PENSIONS- Introduction and Definitions
[Pages:13]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:
Pensions - 2
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]
Pensions - 3
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
DEERE CO. Pension Benefits
The company has several pension plans covering substantially all of its United States employees and employees in
certain foreign countries. The United States plans and significant foreign plans in Canada, Germany and France are
defined benefit plans in which the benefits are based primarily on years of Service and employee compensation
near retirement.
Provisions of FASB Statement No.87 require the company to record a minimum pension liability relating
to certain unfunded pension obligations, establish an intangible asset relating thereto and reduce stockholders'
equity. At October 31, 1994, this minimum pension liability was remeasured, as required by the statement. As a
result, the adjustment to recognize the minimum pension liability was increased from $515 million at October 31,
1993 to $545 million at October 31, 1994; the related intangible asset was adjusted from $181 million to $158
million; and the amount by which stockholders' equity had been reduced was adjusted from $215 million to $248
million (net of applicable deferred income taxes of $119 million in 1993 and $139 million in 1994).
The components of net periodic pension cost and the significant assumptions for the United States plans
consisted of the following in millions of dollars and in percents:
1994 1993 1992
Service cost Interest cost
$79 $74 $63 286 283 259
Return on assets:
Actual gain Deferred gain (loss)
(86) (590) (157) (218) 324 (87)
Net amortization
43
32
18
Net cost
$104 $123 $96
Discount rates for obligations Discount rates for expenses Assumed rates of compensation increases Expected long-term rates of return
8.0% 7.25% 8.0% 7.25% 8.0% 8.25% 5.0% 5.0% 5.7% 9.7% 9.7% 9.7%
A reconciliation of the funded status of the United States plans at October 31 in millions of dollars follows:
Actuarial present value of benefit
obligations
Vested benefit obligation Nonvested benefit obligation Accumulated benefit obligation Excess of projected benefit obliga-
clan over accumulated benefit obligation Projected benefit obligation Plan assets at fair value Projected benefit obligation in excess of plan assets Unrecognized net loss Prior service cost not yet recognized in net periodic pension cost Remaining unrecognized transition net asset from November 1, 1985 Adjustment required to recognize minimum liability Pension liability recognized in the consolidated balance sheet
1994
1993
Assets
Accumulated Assets Accumulated
Exceed
Benefits
Exceed
Benefits
Accumulated Exceed Accumulated Exceed
Benefits
Assets
Benefits
Assets
$(1,522) (73)
(1,595)
(340) (1,935) 1,756
(179) 35
9
(73)
-----
$ (208)
$(1,693) (270)
(1,963)
(20) (1,983) 1,767
(216) 415
154
(10)
(545)
$ (202)
$(1,555) (94)
(1,649)
(378) (2,027) 1,805
(222) 114
3
(83)
-----
$ (188)
$(1,689) (276)
(1,965)
(21) (1,986) 1,510
(476) 373
176
(13)
(515)
$ (455)
Source Deere, 1994 Annual Report
Pensions - 6
Other Postretirement Benefits
The parent company and certain subsidiaries
provide medical dental and life insurance benefits
to pensioners and survivors. The associated plans
are unfunded, and approved claims are paid from
company funds. Under the terms of the benefit
plans, the company reserves the right to change,
modify or discontinue the plans.
In 1992, the company adopted SFAS No. 106,
"Employers' Accounting for Postretirement Benefits
Other Than Pensions." Medical, dental and life
insurance costs for these plans and related
disclosures are determined under the provisions of
SFAS No.105. Cash expenditures are not affected
by this accounting change. At January 1, 1992, the
accumulated postretirement benefit obligation was
$5,990, and related accrued liabilities were $68,
resulting in a transition charge of $5,922. Other
postretirement benefits cost includes the following
components:
Health Life
Care Insurance Total
1994
Service cost--benefits allocated
to current period
$56 $17 $73
Interest cost on accumulated
postretirement benefit obligation 288
77 365
Amortization of net gains and
prior service credit
(78)
8 (70)
Other postretirement benefits cost $266 $102 $368
1993
Service cost--benefits allocated
to current period
$ 55 $ 12 $ 67
Interest cost on accumulated
postretirement benefit obligation 305
69 374
Amortization of net gains and
prior service credit
(94) -- (94)
Other postretirement benefits cost $266 $ 81 $347
1992 Service cost--benefits allocated
to current period
$ 82
Interest cost on accumulated
postretirement benefit obligation 431
Other postretirement benefits cost $513
$ 11 $ 93
67 498 $78 $591
The lower health care costs in 1994 and 1993 versus 1992 were due to changes in the company's health care benefits programs in the
United States, which were announced on December 31, 1992. These changes provide for increased cost control through prevention and managed care, and for increased cost sharing by
employees and pensioners. The impact of these changes resulted in an unrecognized prior service credit of $1,219 at the beginning of 1993; the accumulated postretirement benefit obligation was reduced by a similar amount
The following provides a reconciliation of the
accumulated postretirement benefit obligation to
the liabilities reflected in the balance sheet at
December 31 1994 and 1993.
1994
Health Life Care Insurance Total
Accumulated postretirement benefit obligation for:
Current pensioners and survivors $(2,366) $ (570) $(2,936)
Fully eligible employees
(139) -- (139)
Other employees
(674) (319) (993)
(3,179) (889) (4,068)
Unrecognized net loss/(gain)
(1,267)
3 (1.264)
Unrecognized prior service credit (1,059)
-- (1,059)
Accrued postretirement benefit cost $(5,505) $ (886) $(6,391)
Amount included in Other Accrued Liabilities (see Note 18)
Amount included in Other Liabilities
(see Note 21)
$ 333 $ 6,058
1993
Accumulated postretirement benefit obligation for:
Current pensioners and survivors $(2,933) $ (692) $(3,685)
Fully eligible employees
(146) -- (146)
Other employees
(934) (404) (1,338)
(4,073) (1,096) (5,169)
Unrecognized net loss/(gain)
(285) 252 (33)
Unrecognized prior service credit (1,139)
-- (1,139)
Accrued postretirement benefit cost $(5,497) $ (844) $(6,341)
Amount included in Other Accrued Liabilities (see Note 18)
Amount included in Other Liabilities
(see Note 21)
$ 343 $ 5.998
The health care accumulated postretirement benefit obligation was determined at December 31,1994 using a health care cost escalation rate of 8 percent decreasing to 5 percent over 8 years and at December 31,1993 using a health care escalation rate of 10 percent decreasing to 5 percent over 10 years. The assumed long term rate of compensation increase used for life insurance was 5 percent The discount rate was 9 percent at December 31, 1994 and 7.25 percent at December31, 1993. A one percentage point increase in the health care cost escalation rate would have increased the accumulated postretirement benefit obligation by $251 at December 31, 1994, and the 1994 other postretirement benefit cost would have increased by $44.
Pensions - 7
October 25, 2000 Retiree-Medical Plans Are Transformed Into Source of Profits by Sears, Others ELLEN E. SCHULTZ Staff Reporter of THE WALL STREET JOURNAL
Sears Roebuck & Co. has figured out how to turn its medical-benefits program for retirees into a source of corporate income.
You read that correctly. Last year, the giant retailer's retiree-medical plan added $46 million to the Sears bottom line. And that was on top of the $38 million the benefits program contributed in 1998.
The key to these surprising profits is an arcane accounting rule introduced in the early 1990s. The rule required companies for the first time to report their total anticipated costs for retiree-health coverage. Many companies used the rule to justify cutting that coverage, or shifting its cost to retirees. As a result, a lot of older Americans are struggling to pay their medical bills.
The rule also offered companies a way to arrange their financial statements so that retiree-benefit programs actually became new profit centers. Employers and benefits consultants have received heat recently for turning pension plans into sources of corporate income. Now, the transformation of retireemedical programs into opportunities to bolster earnings demonstrates that these companies and their outside advisers possess multiple subtle methods to squeeze profits from their current and former employees
Using Trust Funds to Pay Retiree Benefits Can Help the Bottom Line
This latest corporate maneuver was made possible by Financial Accounting Standard 106. Accounting authorities required that large companies adopt the rule by 1993. At a time when medical-cost inflation was running in double digits, the rule was supposed to force companies to acknowledge the potentially huge retiree-medical liability many of them seemed to face. Some of the charges that companies initially reported on their income statements under the new rule were indeed gargantuan, and they fueled an atmosphere of crisis surrounding corporate health-care costs. Many companies invoked the mammoth liabilities to explain why they had to reduce retiree benefits.
But the crisis turned out to be exaggerated. An analysis of corporate filings with the Securities and Exchange Commission reveal that over the 1990s, companies faced lower medical-cost inflation rates than they had predicted when standard 106 took effect and, as a result, smaller retiree-health liability.
What's more, many companies actually had incentives to err on the side of taking overly large initial charges under the new rule. One incentive was that excessively pessimistic estimates of future healthcare liability provided a rationalization for reducing retiree benefits. That spelled bad news for millions of retirees, such as Elaine Russell, a 77-year-old former Sears worker in Seattle, whose rising medical premiums have forced her to rely on a free food bank. Retired Unisys Corp. accountant Albert Shaklee, 70, was forced to go back to work at a minimum-wage factory job for a time to keep up with his increased premiums.
Companies had a second incentive to take inordinately huge retiree-benefit charges: If the estimates proved too big -- which is, in fact, what happened in many cases -- companies knew they could adjust their retiree liability downward by recognizing a series of paper gains on their income statements. This pool of potential gains could be drawn upon over a period of years and used to offset retiree-medical expenses.
The New Math
The kicker is that at numerous companies, including Sears, the paper gains not only erased the retireebenefit expenses, but exceeded them. And that is how benefit plans came to boost the bottom line.
Pensions - 8
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