1. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Pensions and Other Postretirement Benefits 17

2. 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.

3. 17-3 Nature of Pension Plans For a pension plan to qualify for special tax treatment it must meet the following requirements: For a pension plan to qualify for special tax treatment it must meet the following requirements: 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.

4. 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.

5. 17-5 Learning Objectives Explain the fundamental differences between a defined contribution pension plan and a defined benefit pension plan.

6. 17-6 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

7. 17-7 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

8. 17-8 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

9. 17-9 Pension Expense – An Overview

10. 17-10 Learning Objectives Distinguish among the vested benefit obligation, the accumulated benefit obligation, and the projected benefit obligation.

11. 17-11 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

12. 17-12 Learning Objectives Describe the five events that might change the balance of the PBO.

13. 17-13 Projected Benefit Obligation

14. 17-14 Pension Obligation Service cost is the increase in the PBO attributable to employee service performed during the period.

15. 17-15 Pension Obligation Interest cost is the interest on the PBO during the period.

16. 17-16 Pension Obligation Prior service cost effects result from changes in the pension benefit formula or plan terms.

17. 17-17 Pension Obligation Loss or gain on PBO results from required revisions of estimates used to determine PBO.

18. 17-18 Pension Obligation Retiree benefits paid are the result of paying benefits to retired employees.

19. 17-19 Learning Objectives Explain how plan assets accumulate to provide retiree benefits and understand the role of the trustee in administering the fund.

20. 17-20 Pension Plan Assets Pension plan assets (like the PBO) are not formally recognized on the balance sheet. A trustee manages the pension plan assets.

21. 17-21 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.

22. 17-22 Learning Objectives Describe how pension expense is a composite of periodic changes that occur in both the pension obligation and the plan assets.

23. 17-23 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.

24. 17-24 Defined Benefit Plan You go to work for Matrix, Inc. on 1/1/06. 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.

25. 17-25 Defined Benefit Plan At December 31, 2006, the end of your first year of service, the actuary must calculate the present value of the pension benefits earned by you during 2005. 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 yr of service × $200,000 Pension benefits = $3,000 Service cost is the present value of these benefits and is calculated as follows: Service cost = $3,000 × 8.55948 1 ×.049713 2 Service cost = $1,277 1 Present value of an ordinary annuity at 8% for 15 years. 2 Present value of $1 at 8% for 39 years.

26. 17-26 Defined Benefit Plan Based on the given information, the actuary calculates your accumulated benefit obligation (ABO) as follows: Retirement benefits =.015 × 1 yr × $25,000 Retirement benefits = $375 ABO = $375 × 8.55948 ×.049713 ABO = $160 Your vested benefit obligation (VBO) is calculated as follows: Vested benefits =.015 × 1 × $25,000 ×.2 Vested benefits = $75 VBO = $75 × 8.55948 ×.049713 VBO = $32

27. 17-27 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 The adjustment for future salary of $478, is determine by the plan actuary. 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, 2006. The journal entry to record the pension costs and funding would be: Pension expense638 Accrued pension cost138 Cash500

28. 17-28 Defined Benefit Plan Let’s look at an example for Matrix, Inc.

29. 17-29 Defined Benefit Plan Actuaries have determined that Matrix, Inc. has service cost of $150,000 in 2006 and $155,000 in 2007. We can begin the process of determining pension expense for the company.

30. 17-30 Service Cost

31. 17-31 Interest Cost Interest cost is the growth in PBO during a reporting period. Interest cost is calculated as: PBO Beg × Discount rate

32. 17-32 Interest Cost Actuaries determined that Matrix, Inc. had PBO of $500,000 on 1/1/06, and $640,000 on 1/1/07. Actuaries determined that Matrix, Inc. had PBO of $500,000 on 1/1/06, and $640,000 on 1/1/07. The actuary uses a discount rate of 10%.

33. 17-33 Interest Cost 2006: PBO 1/1/06 $500,000 × 10% = $50,000 2007: PBO 1/1/07 $640,000 × 10% = $64,000

34. 17-34 Return on Plan Assets Trustee’s estimate of long-term rate of return. Expected Return The dividends, interest, and capital gains generated by the fund during the period. Actual Return

35. 17-35 Return on Plan Assets The plan trustee reports that plan assets were $450,000 on 1/1/06, and $600,000 on 1/1/07. The plan trustee reports that plan assets were $450,000 on 1/1/06, and $600,000 on 1/1/07. The trustee uses an expected return of 9% and the actual return is 10% in both years.

36. 17-36 Return on Plan Assets2006 2007

37. 17-37 Return on Plan Assets

38. 17-38 Amortization of Prior Service Cost Prior service cost (PSC) results 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.

39. 17-39 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.

40. 17-40 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.

41. 17-41 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’s service years remaining.

42. 17-42 Amortization of Prior Service Cost Effective 1/1/07, Matrix, 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 1/1/07, is $60,000. The average remaining service life of the active employee group is 12 years. Effective 1/1/07, Matrix, 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 1/1/07, is $60,000. The average remaining service life of the active employee group is 12 years.

43. 17-43 Amortization of Prior Service Cost Since the amendment was not effective until the beginning of 2007, pension expense for 2006 is not affected. 2007: $60,000 PSC ÷ 12 = $5,000

44. 17-44 Amortization of Prior Service Cost

45. 17-45 Gains and Losses

46. 17-46 Corridor Amount Amortization is not required if the net unrecognized gain or loss at the beginning of the period is a minimum amount (corridor amount).

47. 17-47 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

48. 17-48 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 —

49. 17-49 Gains and Losses Let’s determine the amortization of the net gain in 2007. There was no gain or loss amortized in 2006.

50. 17-50 Gains and Losses $9,000 ÷ 9 years = $1,000 per year.

51. 17-51 Pension Expense

52. 17-52 Pension Expense Matrix contributed $200,000 to the plan trustee at the end of 2007. The journal entry to record the pension expense is:

53. 17-53 Learning Objectives Understand the interrelationships among the elements that constitute a defined benefit pension plan.

54. 17-54 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

55. 17-55 Reconciliation of Pension Amounts The four amounts shown on the previous slide combine to account for the one pension account that is reported on the balance sheet: prepaid pension asset or pension liability. The four amounts shown on the previous slide combine to account for the one pension account that is reported on the balance sheet: prepaid pension asset or pension liability.

56. 17-56 Minimum Liability To discourage underreporting of pension liability, SFAS No. 87 requires recognition of an additional minimum pension liability under certain circumstances.

57. 17-57 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.

58. 17-58 Offsetting SFAS No. 87 requires offsetting of the pension liability and the plan assets when determining the minimum liability.

59. 17-59 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 – +

60. 17-60 Learning Objectives Describe how pension disclosures fill a reporting gap left by the minimal disclosures in the primary financial statements.

61. 17-61 Pension Disclosures – A Compromise The pension information actually reported in the financial statements falls short of the conceptual ideal and even shy of the FASB’s own preferences. Here are the items included in the income statement and balance sheet.

62. 17-62 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.

63. 17-63 Learning Objectives Describe the nature of postretirement benefit plans other than pensions and identify the similarities and differences in accounting for those plans and pensions.

64. 17-64 Postretirement Benefit Plan Encompass all types of retiree health and welfare benefits including... Medical coverage, Medical coverage, Dental coverage, Dental coverage, Life insurance, Life insurance, Group legal services, and Group legal services, and Other benefits. Other benefits.

65. 17-65 Postretirement Health Benefits and Pension Benefits Compared Pension Plan Benefits Usually based on years of service. Identical payments for same years of service. Cost of plan usually paid by employer. Vesting usually required. Pension Plan Benefits Usually based on years of service. Identical payments for same years of service. Cost of plan usually paid by employer. Vesting usually required. Postretirement Health Benefits Typically unrelated to service. Payments vary depending on medical needs. Company and retiree share the costs. True vesting does not exist. Postretirement Health Benefits Typically unrelated to service. Payments vary depending on medical needs. Company and retiree share the costs. True vesting does not exist.

66. 17-66 The Net Cost of Benefits Estimated medical costs in each year of retirement Estimated medical costs in each year of retirement Estimated net cost of benefits Estimated net cost of benefits Retiree share of costRetiree costMedicarepaymentsMedicarepayments Less: Equals:

67. 17-67 The Net Cost of Benefits Estimating postretirement health care benefits is like estimating pension benefits, but there are some additional assumptions required: Estimating postretirement health care benefits is like estimating pension benefits, but there are some additional assumptions required:  Current cost of providing health care benefits (per capita claims cost).  Demographic characteristics of participants.  Benefits provided by Medicare.  Expected health care cost trend rate. Estimating postretirement health care benefits is like estimating pension benefits, but there are some additional assumptions required: Estimating postretirement health care benefits is like estimating pension benefits, but there are some additional assumptions required:  Current cost of providing health care benefits (per capita claims cost).  Demographic characteristics of participants.  Benefits provided by Medicare.  Expected health care cost trend rate.

68. 17-68 Learning Objectives Explain how the obligation for postretirement benefits is measured and how the obligation changes.

69. 17-69 Postretirement Benefit Obligation Accumulated (APBO) The portion of the EPBO attributed to employee service to date. Accumulated (APBO) The portion of the EPBO attributed to employee service to date. Expected (EPBO) The actuary’s estimate of the total postretirement benefits (at their discounted present value) expected to be received by plan participants. Expected (EPBO) The actuary’s estimate of the total postretirement benefits (at their discounted present value) expected to be received by plan participants.

70. 17-70 Measuring the Obligation On December 31, our actuary estimates that the present value of the expected benefit obligation for your postretirement health care costs is $10,250. You have worked for the company for 6 years and are expected to have 30 years of service at retirement. The actuary uses a 6% discount rate. Let’s calculate the APBO. On December 31, our actuary estimates that the present value of the expected benefit obligation for your postretirement health care costs is $10,250. You have worked for the company for 6 years and are expected to have 30 years of service at retirement. The actuary uses a 6% discount rate. Let’s calculate the APBO.

71. 17-71 Measuring the Obligation EPBO Fraction attributed to service to date Fraction attributed to service to date APBO × × = = $10,250630 = $2,050 = $2,050× APBO at the beginning of the year.

72. 17-72 Measuring the ObligationEPBOBeginning of Year × (1 + Discount Rate) =EPBOEnd of Year To calculate the APBO at the end of the year, we start by determining the ending EPBO. $10,250 × 1.06 = $10,865 APBO End of Year $10,865× 730 = $2,535

73. 17-73 Measuring the Obligation APBO may also be calculated like this: The APBO increases because of interest and the service fraction (service cost).

74. 17-74 Attribution The process of assigning the cost of benefits to the years during which those benefits are assumed to be earned by employees.

75. 17-75 Learning Objectives Determine the components of postretirement benefit expense.

76. 17-76 Postretirement Benefit Expense

77. 17-77 Postretirement Benefit Expense Interest accrues on the APBO as time passes. APBO at the beginning of the year times the assumed discount rate equals the interest cost. assumed discount rate equals the interest cost. Interest accrues on the APBO as time passes. APBO at the beginning of the year times the assumed discount rate equals the interest cost. assumed discount rate equals the interest cost.

78. 17-78 Postretirement Benefit Expense Unlike pension plans, many postretirement benefit plans are not funded currently. For funded plans, the earnings on plan assets reduce postretirement benefit expense. Unlike pension plans, many postretirement benefit plans are not funded currently. For funded plans, the earnings on plan assets reduce postretirement benefit expense.

79. 17-79 Postretirement Benefit Expense Prior service cost is allocated over the average time from the date of the amendment to the date for active employees, not the expected retirement date.

80. 17-80 Postretirement Benefit Expense The amount subject to amortization is the net gain or loss at the beginning of the year in excess of 10% of the APBO or 10% of the plan assets. The excess is amortized over the average remaining service period of active employees. The amount subject to amortization is the net gain or loss at the beginning of the year in excess of 10% of the APBO or 10% of the plan assets. The excess is amortized over the average remaining service period of active employees.

81. 17-81 Amortize Net Losses or Gains

82. 17-82 Postretirement Benefit Expense Amortization of the transition amount is part of expense in the current period. For financial reporting, the amortization reduces current earnings. For income tax purposes, income is reduced when actual payments are made. This creates a temporary difference between financial and taxable income. Amortization of the transition amount is part of expense in the current period. For financial reporting, the amortization reduces current earnings. For income tax purposes, income is reduced when actual payments are made. This creates a temporary difference between financial and taxable income.

83. 17-83 Amortization of Transition Amount An employer may choose to recognize: The entire transition obligation immediately, or Amortize the transition obligation on a straight- line basis over the plan participants’ future service periods (or 20 years if that is longer). An employer may choose to recognize: The entire transition obligation immediately, or Amortize the transition obligation on a straight- line basis over the plan participants’ future service periods (or 20 years if that is longer).

84. 17-84 Determining the Expense Recall our example of postretirement benefits. Let’s calculate postretirement benefits expense.

85. 17-85 Determining the Expense The beginning APBO ($2,050) is the initial transition liability. Your service life is 24 years (30 - 6). The amortization amount is $85 rounded ($2,050 ÷ 24 years). Because most postretirement health plans are not funded, there are no fund assets, no credit for prior service, and no net loss. Because most postretirement health plans are not funded, there are no fund assets, no credit for prior service, and no net loss.

86. 17-86 Pension Disclosures Description of the pension plan. Description of the pension plan. Estimates of the obligations PBO, ABO, vested benefit obligation, EPBO, and APBO). Estimates of the obligations PBO, ABO, vested benefit obligation, EPBO, and APBO). Description of the pension plan. Description of the pension plan. Estimates of the obligations PBO, ABO, vested benefit obligation, EPBO, and APBO). Estimates of the obligations PBO, ABO, vested benefit obligation, EPBO, and APBO). The disclosure requirement of pension plans and postretirement benefits are very similar. On this and the next three screens are the disclosures for FedEx in the Appendix to Chapter 1.

87. 17-87 Pension Disclosures The percentage of total plan assets for each major category of assets (equity securities, debt securities, real estate, other) as well as a description of investment strategies, including any target asset allocations and risk management practices. The percentage of total plan assets for each major category of assets (equity securities, debt securities, real estate, other) as well as a description of investment strategies, including any target asset allocations and risk management practices. A breakdown of the components of the annual pension and postretirement benefit expenses for 2004, 2003, and 2002. A breakdown of the components of the annual pension and postretirement benefit expenses for 2004, 2003, and 2002. The percentage of total plan assets for each major category of assets (equity securities, debt securities, real estate, other) as well as a description of investment strategies, including any target asset allocations and risk management practices. The percentage of total plan assets for each major category of assets (equity securities, debt securities, real estate, other) as well as a description of investment strategies, including any target asset allocations and risk management practices. A breakdown of the components of the annual pension and postretirement benefit expenses for 2004, 2003, and 2002. A breakdown of the components of the annual pension and postretirement benefit expenses for 2004, 2003, and 2002.

88. 17-88 Pension Disclosures A reconciliation of the changes in the plans’ benefit obligation and fair value of assets over a two year period ended May 31, 2004, and a statement of the funded status. A reconciliation of the changes in the plans’ benefit obligation and fair value of assets over a two year period ended May 31, 2004, and a statement of the funded status. The discount rates, the assumed rate of compensation increases used to measure the PBO, the expected long- term rate of return on plan assets and the expected rate of increase in future medical and dental benefit costs. The discount rates, the assumed rate of compensation increases used to measure the PBO, the expected long- term rate of return on plan assets and the expected rate of increase in future medical and dental benefit costs. A reconciliation of the changes in the plans’ benefit obligation and fair value of assets over a two year period ended May 31, 2004, and a statement of the funded status. A reconciliation of the changes in the plans’ benefit obligation and fair value of assets over a two year period ended May 31, 2004, and a statement of the funded status. The discount rates, the assumed rate of compensation increases used to measure the PBO, the expected long- term rate of return on plan assets and the expected rate of increase in future medical and dental benefit costs. The discount rates, the assumed rate of compensation increases used to measure the PBO, the expected long- term rate of return on plan assets and the expected rate of increase in future medical and dental benefit costs.

89. 17-89 Pension Disclosures Estimated benefit payments presented separately for years 2005-2009 and in the aggregate for years 2010- 2014. Estimated benefit payments presented separately for years 2005-2009 and in the aggregate for years 2010- 2014. Estimate of expected contributions to fund the plan for 2005. Estimate of expected contributions to fund the plan for 2005. Other information to make it possible for interested analysts to reconstruct the financial statements with plan assets and liabilities included Other information to make it possible for interested analysts to reconstruct the financial statements with plan assets and liabilities included Estimated benefit payments presented separately for years 2005-2009 and in the aggregate for years 2010- 2014. Estimated benefit payments presented separately for years 2005-2009 and in the aggregate for years 2010- 2014. Estimate of expected contributions to fund the plan for 2005. Estimate of expected contributions to fund the plan for 2005. Other information to make it possible for interested analysts to reconstruct the financial statements with plan assets and liabilities included Other information to make it possible for interested analysts to reconstruct the financial statements with plan assets and liabilities included

90. 17-90 Appendix 17 Service Method of Allocating Prior Service Cost

91. 17-91 The Service Method The allocation approach that reflects the declining service pattern of employees is called the service method. The method requires that the total number of service years for all employees be calculated. This calculation is usually done by the actuary. Assume Matrix, Inc. has 2,000 employees and the company’s actuary determined that the total number of service years of these employees is 30,000. We would calculate the following amortization fraction: 30,000 2,000 = 15 average service years

92. 17-92 End of Chapter 17