PENSIONS- Introduction and Definitions

PENSIONS- Introduction and Definitions

Contributory (noncontributory) pension plan: Employees and the employer (only the employer) contribute to the plan.

Defined contribution pension plan: The specific contribution that the employer has to make to the plan are set. (The employer discharges all responsibilities when the necessary contributions are forwarded.)

Defined benefit pension plan: Plans that promise specific monetary payments to employees (or their remaining spouses) upon retirement, The employer has the responsibility to make sure funds will be available to pay the future benefits. (The employer bears the risk of shortfall in funds.)

? Defined benefit (contribution) plan represent big (no) problem to accountant and investors. In defined benefit plans, until all future payments are made, the employer is liable for the benefits. Throughout the remainder of the lecture, therefore, o.nly defined benefit plans are discussed (impact on cash flows and long-term solvency).

Accumulated benefit obligation: The present value of pension benefits, promised by the company to its employees, on the basis of to date compensation levels.

Projected benefit obligation: The present value of pension benefits, promised by the company to its employees, on the basis of future compensation levels.

Economic Liability = Funded status of the plan = the difference between the benefit obligation and the value of plan assets at the end of the year ? For Going Concern -- use projected benefit obligation (PBO) ? Liquidation Analysis-- use accumulated benefit obligation (ABO)

Pensions - 1

Balance Sheet Liability -- Generally not equal to Economic Liability as for accounting purposes the following items need not be recognized immediately but can be deferred and amortized over time. 1. Actuarial Gains and Losses: Gains or Losses originate when the PBO is recomputed each year due to changes in one or more actuarial assumptions, such as discount rate, quit rates, retirement dates, or mortality. 2. Pension Plan Gains and Losses- Accountant does not recognize actual returns on pension plan investments. Rather, they recognize expected returns based on long-term expected rate. Difference between actual and expected returns are pension plan gains and losses.

Items 1 and 2 are usually netted together as Net Gains and Losses.

3. Prior Service Cost : Pension Plan Amendments may increase (or decrease) previously computed pension benefit obligations. The changes relating to periods of employment prior to the amendment are known as prior service cost.

4. Transition Asset/Liability - Net economic asset/liability at time of adoption of SFAS 87 not recognized immediately but amortized over time

HOWEVER accounting deferrals must satisfy the minimum liability requirement:

Minimum liability At each balance sheet date, SFAS No. 87 requires reporting a liability on the balance sheet which is equal, at least, to the unfunded accumulated benefit obligation (i.e., accumulated benefit obligation minus the fair value of plan asset).

Thus if the balance of accrued benefit cost is less than the minimum liability we credit the liability in order to reach the minimum liability requirement: The corresponding debit bypasses the income statement and a certain portion is made to an intangible asset and the remainder is made to equity and a deferred tax asset. Note:the adjustment is made on a plan by plan basis:

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Illustration: For each year of service, a firm promises to pay an employee at retirement an amount equivalent to one week's salary for 15 years. Our assumptions are:

Employee's age =30

Retirement Age =65

Current Salary Level = $1 ,500iWeek

Interest rate = 10%

Projected Salary at retirement = $2,000/week

Obligation Based on Current Salary Levels: Accumulated Benefit Obligation (ABO) after the first year of work is equal to the

Present Value of a 15 year annuity of $1,500 discounted 35 years; Using Table 4 and Table 2 for an interest rate of 10% yields

ABO= (1,500 x 7.606) x .03558 = 11,409 x .03558 = $406

Obligation Based on Projected Salary Levels: Projected Benefit Obligation (PBO) after the first year of work is equal to the Present Value of a 15 year annuity of $2,000 discounted 35 years;

PBO= (2,000 x 7.606) x .03558 = 15,212 x .03558 = $541

REQUIRED ADJUSTMENTS

(1) Adjust balance sheet liability/asset to equal Economic Liability/Asset ? Corresponding entry should go to Equity [and deferred taxes if adjusting on after-tax basis] ? Definition of Economic Liability/Asset depends on whether analysis being done as going concern or liquidation --see above.

(2) If there is Minimum Liability, additional adjustment required -that is; Credit intangible asset and debit Equity [and deferred taxes if adjusting on after-tax basis]

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Example:

HYPOTHETICAL COMPANY I

ABO

$1,000

PB0

1,400

Plan Assets

900

PBO Greater than Plan Assets 500 Unrecognized:

Net Losses

150

Prior Service Cost

175

Transition Asset

(25)

Balance Sheet Liability

200

Economic Liability as Going Concern = 500 (1400-900)

Economic Liability as Liquidation

= 100 (1000-900)

Balance Sheet Liability = 200 differs from Economic Liability (Going

Concern) as did not recognize liabilities of

(1&2) net losses

150

(3) prior service cost of

175

(4) transition asset of

(25)

Adjustments:

Going concern

Equity 300

Economic Liability = 500

B/S Liability

= 200

Liability 300

or after tax assume 35% tax rate

Equity Deferred Tax Asset

Liability

195 105

300

Liquidation Liability 100

OR

Economic Liability = 100

B/S Liability

= 200

Equity 100

or after tax assume 35% tax rate

Liability

100

Deferred Tax Asset

35

Equity

65

Pensions - 4

Example:

HYPOTHETICAL COMPANY II

ABO

$1,200

PB0

1,400

Plan Assets

900

PBO Greater than Plan Assets 500 Unrecognized:

Net Losses

150

Prior Service Cost

175

Transition Asset

(25)

Minimum Liability Adjustment

200 100 (charged 100% to intangible asset)

Balance Sheet Liability

300

Economic Liability as Going Concern = 500 (1400-900)

Economic Liability as Liquidation

= 300 (1200-900)

Balance Sheet Liability = 300 differs from Economic Liability (Going

Concern) as did not recognize liabilities of

(1&2) net losses

150

(3) prior service cost of

175

(4) transition asset of

(25)

Therefore without minimum liability adjustment B/S liability would be 500-150-175+25 = 200. However as must equal liquidation economic liability, accountant made minimum liability adjustment of 100 to bring B/S liability to 300.

Adjustments:

Going concern

(1) Equity 200

Economic Liability = 500

B/S Liability

= 300

Liability 200

or after tax assume 35% tax rate

Equity Deferred Tax Asset

Liability

130 70

200

(2) Remove Intangible asset Equity 100 Intangible Asset 100

Equity

Deferred Tax Asset Intangible Asset

65

35 100

For Liquidation only need (2) -- removal of intangible asset

Pensions - 5

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