Presentation on theme: "Pensions RCJ Chapter 14. Paul Zarowin2 Key Issues 1.Types of pension plans: defined benefit vs. defined contribution 2.Pension liability: PBO, ABO, VBO."— Presentation transcript:
Paul Zarowin2 Key Issues 1.Types of pension plans: defined benefit vs. defined contribution 2.Pension liability: PBO, ABO, VBO 3.Assumptions: discount rate%, salary growth rate%, E(ROA)%, actuarial 4.PENSION assets 5.Primary (ongoing) factors 6.Journal entries 7.Smoothing of transitory gains and losses 8.Types of transitory gains and losses 9.Additional factors 10.Funded status reconciliation 11.Minimum liability 12.Corridor amortization 13.Pension worksheet 14.Footnote disclosures 15.Correction JE 16.OPEB ’ s
Paul Zarowin3 Structure of Pension Plan firm or employee pension fund retiree Cash Pay benefits
Paul Zarowin4 Types of Pension Plans 1.Defined contribution: employee bears risk, no firm liability 2.Defined benefit: firm bears risk and has liability (our focus)
Paul Zarowin5 Ex. Defined Benefit Plan worker ’ s age = 60 service = 30 yrs so far retire @ 65 (5 more years) current salary = $50,000 Pension contract: X% per year * final salary (X = # of years of service @ retirement) Example: 35% x $50,000 = $17,500
Paul Zarowin6 Pension Liabilities Pension liability: discounted PV of expected future cash payments - like any other non-current liability (effective interest method). compare to other non-current liabilities: r% E(CF) Bonds known known Leases known? known Pensions ? ? Both discount rate and expected cash flows are subjective
Paul Zarowin7 3 Definitions of Liabilities PBO = PV of expected payments, given expected future salaries ABO= PV of expected payments, given current salaries VBO =PV of vested portion of expected payments, given current salaries PBO ABO VBO Which definition is appropriate for which case? 1. valuing a going concern 2. Takeover 3. Firm in bankruptcy We’ll use PBO, unless otherwise stated.
Paul Zarowin8 Key Assumptions discount rate = r% salary growth rate = g% (for PBO) actuarial (life span, tenure, turnover, etc.) EROA% (expected rate of return on pension assets), see below Q: Is liability bigger for older or younger workers? What are management ’ s incentives?
Paul Zarowin9 Ex. Defined Benefit Plan, Continued Assumptions Expected salary growth rate = 5% Discount rate = 10% Life expectancy = 80 years (15 years in retirement) Expected final salary = 50,000 * (1.05) 5 = 63,814 30% * 63,814 = 19,144 = amount he ’ ll receive per year in retirement (based on service so far) PV of annuity factor, 10%, 15 yrs = 7.606 19,144 * 7.606 = 145,611 = PV @ retirement PBO = 145,611/(1.10) 5 = 90,413 = PV of annuity now ABO = (30% * 50,000 * 7.606)/1.10 5 = 70,841 PBO > ABO due to expected salary growth
Paul Zarowin10 Primary (Ongoing) Factors Affecting PBO PBO - + DR CR pay benefits Interest cost Service cost def: interest cost = r% * PBO @ beginning of year (remember: effective interest method) [debt accretion, like zero coupon bond] def: service cost = PV of future benefits earned this year Ex. E14-1, E14-13
Paul Zarowin11 Ex. Defined Benefit Plan, Continued Interest cost = 90413*.10 = 9041 Service cost = (1% * 63,814 * 7.606)/1.10 5 = 3014 Q: how does a higher or lower r% affect interest cost? Q: how does an employee ’ s age affect his service cost? E14-1,13
Paul Zarowin13 Primary (Ongoing) Factors Affecting Pensions Assets Assets + - DR CR Funding (contribution) Pay benefits (ROA)Return on assets # # note: this is actual ROA; ROA is shown as +, but could be – Ex. E14-6, E14-13
Paul Zarowin14 Primary Journal Entries * note: actual ROA is shown as +, but could be – UNL = unexpected net loss (if actual ROA < expected ROA) UNG = unexpected net gain (if actual ROA > expected ROA) DRCR service, interestPension expensePBO Funding (contributions) AssetsCash benefitsPBOAssets ROAAssets(actual ROA) * Pension Expense (expected ROA= EROA%*beginning assets) UNLor UNG
Paul Zarowin15 Ex. Defined Benefit Plan, Continued Assume: pension assets = 100,000 E(ROA)% = 10% actual ROA = 15,000 DRassets 15,000 CRPension expense 10,000 CRUNGain 5,000 Q: How does assumed EROA% affect FMV of assets?
Paul Zarowin16 Primary Factors Affecting Pension Expense Pension Expense + - DR CR Service E(ROA) Interest Q: What is the effect of funding on expense?
Paul Zarowin17 Ex. Defined Benefit Plan, Continued Service 3,014 Interest 9,041 E(ROA) (10,000) pension expense 2,055 Ex. E14-12 without amortization and unexpected loss P 14-1, Parts 1-3 in Summary So Far
Paul Zarowin18 Smoothing of Transitory Gains and Losses def: unrecognized = deferred (in footnotes) def: recognized = amortized (into pension expense on I/S) Transitory gains, losses are CR ’ d (gains) or DR ’ d (losses) to unrecognized (footnote) accounts, rather than recognized as gain or loss on I/S. The unrecognized balances are amortized onto I/S. This smooths NI and keeps assets and PBO off of B/S. Full Exp For E14-13
Paul Zarowin19 Smoothing (cont ’ d): Intuition Loss in DR, Gain in CR DR CR Loss: Unrecognized lossAsset or liab. Amort ’ n: Exp.(recorded) Unrecognized loss Gain: Asset or liab.Unrecognized gain Amort ’ n: Unrecognized gain Exp.(recorded)
20 Types of Transitory Gains, Losses DRCR asset gain: actual ROA > expected ROAAssetsPension expense UNG asset loss: actual ROA < expected ROAAssets UNL Pension expense * assets are DR ’ d (or CR ’ d) for actual ROA; pension expense is CR ’ d for expected ROA; difference is UNG or UNL (see slide #15) liability loss (due to assumption r%, g%, etc.) UNLPBO liability gain (due to assumption r%, g%, etc.) PBOUNG note: asset and liability gains and losses are all aggregated into one UNG/L account note: liability gains and losses are also called actuarial gains and losses Q: What happens if EROA% is set too high (higher than true average ROA%)?
Paul Zarowin21 2 Types of Liability Gain/Loss 1.Change in assumptions 2.Change in contracts Intuition: What affects r% and E(CF) ’ s
Paul Zarowin22 Types of Transitory Gains, Losses (cont ’ d) DRCR Change in pension contract: sweeteningUPSCPBO Change in pension contract: souringPBOUPSC def: UPSC = unrecognized prior service cost (retroactive benefits)
Paul Zarowin23 Ex. Defined Benefit Plan, Continued 1. assume benefits are sweetened to pay 1.1% * final salary per year (increased by 10%) increase in PBO = 10% * 90,413 = 9041 DRUPSC 9041 CRPBO 9041 2. assume salary growth rate is increased to 6% (final salary = 66,912), so PBO = 94,802 and increase in PBO = 4389 (94,802 – 90,413) DRUNLoss 4389 CRPBO 4389
Paul Zarowin24 Additional Factors Affecting PBO PBO DR (+)CR (-) Primary factors Pay benefitsInterest cost Service cost Additional factors Liability gainLiability loss SouringSweetening ( assumptions) ( contracts)
Paul Zarowin25 Additional Factors Affecting Pension Expense Expense DR (+)CR (-) Primary factors Interest costE(ROA) Service cost Additional factorsloss amortizationGain amortization
Paul Zarowin26 Additional Factors Affecting Pension Expense (cont ’ d) Loss amortization: DRPension expense CRUPSC or UNL or UTL Gain amortization: DRUPSC or UNG or UTA CRPension expense UTA, UTL = unrecognized transition asset, liability = net position (assets - PBO) @ adoption of SFAS #87 remember: amortization = recognized into expense amortization is generally SL over average remaining service life of employees
Paul Zarowin27 Ex. Defined Benefit Plan, Continued Amortize UPSC over 5 years: 9041/5 = 1808 DRpension expense 1808 CRUPSC 1808 service 3,014 interest 9,041 E(ROA) (10,000) UPSC Amort. 1,808 pension expense 3,863 Ex. E14-13 GM disclosure E 14-12 w/o Loss
Paul Zarowin28 Funded Status Reconciliation Reconcile true vs. recognized position assets - PBO funded status (can be net asset or net liability): ‘true position’ + UNL (or - UNG) + UPSC + UTL (or - UTA) recognized (on B/S) position: prepaid pension cost (asset) or deferred pension cost (liab) note: funded status (true economic position) vs. recognized position unrecognized losses & liab’s make the recognized position better than the true position unrecognized gains & assets make the recognized position worse than the true position Ex. E14-14, 19 Unrecognized Gains/Losses
Paul Zarowin29 Minimum Liability if ABO > assets the pension plan is considered ‘severely underfunded’ and a liab. (ABO - assets) must be recognized. if recognized position is asset (prepaid cost) or liab (accrued cost) < (ABO-assets), additional entry is needed to bring recognized position to minimum level: DRIntangible asset* CRAdditional liability * should be DR to a loss account additional liab can be shown separately or aggregated with accrued pension cost on B/S Ex. E14-2, E14-5
30 Corridor (Minimum) Amortization UNL or UNG must be amortized only if it > “ corridor ” corridor = 10% of bigger (PBO, assets) @BOY amortization is down to corridor, not zero if amort ’ n is required one year, it might or might not be the next year, and vice versa UNG/L DR CR *BOY net loss*BOY net gain (* for current year amort’n test) Current year lossCurrent year gain gain amort’nloss amort’n (amort’n only if required) #EOY net loss#EOY net gain (# for next year’s amort’n test) Ex. P14-1, sec 1-6 E14-18
Pension Worksheet - put it all together - relate to funded status reconciliation Recognized (on FS) bal.Unrecognized (footnote) balances Pen. expCashpp’d/acc costPen AssPen LiabUNGLUPSC Service costDRCR Interest costDRCR ROACRDRplug Funding (contribution)CRDR BenefitsCRDR liability loss 6 CRDR Sweetening 7 CRDR Amortization UNL 8 DRCR Amortization of UPSC (from sweetening) 9 DRCR Summary JE; only recognized (on FS) JE DRCRCR or DR 6. reverse DR and CR for a liability gain 8. reverse DR and CR for amort ’ n of unrecognized gain 7. reverse DR and CR for souring9. reverse DR and CR for amort ’ n from souring Note: recognized asset/liab (prepaid/accrued pension cost) is net of all unrecognized accounts
Paul Zarowin33 Footnote Disclosures The pension footnote includes: 1.total pension expense and its components 2.reconciliation of BOY vs EOY PBO and asset accounts (like t-accounts) 3.funded status reconciliation 4.assumptions (r%, g%, EROA%) C 14-2,3
Paul Zarowin34 Correction JE (to put assets and liabs on B/S) using information in pension footnote, put pension assets and liab on B/S; replace recognized position with true position DR CR pension assets PBO accrued pension cost or Prepaid pension cost R/E or R/E 1.put pension assets and PBO on B/S 2.remove accrued or prepaid pension cost from B/S 3.plug: DR or CR R/E = cumulative unrecognized gains/losses (sum of UNGL, UPSC, UTAL) note: DR or CR to R/E rather than current year gain or loss
Paul Zarowin35 Other Post-Employment Benefits (OPEB ’ s) Same accounting as pensions, with minor differences 1. ABO instead of PBO (OPEB ’ s not tied to salary) 2. significance of (TL) transition liability (no incentive to fund, so ABO > assets) firms can: amortize TL over <= 20 years DROPEB expense CRAccrued OPEB cost or take loss as change in accounting principle (below the line): DRloss due to change in acct principle CRAccrued OPEB cost most firms chose latter: why? 3. service cost is accrued (earned) over short (vesting) period, since benefits don ’ t increase with tenure