© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter 17 Pensions

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 17-2 Nature of Pension Plans Sponsor I agree to make payments into a fund for future retirement benefits for employee services. Participant I am the employee for whom the pension plan provides benefits.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 17-3 Nature of Pension Plans For a pension plan to qualify for special tax treatment it must meet the following requirement: For a pension plan to qualify for special tax treatment it must meet the following requirement: 1.Cover at least 70% of employees. 2.Cannot discriminate in favor of highly compensated employees. 3.Must be funded in advance of retirement through a trust. 4.Benefits must vest after a specified period of service. 5.Complies with timing and amount of contributions.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 17-4 Nature of Pension Plans The right to receive earned pension benefits vest (vested benefits) when it is no longer contingent on continued employment. The right to receive earned pension benefits vest (vested benefits) when it is no longer contingent on continued employment.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 17-5 Contributions are established by formula or contract. Employer deposits an agreed upon amount into an employee-directed investment fund. Employee bears all risk of pension fund performance. Defined Contribution Plans

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 17-6 Employer is committed to specified retirement benefits. Retirement benefits are based on a formula that considers years of service, compensation level, and age. Employer bears all risk of pension fund performance. Defined Benefit Pension Plans

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 17-7 Defined Benefit Plan Pension expense is measured by assigning pension benefits to periods of employee service as defined by the pension benefit formula. A typical benefit formula might be: 1% × Years of Service × Final year’s salary So, for 35 years of service and a final salary of $80,000, the employee would receive: 1% × 35 × $80,000 = $28,000 per year.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 17-8 Pension Expense – An Overview

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 17-9 Pension Obligation Present value of benefits at present pay levels. Present value of nonvested benefits at present pay levels. Present value of additional benefits related to projected pay increases. VBOABOPBO Accumulated Benefit Obligation Projected Benefit Obligation Vested Benefit Obligation

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Projected Benefit Obligation

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Pension Obligation Service cost is the increase in the PBO attributable to employee service performed during the period.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Pension Obligation Interest cost is the accrued interest on the PBO during the period.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Pension Obligation Prior service cost effects result from changes in the pension benefit formula or plan terms.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Pension Obligation Loss or gain on PBO results from required revisions of estimates used to determine PBO.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Pension Obligation Retiree benefits paid are the result of paying benefits to retired employees.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Pension Plan Assets Pension plan assets (like the PBO) are not formally recognized on the balance sheet. A trustee manages the pension plan assets.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Pension Plan Assets OVERFUNDED Market value of plan assets exceeds the actuarial present value of all benefits earned by participants. UNDERFUNDED Market value of plan assets is below the actuarial present value of all benefits earned by participants.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Pension Expense Pension expense is the net cost of:  Service cost  Interest cost  Return on plan assets  Amortization of prior service costs  Gain or loss recognized.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Defined Benefit Plan You go to work for Matrix, Inc. on 1/1/00. You are eligible to participate in the company's defined benefit pension plan. The benefit formula is: Annual salary in year of retirement × Number of years of service × 1.5% Annual retirement benefits You are 25 years old when you start work and may accumulate 40 years of service before retiring at age 65. If your salary is $200,000 during your last year of service, you will receive the following annual benefits: $200,000 × 40 × 1.5% $120,000 You are not required to make any contributions. The plan vests at the rate of 20% per year. The plan actuary estimates that upon reaching age 65, you will receive payments for 15 years. The actuary uses an 8% discount rate in all present value computations.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Defined Benefit Plan At December 31, 2000, the end of your first year of service, the actuary must calculate the present value of the pension benefits earned by you during Remember that you will not receive pension benefits until you are 65 and the actuary estimates payments will be made for 15 years after you retire. After one year of service you will have earned $3,000 in pension benefits: At December 31, 2000, the end of your first year of service, the actuary must calculate the present value of the pension benefits earned by you during Remember that you will not receive pension benefits until you are 65 and the actuary estimates payments will be made for 15 years after you retire. After one year of service you will have earned $3,000 in pension benefits: Pension benefits =.015 × 1 × $200,000 Pension benefits = $3,000. Service cost is the present value of these benefits and are calculated as follows: Service cost = $3,000 × × Service cost = $1, Present value of an ordinary annuity at 8% for 15 years. 2 Present value of $1 at 8% for 39 years.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Defined Benefit Plan Based on the given information, the actuary calculates your accumulated benefit obligation (ABO) as follows: Retirement benefits =.015 × 1 × $25,000 Retirement benefits = $375 ABO = $375 × × ABO = $160. Your vested benefit obligation (VBO) is calculated as follows: Vested benefits =.015 × 1 × $25,000 ×.2 Vested benefits = $75 VBO = $75 × × VBO = $32

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Defined Benefit Plan A reconciliation of the VBO, ABO and PBO would look like this A reconciliation of the VBO, ABO and PBO would look like this : VBO$ 32 Non-vested benefits 128 ABO 160 Adjustment for future salary 478 PBO 638 If you are the only employee at Matrix, the computations would be similar for future years. Let’s assume Matrix funds $500 of its pension costs with the plan trustee on December 31, The journal entry to record the pension costs and funding would be: Provision for Pension Costs638 Accrued Pension Liability138 Cash500

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Defined Benefit Plan Let’s look at an example for Cotton, Inc.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Defined Benefit Plan Actuaries have determined that Cotton, Inc. has service cost of $150,000 in 2002 and $155,000 in We can begin the process of determining pension expense for the company,

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Service Cost

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Interest Cost Interest cost is the growth in PBO during a reporting period. Interest cost is calculated as: PBO Beg × Discount rate

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Interest Cost Actuaries determined that Cotton, Inc. had PBO of $500,000 on 1/1/02, and $640,000 on 1/1/03. Actuaries determined that Cotton, Inc. had PBO of $500,000 on 1/1/02, and $640,000 on 1/1/03. The actuary uses a discount rate of 10%.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Interest Cost 2002: PBO 1/1/02 $500,000 × 10% = $50, : PBO 1/1/03 $640,000 × 10% = $64,000

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Return on Plan Assets Estimated each year to determine the amount of funds to set aside to pay retirement benefits as they become due. Expected Return The dividends, interest, and capital gains generated by the fund during the period. Actual Return

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Return on Plan Assets The plan trustee reports that plan assets were $450,000 on 1/1/02, and $600,000 on 1/1/03. The plan trustee reports that plan assets were $450,000 on 1/1/02, and $600,000 on 1/1/03. The trustee uses an expected return of 9% and an actual return of 10%.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Return on Plan Assets

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Return on Plan Assets

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Amortization of Prior Service Cost Prior service cost (PSC) results from the granting of pension benefits for service rendered before the pension plan began or from plan amendments granting increased pension benefits for service rendered before the amendment. PSC is the present value of the retroactive benefits and increases PBO.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Amortization of Prior Service Cost Benefits attributable to prior service are assumed to benefit future periods by: Improving employee productivity. Improving employee morale. Reducing turnover. Reducing demands for pay raises.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Amortization of Prior Service Cost PSC is amortized over the remaining service period of those employees active at the date of the amendment who are expected to receive benefits under the plan. PSC is amortized over the remaining service period of those employees active at the date of the amendment who are expected to receive benefits under the plan. If most of a plan’s participants are inactive, then amortize PSC over the participants’ remaining life expectancy.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Amortization of Prior Service Cost Two approaches to amortizing PSC:  Straight-line method  Amortize PSC over the average remaining service period.  Service method  Amortize PSC by allocating equal amounts to each employee service year remaining.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Amortization of Prior Service Cost Effective 1/1/03, Cotton, Inc. amends the retirement plan to provide increased benefits attributable to service performed before 1/1/03, for all active employees. The present value of the increased benefits (PSC) at 1/1/03, is $60,000. The average remaining service life of the active employee group is 12 years. Effective 1/1/03, Cotton, Inc. amends the retirement plan to provide increased benefits attributable to service performed before 1/1/03, for all active employees. The present value of the increased benefits (PSC) at 1/1/03, is $60,000. The average remaining service life of the active employee group is 12 years.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Amortization of Prior Service Cost Since the amendment was not effective until the beginning of 2003, pension expense for 2002 is not affected. 2003: $60,000 PSC ÷ 12 = $5,000

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Amortization of Prior Service Cost

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Gains and Losses

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Corridor Amount Amortization is not required if the net unrecognized gain or loss at the beginning of the period is within a minimum amount (corridor amount).

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Corridor Amount The corridor amount is 10% of the greater of... PBO at the beginning of the period. Fair value of plan assets at the beginning of the period. Or

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Gains and Losses If the beginning net unrecognized gain or loss exceeds the corridor amount, amortization is recognized as... Net unrecognized gain or loss Net unrecognized gain or loss at beginning of year at beginning of year Average remaining service period of active employees expected to receive benefits under the plan Corridor amount Corridor amount —

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Gains and Losses Let’s determine the amortization of the net gain in There was no gain or loss amortized in 2002.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Gains and Losses $9,000 ÷ 9 years = $1,000 per year.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Pension Expense

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Pension Expense Cotton contributed $200,000 to the plan trustee at the end of The journal entry to record the pension expense is:

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Reconciliation of Pension Amounts Four “off-balance sheet” accounts:  PBO  Plan Assets  Unamortized PSC  Unamortized Gain or Loss Four “off-balance sheet” accounts:  PBO  Plan Assets  Unamortized PSC  Unamortized Gain or Loss

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Reconciliation of Pension Amounts These four amounts combine to account for the one pension account that is reported on the balance sheet: prepaid pension asset or pension liability. These four amounts combine to account for the one pension account that is reported on the balance sheet: prepaid pension asset or pension liability.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Minimum Liability To discourage underreporting of pension liability, SFAS No. 87 requires recognition of an additional minimum pension liability under certain circumstances.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Measurement Issue Accumulated Benefit Obligation (ABO) - Plan Assets at Fair Value Minimum Pension Liability Accumulated Benefit Obligation (ABO) - Plan Assets at Fair Value Minimum Pension Liability This amount is also called the underfunded ABO.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Offsetting SFAS No. 87 requires offsetting of the pension liability and the plan assets when determining the minimum liability.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Additional Liability An additional pension liability is recognized if total minimum liability exceeds accrued pension cost. Total minimum liability Accrued pension cost balance (liability) Additional pension liability balance Total minimum liability Prepaid pension cost balance (asset) Additional pension liability balance – +

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Pension Disclosures  Description of the pension plan  Pension expense, service cost, interest cost, return on plan assets (actual and expected), and net total of other components  Description of the pension plan  Pension expense, service cost, interest cost, return on plan assets (actual and expected), and net total of other components

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Pension Disclosures  Reconciliation of the funded status of the plan with (a) plan assets at fair value, (a) plan assets at fair value, (b) PBO, (b) PBO, (c) unrecognized PSC, (c) unrecognized PSC, (d) unrecognized gain or loss, (d) unrecognized gain or loss, (e) unrecognized transition asset or liability, (e) unrecognized transition asset or liability, (f) additional minimum pension liability, and (f) additional minimum pension liability, and (g) net pension asset or liability (g) net pension asset or liability  Reconciliation of the funded status of the plan with (a) plan assets at fair value, (a) plan assets at fair value, (b) PBO, (b) PBO, (c) unrecognized PSC, (c) unrecognized PSC, (d) unrecognized gain or loss, (d) unrecognized gain or loss, (e) unrecognized transition asset or liability, (e) unrecognized transition asset or liability, (f) additional minimum pension liability, and (f) additional minimum pension liability, and (g) net pension asset or liability (g) net pension asset or liability

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Pension Disclosures  Discount rate, rate of compensation increase used to measure PBO, and the expected long-term rate of return on plan assets  Amount and types of employer securities included in plan assets

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Settlements and Curtailments Pension plan settlements  Reduce PBO and are viewed as the realization of a portion of the net unrecognized gain or loss and a portion of the unrecognized transition asset. Pension plan curtailments  Often reduce PBO, resulting in a gain, which reduces accrued pension cost.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide End of Chapter 17