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Pensions and Other

Postretirement
Benefits

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PENSION PLANS
Ñ Pension plans provide income to
individuals during their retirement years.
Ñ This is accomplished by setting aside funds
during an employeeƞs working years so that
at retirement, the accumulated funds plus
earnings from investing those funds are
available to replace wages.



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m PES OF PENSION PLANS


Ñ    coo p  o pla promise fixed
annual contributions to a pension fund (say, 10% of the
employees' pay). The employee chooses (from designated
options) where funds are invested ƛ usually stocks or fixed-
income securities. Retirement pay depends on the size of
the fund at retirement.
Ñ       p  o pla promise fixed retirement
benefits Ơdefinedơ 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.


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Defined Contribution
Plans

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Defined Benefit
Pension Plans

 
 


  


 
  

 
 
  


      
  



  

  
  



 


 
  


   



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EFINE BENEFIm
PENSION PLANS
Ä pension formula might define annual retirement benefits as:

1 1/2 % x Years of service x Final yearƞs salary

By this formula, the annual benefits to an employee who retires


after 40 years of service, with a final salary of $100,000,
would be:

1 1/2 % x 40 years x $100,000 = $60,000



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PENSION OBLIGAmION
Three different ways to measure the pension obligation:
Ñ Acc
la     ol ao (ABO) ƛ The actuary's
estimate of the total retirement benefits (at their discounted
present value) earned so far by employees, applying the
pension formula to existing compensation levels.
Ñ A      ol ao (ABO) - The portion of the
accumulated benefit obligation that plan participants are
entitled to receive regardless of their continued
employment.
Ñ Poj c     ol ao (PBO) ƛ The actuary's
estimate of the total retirement benefits (at their discounted
present value) earned so far by employees, applying the
pension formula to estimated future compensation levels.



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PROJECmE BENEFIm
OBLIGAmION
^essica Farrow was hired by Global Communications in
2000. The company has a defined benefit pension plan that
specifies annual retirement benefits equal to:
1.5% x service years x final yearƞs salary
Farrow is expected to retire in 2039 after 40 years service.
Her retirement period is expected to be 20 years. Ät the
end of 2009, 10 years after being hired, her salary is
$100,000. The interest rate is 6%. m co
pa
aca poj c Faow ala o  $400,000 a
 

What is the companyƞs poj c     ol ao with
respect to ^essica Farrow?


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PROJECmE BENEFIm
OBLIGAmION
Gteps to calculate the projected benefit obligation:

1. Use the pension formula (including a projection of


future salary levels) to determine the retirement
benefits.
2. Find the present value of the retirement benefits as
of the retirement date.
3. Find the present value of retirement benefits as of
the current date.



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PBO IN 2007
 present value [n=30, i=6%] actuary estimates employee has
of retirement benefits at 2007 is earned (as of 2009)
retirement benefits of
$688,195 x .17411 = 1.5% x 10 years x $400,000 =
$119,822 $60,000 p  a
2000 2009 2039 2059
____________________________________________________________

10 years 30 years 20 years


S c p o R 


m   PBO Πpresent value [n=20, i=6%] of the


retirement annuity at the retirement date is
$60,000 x 11.46992 =



$688,195
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PBO IN 2010
Of the actuaryƞs estimate of the final
salary hasnƞt changed, the PBO at the
end of 2010 would be $139,715:



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PBO IN 2010
actuary estimates employee has
earned (as of 2010)
retirement benefits of
1.5% x 11 years x $400,000 =
$66,000 p  a
2000 2009
2010 2039 2059
____________________________________________________________


11 years
10 years 29
30 years
years 20 years
S c p o R 


Πpresent value [n=20, i=6%] of the


retirement annuity at the retirement date is
$66,000 x 11.46992 =



$757,015
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PBO IN 2010
 present value [n=29, i=6%] actuary estimates employee has
of retirement benefits at 2010 is earned (as of 2010)
retirement benefits of
$757,015 x .18456 = 1.5% x 11 years x $400,000 =
$139,822 $66,000 p  a
2000 2010 2039 2059
____________________________________________________________

11 years 29 years 20 years


S c p o R 


Πpresent value [n=20, i=6%] of the


retirement annuity at the retirement date is
$66,000 x 11.46992 =



$757,015
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Changes in the PBO


Notice that the PBO increased during 2010 from
$119,822 to $139,715 for two reasons:
1. One more service year is included in the
pension formula calculation.
2. The employee is one year closer to
retirement, causing the present value of
benefits to increase due to the time value of
future benefits.



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OOW mOE PBO COANGE


IN 2008
PBO at the beginning of 2010 (end of 2009) $119,822
S c co : (1.5 x 1 yr. x $400,000) x 11.46992 x .18456 12,701
annual retirement benefits to discount to discount
from 2010 service to 2039 * to 2010 **

I   co : $119,822 x 6% 7,189


PBO at the end of 2010 $139,712

* present value of an ordinary annuity of $1: n=20, i=6%


** present value of $1: n=29, i=6%



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Projected Benefit Obligation


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Pension Obligation
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Pension Obligation
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Pension Obligation
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Po S c Co 
Ässume the formulaƞs salary percentage is
increased in 2010 from 1.5% to 1.7%:

17% x Gervice years x Final yearƞs salary


[R   P  o Fo
la]

The increase in the PBO attributable to


making a plan amendment retroactive is
referred to as po c co .


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Po S c Co 
PBO Wou A

 PBO W A


1.5 x 10 years x $400,000 = $60,000 17 x 10 years x $400,000 = $68,000

Π$60,000 x 11.46992 = $688,195 $68,000 x 11.46992 = $779,955

 $688,195 x .17411 = $119,822 $779,955 x .17411 = $135,798

$15,976
Prior service cost


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Pension Obligation
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GAIN OR LOSS
ON mOE PBO

Ñ àany estimates are needed to derive the PBO.


When one or more of these estimates requires
revision, the estimate of the PBO also will
require revision.
Ñ The resulting decrease or increase in the PBO
is referred to as a a or lo , respectively.



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GAIN OR LOSS
ON mOE PBO
Ässume the estimate of Farrowƞs final salary should be increased by 5% to
$420,000. This would affect the estimate of the PBO as follows:

PBO Wo PBO W


R   E 
a R   E 
a

1.7 x 12 years x $400,000 = $81,600 1.7 x 12 years x $420,000 = $85,680

Π$81,600 x 11.46992 = $935,945 $85,680 x 11.46992 = $982,743

 $935,945 x .19563 = $183,099 $982,743 x .19563 = $192,254

$9,155
Loss on PBO


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Pension Obligation
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ILLUSmRAmION EXPANE mO mOE


ENmIRE EMPLO EE POOL
($ in millions)
PBO at the beginning of 2011 (amount assumed) $400
S c co , 2011 (amount assumed) 41
I   co : $400 x 6% 24
Lo ( a) o PBO (amount assumed) 23
L  R     pa (amount assumed) (38)
PBO at the end of 2011 $450



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PENSION PLAN ASSEmS


Global Communications funds its defined benefit pension plan by
contributing each year the yearƞs service cost plus a portion of the prior
service cost. Cash of $48 million was contributed to the pension fund in
2011.
Plan assets at the beginning of 2011 were valued at $300 million. The
expected rate of return on the investment of those assets was 9%, but
the actual return in 2011 was 10%. Retirement benefits of $38 million
were paid at the end of 2011 to retired employees.
What is the value of the companyƞs pension plan assets at the end of
2011?
($ in millions)
Plan assets at the beginning of 2011 $300
R  o pla a  (10% x $300) 30
Ca  coo 48
L  R     pa (38)
Plan assets at the end of 2011 $340


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Funded Gtatus of Pension Plan


OAERFUNE UNERFUNE
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Funded Gtatus of Pension Plan


Projected Benefit Obligation (PBO)
- Plan Assets at Fair Value
Underfunded / Overfunded Status

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REPORmING mOE FUNE SmAmUS


OF mOE PENSION PLAN

($ in millions) 2011 2010


Projected benefit obligation (PBO) $450 $400
Fair value of plan assets 340 300
Underfunded status $110 $100

Ñ Because the plan is underfunded, Global reports a


pension liability of $110 million in its 2011 balance
sheet and $100 million in 2010.

Of the plan becomes overfunded in the future,


Global will report a pension asset instead.



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Pension Expense ƛ Än
Overview
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PENSION EXPENSE
PLAN
($ in millions) PBO ASSEmS
Beginning of 2011 $400 Beginning of 2011 $300
Gervice cost 41 Return on plan assets,
Onterest cost, 6% 24 10% (9% expected) 30
Loss (gain) on PBO 23 Cash contributions 48
Less: Retiree benefits (38) Less: Retiree benefits (38)
End of 2011 $450 End of 2011 $340
N  po c cost of $60 million due to a plan amendment increasing the PBO at beg.
of 2009. N  lo is $55 million. Ävg. service life of employees is 15 yrs.

Globalƞs 2011 pension expense is determined as follows:


Gervice cost $41
Onterest cost 24
Expected return on the plan assets ($30 actual, less $3 gain) (27)
Ämortization of prior service cost 4
Ämortization of net loss 1
P  o p  $43


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AMORmIZAmION OF PRIOR
SERAICE COSm
Ñ By the straight-line method, prior service cost is recognized
over the average remaining service life of the active
employee group.
($ in millions)
Gervice cost $41
Onterest cost 24
Expected return on plan assets ($30 actual, less $3 gain) (27)
A
oao o po c co AOCI
($60
llo ÷ 15 a ) 4
Ämortization of net loss-ÄOCO 1
P  o p  $43



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Gains and Losses


 

   


  

 
  

  

 

 




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Return on Plan Ässets


Actual u ected
Return Return

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AMORmIZAmION OF NEm LOSS


Ñ We assume a net loss of $55 million at the beginning of
2011. The PBO and plan assets are $400 million and $300
million, respectively, at that time.
($ in millions)
Net loss (previous losses exceeded previous gains) $55
10% of $400 ($400 is greater than $300) 40
Excess at the beginning of the year $15
Äverage remaining service period ÷ 15 yrs
Ämount amortized to 2011 pension expense $1



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R co Ga a Lo


($ in millions)

LossƛOCO (from change in assumption) 23


PBO 23

Plan assets 3
GainƛOCO (from actual return exceeding expected return) 3

Ñ Gains and losses are not immediately included in pension expense and net
income.
Ñ Onstead, they are reported in the statement of comprehensive income.
23 á PBO
3 á £ess: plan assets
20 á Net pension liability
Ñ The gain and loss become part of the net lossƛÄOCO account which is a
shareholdersƞ equity account.
Note: Äny new prior service cost should it arise, is reported as Other comprehensive income in the same manner.



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RECOR PENSION EXPENSE IN 2009


($ in millions)
Pension expense (calculated above) 43
Plan assets ($27 expected return on assets) 27
PBO ($41 service cost + $24 interest cost) 65
Ämortization of prior service costƛOCO 4
Ämortization of net lossƛOCO 1
OCO = Other comprehensive income
Ñ Gervice cost and interest cost add to Globalƞs PBO.
Ñ The return on plan assets adds to the plan assets.
Ñ Ämortization of OCO items also is OCO.
Gervice cost $41
Onterest cost 65 á PBO 24
Expected return on plan assets
27 á ($30
£ess:actual, less $3 gain)
plan assets (27)
Ämortization of prior service
38cost
á Net pension liability 4
Ämortization of net loss 1
P  o p  $43



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RECOR PENSION FUNING

Ñ When Global adds its annual cash investment to its


plan assets, the value of those plan assets increases
by $48 million:
($ in millions)
Plan assets 48
Cash (contribution to plan assets) 48

PBO
48 á £ess: plan assets
48   Net pension liability


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Effect on Balances
Now that weƞve recorded these entries for the funding of the pension plan and
payment of benefits, we have recorded all the changes in the PBO and Plan
Ässets:
($ in millions) PBO Pla A 
________________________________ __________________________________
400 Balac Balac 300
23 £oss Gain 3
41 Gervice cost Expected return 27
24 Onterest cost Funding 48
Benefits paid 38 38 Benefits paid
__________ __________
450 Balac Balac 340



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Comprehensive Oncome -
Revisited
@ 


 
 
 
  
      


 
 
 

Gains
Whenoralosses from changes
derivative in
designated Oncreases (decreases)
foreign
as currency
a cash flowexchange
hedgerates.
is in the postretirement
Œet holding The amount to
adjusted From
could
fairbechanges
value, theingain
an addition the
to Deferred
benefit losses
obligation from
or reduction in shareholdersƞ equity.
losses (gains) or loss is market
deferredvalue
as a of changing assumptions
(gains) from
(This item is discussed
securitieselsewhere
available-in as well as plan assets
on investments. component of comprehensive
your accounting curriculum.) derivatives.
for-sale
income and included in earning less or more
than expected
earnings later, at the same
time as earnings are affected Cost of recalculating
Postretirement lans: Losses (gains)
by the hedged transaction postretirement benefits
Losses (gains) from foreign
(described in the Derivatives in prior years after
Prior service Äppendix
cost. to the text). currencyamending a plan.



translations.
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Gtatement of Comprehensive Oncome


($ in millions)

Net income $xxx


Other comprehensive income:
Unrealized holding gains (losses) on investments $x
Pension plan:
£oss ƛ due to revising a PBO estimate (23)
Gain ƛ return on plan assets exceeds expected 3
Ämortization of net loss 1
Ämortization of prior service cost 4
Prior service cost 0
Deferred gains (losses) from derivatives x
Gains (losses) from foreign currency translation x xx
Comprehensive income $xxx


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Comprehensive Oncome
Other comrehensive income (a) is reorted eriodically
as it is created and (b) also is reorted as a cumulative
amount.

mhere are 3 otions for reorting mhe accumulated amount of


comrehensive income created
comrehensive income is
during the reorting eriod. mhe
reorted as a searate item of
statement of comrehensive
income can be resented: Su in the balance sheet.

As an e anded Within the As a searate


version of the statement of statement.
income shareholders¶
statement. equity.


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Äccumulated Other
Comprehensive Oncome
Global Communication
Balance Gheets
For Years Ended December 31
2011 2010
A 
Current assets $xxx $xxx
Property, plant, and equipment xxx xxx
Lal
Current £iabilities $xxx $xxx
Net pension liability 110 100
Other long-term liabilities xxx xxx
Sa ol  Eq
Common stock $xxx $xxx
Retained earnings xxx xxx
Äccumulated other comprehensive income
Net unrealized holding gains on investments xxx xxx
Net lossƛÄOCO (74) (55)
Net prior service costƛÄOCO (52) (56)


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PENSION SPREASOEEm
R po 
R co   Acco Ol
M    
   
Prior Net
M    Service Net Pension
Plan Cost- Loss- Pension (Liability)
PBO Assets AOCI AOCI Expense Cash / Asset

Balance, Jan. 1, 2011 (400) 300 56 55 (100)


    M  M
     M  M
         M 
     M 
Y Y
Y
    !" M 
#   !" M 
     M $ M% % %
&   ' M  M
      ( ) M) )
*   (  ) M)
Balance, Dec. 31, 2011 (450) 340 52 74  (110)

> 
    
  



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Postretirement Benefit Plan


Refers to any type of retiree health and
welfare benefits including . . .
i àedical coverage,
i Dental coverage,
i £ife insurance,
i Group legal services, and
i Other benefits.



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The Net Cost of Benefits


ustimated medical
costs in each
year of retirement

Retiree
Medicare
Less: share of
ayments
cost

ustimated — 
uquals: cost of benefits


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OmOER POSmREmIREMENm
BENEFImS
®Ep c  Po  
 B  
Ol ao (EPBO) ƛ The actuary's estimate
of the total postretirement benefits (at their
discounted present value) expected to be
received by plan participants.
®Acc
la  Po  
 B  
Ol ao (APBO) ƛ The portion of the
EPBO attributed to employee service to date.



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POSmREmIREMENm
BENEFIm OBLIGAmION
® Ässume the actuary estimates the net cost of providing health care
benefits to a particular employee during her retirement years to have
a present value of $10,842 as of the end of 2009. This is the EPBO.
Of the benefits (and therefore the costs) relate to an estimated 35
years of service and 10 of those years have been completed, the ÄPBO
would be:

2009 $10,842 x 10/35 = $3,098


EPBO fraction ÄPBO
attributed
x 1.06
The obligation increases by the 6% accrued interest

2010 $11,492 x 11/35 = $3,612


EPBO fraction ÄPBO
attributed
Ghe now has worked 11 of her estimated 35 years


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OOW mOE APBO COANGE

ÄPBO at the beginning of the year $3,098

I   co : $3,098 x 6% 186

S c co : ($11,492 x 1/35) 328


portion of EPBO
attributed to the year

ÄPBO at the end of the year $3,612




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Ättribution
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AmmRIBUmION
^essica Farrow was hired at age 22 at the beginning of 2000and is expected to retire at the
end of 2039 at age 61. The retirement period is estimated to be 20 years. Ghe is eligible
for benefits after both reaching age 56 while in service and having worked 20 years.

Gince Farrow becomes fully eligible at age 56 (the end of 2034) retiree benefits are
attributed to the 35-year period from her date of hire through that date.

Ao P o R 


 P o
35 years 20 years

Äge Äge Äge Äge


22 56 61 81

2000 2034 2039 2059


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Postretirement Benefit
Expense
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Postretirement Benefit
Expense
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Otƞs    
important to understand that the service cost for pensions
       
reflects additional benefits
   
  
employees earn
      from an
   
additional yearƞs service,    
whereasthe service cost for
        
retiree health care plans 

G  
is simply an allocation to the
    
current year of a portion
  of a fixed total cost.
 
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Postretirement Benefit
Expense
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Postretirement Benefit
Expense
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Unlike pension plans,     "  
many postretirement benefit
 !           
plans are not funded
   currently.



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Postretirement Benefit
Expense
@    
 

        
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Postretirement Benefit
Expense
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Postretirement Benefit
Expense
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End of Chapter 17



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