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)

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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

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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

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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

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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.

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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.

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