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CHAPTER 13 EMPLOYEE COMPENSATION: POSTEMPLOYMENT AND SHARE-BASED Presenters name Presenters title dd Month yyyy.

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Presentation on theme: "CHAPTER 13 EMPLOYEE COMPENSATION: POSTEMPLOYMENT AND SHARE-BASED Presenters name Presenters title dd Month yyyy."— Presentation transcript:

1 CHAPTER 13 EMPLOYEE COMPENSATION: POSTEMPLOYMENT AND SHARE-BASED Presenters name Presenters title dd Month yyyy

2 TYPES OF POSTEMPLOYMENT BENEFITS: PENSION PLANS Copyright © 2013 CFA Institute 2 Amount of Future benefit to Employee Contribution from Employer Defined contribution (DC) pension plan Defined benefit (DB) pension plan Depends on investment performance of plan assets Amount (if any) is defined in each period Depends on current period estimate and investment performance of plan assets Defined based on plans formula

3 TYPES OF POSTEMPLOYMENT BENEFITS: PENSION PLANS & EMPLOYERS OBLIGATION Type of Benefit Amount of Future benefit to Employee Contribution from Employer Employers Prefunding of Its Future Obligation Defined contribution DependsDefinedN/A Defined benefitDefinedDepends Typically prefunded; regulatory requirements. Copyright © 2013 CFA Institute 3

4 TYPES OF POSTEMPLOYMENT BENEFITS: OTHER Type of Benefit Amount of Future benefit to Employee Contribution from Employer Employers Prefunding of its Future Obligation Other postemployment benefits (e.g., retirees health care) Depends on plan specifications and type of benefit. Eventual benefits are specified. The amount of the future obligation must be estimated in the current period. Typically not prefunded. Copyright © 2013 CFA Institute 4

5 MEASURING A DEFINED BENEFIT PENSION OBLIGATION Pension obligation is measured as the present value of estimated future payments to employees for benefits earned to date. Measured without deducting any plan assets. Requires company to make actuarial assumptions: -Estimated future benefits. -The discount rate at which to discount future payments. Copyright © 2013 CFA Institute 5

6 MEASURING NET PENSION LIABILITY (OR ASSET) FOR DB OBLIGATIONS Pension obligation is measured without deducting any plan assets. The net pension deficit (or surplus) deducts fair value of plan assets. Present value of the DB obligation – Fair value of the plan assets = Funded status Copyright © 2013 CFA Institute 6

7 NET PENSION LIABILITY (OR ASSET) Underfunded -Pension obligation exceeds pension plan assets. -Liability equal to the net pension obligation is reported. Overfunded -Pension plan assets exceed the pension obligation. -Asset equal to the overfunded pension obligation is reported, subject to limitations. Copyright © 2013 CFA Institute 7

8 COMPONENTS OF A COMPANYS DEFINED BENEFIT PENSION EXPENSE Copyright © 2013 CFA Institute 8 Current Service Cost Interest Past Service Cost Actuarial Losses Return on Plan Assets

9 DEFINED BENEFIT PLAN ASSUMPTIONS Estimated future benefits, which depend on -Future compensation increases and levels, -Length of service, -Vesting rate and turnover, and -Life expectancy postretirement. Discount rate at which to discount future payments and for net interest calculations. Copyright © 2013 CFA Institute 9

10 DEFINED BENEFIT PLAN ASSUMPTIONS: EXAMPLE Assume for a company establishing a DB pension plan, the discount rate is 6%. Assume for an employee covered by a DB pension plan: -Salary in the coming year of 50,000. -Expected to work 5 more years before retiring. -Annual compensation increase is 4.75%. -Will receive benefit for 20 years. -Benefit based on (Estimated final salary × 1.5%) × Years of service. Employees estimated final year salary = 50,000 × [(1 + 4.75%) 4 ] = 60,198.56. Copyright © 2013 CFA Institute 10

11 DEFINED BENEFIT PLAN ASSUMPTIONS: EXAMPLE Copyright © 2013 CFA Institute 11 Today Retirement Date Retirement Period End Annual benefit = (Estimated final salary × Benefit formula) × Years service Value at retirement date of estimated future benefits = Present value of annual benefit during retirement period Annual unit credit = Value at retirement date/Years of service

12 DEFINED BENEFIT PLAN ASSUMPTIONS: EXAMPLE Copyright © 2013 CFA Institute 12 Today Retirement Date Retirement Period End Annual benefit = (Estimated final salary × Benefit formula) × Years service = 60,198.56 × 1.5% × 5 = 4,514.89 Value at retirement date of estimated future benefits = Present value of annual benefit during retirement period Annual unit credit = Value at retirement date/Years of service

13 DEFINED BENEFIT PLAN ASSUMPTIONS: EXAMPLE Copyright © 2013 CFA Institute 13 Today Retirement Date Retirement Period End Annual benefit = 4,514.89 Value at retirement date of estimated future benefits = Present value of annual benefit during retirement period = Present value of annuity of 4,514.89 for 20 years, discounted at 6% = 51,785.46 Annual unit credit = Value at retirement date/Years of service

14 DEFINED BENEFIT PLAN ASSUMPTIONS: EXAMPLE Copyright © 2013 CFA Institute 14 Today Retirement Date Retirement Period End Annual benefit = 4,514.89 Value at retirement date of estimated future benefits = 51,785.46 Annual unit credit = Value at retirement date/Years of service = 51,785.46/5 years = 10,357.09 per year Pension obligation increases by an amount equal to the present value of the annual credit earned in the year

15 DEFINED BENEFIT PLAN ASSUMPTIONS: IMPACT OF CHANGES Changes in assumptions change the estimated obligation. Direction of change in assumption that would increase a DB pension plan obligation: -Lower discount rate. -Longer estimated working period before retiring. -Higher assumed annual compensation increase. -Longer estimated retirement period (longer life expectancy). Copyright © 2013 CFA Institute 15

16 PENSION AND OTHER POSTEMPLOYMENT BENEFITS: USING DISCLOSURES Differences in key assumptions used for pensions and other postemployment benefits can affect comparisons across companies. Companies disclose their assumptions about -discount rates, -expected compensation increases, and -expected return on plan assets. An analyst can compare these assumptions over time and across companies to assess any conservative or aggressive biases. In some cases, an analyst can adjust items as reported to create more comparable data. Copyright © 2013 CFA Institute 16

17 PENSION AND OTHER POSTEMPLOYMENT BENEFITS: USING DISCLOSURES In assessing potential conservative or aggressive biases, other fundamental explanations for differences should be considered. For example, the assumed discount rates used to estimate pension obligations -are generally based on the market interest rates of high-quality corporate fixed-income investments, and -the investments have a maturity profile similar to the timing of a companys future pension payments. Discount rates may thus differ across companies because of -differences in the regions/countries involved and/or -differences in the timing of obligations. An important consideration is whether the assumptions are internally consistent (e.g., do the companys assumed discount rates and assumed compensation increases reflect a consistent view of inflation?). Copyright © 2013 CFA Institute 17

18 PENSION AND OTHER POSTEMPLOYMENT BENEFITS: USING DISCLOSURES 20092008200720062005 Fiat S.p.A.5.505.105.80 5.50 The Volvo Group4.005.755.756.25 5.505.75 General Motors5.526.276.355.905.70 Ford Motor Company6.506.25 5.865.61 Copyright © 2013 CFA Institute 18 Assumed discount rates used to estimate pension obligations for U.S. plans (percent). Source: Companies annual reports.

19 PENSION AND OTHER POSTEMPLOYMENT BENEFITS: USING DISCLOSURES As noted, in some cases, an analyst can adjust items as reported to create more comparable data or to examine sensitivities. For example, postemployment health care plans, a type of defined benefit plan, disclose assumptions about increases in health care costs. Copyright © 2013 CFA Institute 19 Effect of 1% increase (decrease) in assumed health care cost trend rates on 2009 total accumulated postemployment benefit obligations and periodic expense. 1% Increase1% Decrease CNH Global N.V.+ $106 million (Obligation) + $8 million (Expense) – $90 million (Obligation) – $6 million (Expense) Caterpillar Inc.+ $220 million (Obligation) + $23 million (Expense) – $186 million (Obligation) – $20 million (Expense) Source: Companies annual reports.

20 PENSION AND OTHER POSTEMPLOYMENT BENEFITS: USING DISCLOSURES Example: Adjust items as reported to examine sensitivities. Copyright © 2013 CFA Institute 20 Caterpillar Inc. ($ millions)Reported Adjustment for 1% Increase in Health Care Cost Trend RateAdjusted Total liabilities$50,738+ $220$50,958 Total equity$8,823– $220$8,603 Ratio of debt to equity5.75 5.92

21 PENSION PLAN NOTE DISCLOSURES: EXCERPTS ON FUNDED STATUS Copyright © 2013 CFA Institute 21 Source: Loréal, Registration Document (2011).

22 PENSION PLAN NOTE DISCLOSURES: EXCERPTS ON FUNDED STATUS Copyright © 2013 CFA Institute 22 Source: Loréal, Registration Document (2011).

23 PENSION PLAN NOTE DISCLOSURES: EXCERPTS ON FUNDED STATUS Copyright © 2013 CFA Institute 23 Source: Colgate-Palmolive Company, Annual Report (2011).

24 CASH FLOW INFORMATION ON DEFINED BENEFIT PLANS The difference between periodic contributions to a plan and total pension costs of the period can be viewed as financing activity. -If periodic contributions to a plan exceed the total pension costs of the period, the excess is similar to paying loan principal ahead of scheduled amounts. -If periodic contributions to a plan are less than the total pension costs of the period, it can be viewed as a source of financing. Where the amounts are material, an analyst may choose to adjust the reported cash flows. Copyright © 2013 CFA Institute 24

25 CASH FLOW INFORMATION: EXAMPLE Assume a company reported ( millions): -Total pension cost for period: 437 -Contribution to pension for period: 504 -Cash inflow from operating activities: 6,161 -Cash outflow from financing activities: 1,741 Using an effective tax rate of 28.7%, adjust cash flow from operations and financing to reflect excess contribution as similar to a repayment of borrowing. Copyright © 2013 CFA Institute 25

26 CASH FLOW INFORMATION: EXAMPLE Assume a company reported ( millions): -Total pension cost for period: 437 -Contribution to pension for period: 504 -Cash inflow from operating activities: 6,161 -Cash outflow from financing activities: 1,741 Using effective tax rate of 28.7%, adjust cash flow from operations and financing to reflect excess contribution as similar to a repayment of borrowing. -After-tax excess contribution: 48 -Increase companys cash outflow from financing activities from 1,741 to 1,789 -Increase companys cash inflow from operations from 6,161 to 6,209 Copyright © 2013 CFA Institute 26

27 SHARE-BASED COMPENSATION Employee compensation packages are structured to fulfill varied objectives, including satisfying employees needs for liquidity, retaining employees, and providing incentives to employees. Common components of employee compensation packages are salary, bonuses, and share-based compensation. Share-based compensation (such as stock and stock options) -Aims to align employees interest with those of the shareholders, -Requires no current-period cash outlays, -Is treated as an expense and thus reduces earnings, -Potentially dilutes EPS (earnings per share), and -Typically dilutes existing shareholders ownership Copyright © 2013 CFA Institute 27

28 SHARE-BASED COMPENSATION: STOCK GRANTS Stock Grants: Stock granted to employees by their employer. Types of stock grants includes -Outright, -Restricted stock grant, and -Contingent stock grant (also known as performance shares). Accounting for stock grants compensation expense: -Amount of expense is based on fair value of the stock on grant date. -Expense is allocated over the employees service period. Copyright © 2013 CFA Institute 28

29 SHARE-BASED COMPENSATION: STOCK OPTIONS Compensation expense is reported at fair value. The fair value of option grants must be estimated using a valuation model. Key assumptions and input into option pricing models include -exercise price, -stock price volatility, -estimated life of each award, -estimated number of options that will be forfeited, -dividend yield, and -the risk-free rate of interest. Some inputs, such as the exercise price, are known at the time of the grant. Other inputs are highly subjective (e.g., stock price volatility or the expected life of stock options) and can greatly change the estimated fair value and thus compensation expense. Copyright © 2013 CFA Institute 29

30 SHARE-BASED COMPENSATION: STOCK OPTIONS Copyright © 2013 CFA Institute 30 Grant Date Vesting Date Exercise Date Expiration Date Day options are granted (usually, the date that compensation expense is measured). Date that options can first be exercised. Date when employees actually exercise the options. Immediate vesting: Expense is recognized on grant date. Otherwise, expense is recognized over the service period.

31 SUMMARY Defined contribution pension plans specify (define) only the amount of contribution to the plan; the eventual amount of the pension benefit to the employee will depend on the value of an employees plan assets at the time of retirement. Defined benefit pension plans specify (define) the amount of the pension benefit, often determined by a plan formula, under which the eventual amount of the benefit to the employee is a function of length of service and final salary. The reported obligation and periodic expense for defined benefit pension plans and other postemployment benefit plans are sensitive to assumptions. Share-based compensation expense is reported at fair value. Stock option compensation expense is estimated using a pricing model. Key inputs into option pricing models include exercise price, stock price volatility, estimated life of each award, estimated number of options that will be forfeited, dividend yield, and the risk-free rate of interest. Certain assumptions (stock price volatility, expected life of stock options) are subjective and can greatly change the estimated fair value and thus compensation expense. Copyright © 2013 CFA Institute 31


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