert for these warning signals of earnings management:1. A significant divergence between any of the various pension and

OPEB rates selected by a firm and the rates chosen by other firms in the industry.

2. A very large difference between the chosen expected rate of return on plan assets and the discount rate used.

3. An increase in the year-to-year expected rate of return on plan assets that seems unrelated to changes in market conditions.

4. A decrease in the assumed rate of increase in future compensation levels that cannot be explained by changing industry or labor market forces.

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Pensions and Postretirement Benefits Revsine/Collins/Johnson: Chapter 14.

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