1. McGraw-Hill /Irwin© 2009 The McGraw-Hill Companies, Inc. PENSIONS AND OTHER POSTRETIREMENT BENEFITS Chapter 17

2. Slide 2 17-2 Nature of Pension Plans 1. Pension plans provide income to individuals during their retirement years. 2. This is accomplished by setting aside funds during an employee’s working years so that at retirement, the accumulated funds plus earnings from investing those funds are available to replace wages. 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 an irrevocable trust fund. 4.Benefits must vest after a specified period of service. 5.Complies with timing and amount of contributions.

3. Slide 3 17-3 Types of Pension Plans Defined contribution pension plans promise fixed annual contributions to a pension fund (say, 10% of the employees' pay). The employee chooses (from designated options) where funds are invested – usually stocks or fixed-income securities. Retirement pay depends on the size of the fund at retirement.

4. Slide 4 17-4 Types of Pension Plans Defined benefit pension plans promise fixed retirement benefits defined by a designated formula. Typically, the pension formula bases retirement pay on the employees' (a) years of service, (b) annual compensation [often final pay or an average for the last few years], and sometimes (c) age. Employers are responsible for ensuring that sufficient funds are available to provide promised benefits.

5. Slide 5 17-5 Contributions are defined by agreement. Employer deposits an agreed-upon amount into an employee- directed investment fund. Employee bears all risk of pension fund performance. Plan Characteristics Defined Contribution Pension Plans

6. Slide 6 17-6 Defined Contribution Pension Plans Accounting for these plans is quite simple. Let’s assume that the annual contribution is to be 3% of an employee’s salary. If an employee earned $110,000 during the year, the company would make the following entry:

7. Slide 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. Plan Characteristics Defined Benefit Pension Plans

8. Slide 8 17-8 Defined Benefit Pension Plan A pension formula might define annual retirement benefits as: 1 1 / 2 % x Years of service x Final year’s salary By this formula, the annual benefits to an employee who retires after 30 years of service, with a final salary of $100,000, would be: 1 1 / 2 % x 30 years x $100,000 = $45,000

9. Slide 9 17-9 The Pension Obligation © 2008 The McGraw-Hill Companies, Inc. 1.Accumulated benefit obligation (ABO) The actuary’s estimate of the total retirement benefits (at their discounted present value) earned so far by employees, applying the pension formula using existing compensation levels. 2.Vested benefit obligation (VBO) The portion of the accumulated benefit obligation that plan participants are entitled to receive regardless of their continued employment. 3.Projected benefit obligation (PBO) The actuary’s estimate of the total retirement benefit (at their discounted present value) earned so far by employees, applying the pension formula using estimated future compensation levels. (If the pension formula does not include future compensation levels, the PBO and the ABO are the same.

10. Slide 10 17-10 Projected Benefit Obligation Jessica Farrow was hired by Global Communications in 1998. She is 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 Farrow is expected to retire in 2037 after 40 years of service. Her retirement period is expected to be 20 years. At the end of 2007, 10 years after being hired, her salary is $100,000. The interest rate is 6%. The company’s actuary projects Farrow’s salary to be $400,000 at retirement. The PBO is a more meaningful measurement because it includes a projection of what the salary might be at retirement.

11. Slide 11 17-11 Projected Benefit Obligation Step 1. Use the pension formula to determine the retirement benefits earned to date. $400,000 × 10 × 1.5% $ 60,000 per year Step 2. Find the present value of the retirement benefits as of the retirement date. The present value (n=20, i=6%,) of the retirement annuity at the retirement date is $688,195 ($60,000 The present value (n=20, i=6%,) of the retirement annuity at the retirement date is $688,195 ($60,000 × 11.46992). Step 3. Find the present value of the retirement benefits as of the current date. The present value (n=30, i=6%,) of the retirement benefits at 2007 is $119,822 ($688,195 The present value (n=30, i=6%,) of the retirement benefits at 2007 is $119,822 ($688,195 ×.17411). This is the PBO.

12. Slide 12 17-12 Projected Benefit Obligation If the actuary’s estimate of the final salary hasn’t changed, the PBO a year later at the end of 2008 would be $139,715. Step 1. Use the pension formula to determine the retirement benefits earned to date. $400,000 × 11 × 1.5% $ 66,000 per year Step 2. Find the present value of the retirement benefits as of the retirement date. The present value (n=20, i=6%,) of the retirement annuity at the retirement date is $757,015 ($66,000 The present value (n=20, i=6%,) of the retirement annuity at the retirement date is $757,015 ($66,000 × 11.46992). Step 3. Find the present value of the retirement benefits as of the current date. The present value (n=29, i=6%,) of the retirement benefits at 2008 is $139,715 ($757,015 The present value (n=29, i=6%,) of the retirement benefits at 2008 is $139,715 ($757,015 ×.18456). This is the PBO.

13. Slide 13 17-13 Changes in the PBO

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

15. Slide 15 17-15 Interest cost is the interest on the PBO during the period. Changes in the PBO

16. Slide 16 17-16 Prior service cost is the increase in the PBO from using a new, more generous pension formula to determine the pension obligation for prior years. Changes in the PBO

17. Slide 17 17-17 Loss or gain on PBO results from revising estimates used to determine the PBO. Changes in the PBO

18. Slide 18 17-18 Retiree benefits paid are payments to retired employees. Changes in the PBO

19. Slide 19 17-19 Changes in the PBO

20. Slide 20 17-20 Pension Plan Assets Global Communications funds its defined benefit pension plan by contributing the year’s service cost plus a portion of the prior service cost each year. Cash of $48 million was contributed to the pension fund in 2009. Plan assets at the beginning of 2009 were valued at $300 million. The expected rate of return on the investment of those assets was 9%, but the actual return in 2009 was 10%. Retirement benefits of $38 million were paid at the end of 2009 to retired employees. The plan assets at the end of 2009 will be: Plan assets at the beginning of 2009 $ 300,000,000 Return on plan assets (10% x $300 million) 30,000,000 Cash contributions 48,000,000 Less: Retiree benefits paid (38,000,000) Plan assets at the end of 2009 $ 340,000,000

21. Slide 21 17-21 Funded Status of the Pension Plan 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. Slide 22 17-22 Funded Status of Pension Plan Projected Benefit Obligation (PBO) - Plan Assets at Fair Value Underfunded / Overfunded Status Projected Benefit Obligation (PBO) - Plan Assets at Fair Value Underfunded / Overfunded Status This amount is reported in the balance sheet as a Pension Liability or Pension Asset.

23. Slide 23 17-23 Pension Expense – An Overview

24. Slide 24 17-24 Pension Expense Actuaries have determined that Global Communications has service cost of $41,000,000 in 2009.

25. Slide 25 17-25 Interest Cost Interest Cost Interest cost is calculated as: PBO Beg × Discount rate Global had PBO of $400,000,000 on 1/1/09. The actuary uses a discount rate of 6%. 2009 Interest Cost: PBO 1/1/09 $400,000,000 × 6% = $24,000,000

26. Slide 26 17-26 Return on Plan Assets The plan trustee reports that plan assets were $300,000,000 on 1/1/09. The trustee uses an expected return of 9% and the actual return is 10%. The plan trustee reports that plan assets were $300,000,000 on 1/1/09. The trustee uses an expected return of 9% and the actual return is 10%.

27. Slide 27 17-27 Amortization of Prior Service Cost In 2008, Global Communications amended the pension plan, increasing the PBO at that time. For all plan participants, the prior service cost was $60 million at 1/1/08. The average remaining service life of the active employee group is 15 years. $60,000,000 PSC ÷ 15 = $4,000,000 per year

28. Slide 28 17-28 Gains and Losses

29. Slide 29 17-29 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

30. Slide 30 17-30 Gains and Losses 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 ־ If the beginning net unrecognized gain or loss exceeds the corridor amount, amortization is recognized using the following formula...

31. Slide 31 17-31 Gains and Losses $15,000,000 ÷ 15 years = $1,000,000

32. Slide 32 17-32 Recording Gains and Losses For 2009, the actual return on plan assets exceeded the expected return by $3 million. In addition, there was a $23 million loss from changes made by the actuary when it revised its estimate of future salary levels causing its PBO estimate to increase. Global would make the following journal entry to record the gain and loss: OCI = Other comprehensive income

33. Slide 33 17-33 Recording the Pension Expense

34. Slide 34 17-34 Pension Expense Spreadsheet

35. Slide 35 17-35 Postretirement Benefits Other Than Pensions 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: Net Cost of Benefits

36. Slide 36 17-36 Other Postretirement Benefits 1. Expected Postretirement Benefit Obligation (EPBO) – The actuary's estimate of the total postretirement benefits (at their discounted present value) expected to be received by plan participants. 2. Accumulated Postretirement Benefit Obligation (APBO) – The portion of the EPBO attributed to employee service to date.

37. Slide 37 17-37 Attribution The process of assigning the cost of benefits to the years during which those benefits are assumed to be earned by employees.

38. Slide 38 17-38 Postretirement Benefit Expense

39. Slide 39 17-39 Appendix 17: Service Method of Allocating Prior Service Cost 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 Global Communications 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

40. McGraw-Hill /Irwin© 2009 The McGraw-Hill Companies, Inc. End of Chapter 17