Accounting For Pensions

• Defined Benefit vs. Defined Contribution Plans

• Defining the Pension Obligation
• Accumulated Benefit Obligation

• Vested Benefit Obligation

• Projected Benefit Obligation

• Service Cost

• Interest Cost

• Prior Service Cost

• Actuarial/Experience Gains and Losses

• Payment of Benefits

• Pension Expense
• Service Cost

• Interest Cost

• Return on Plan Assets

• Actual vs. Expected Return

• Amortization of Prior Service Cost

• Amortization of other gains and losses

• Assessing the funded status of the plan

• Reconciling to the balance sheet asset/liability
• Minimum liability
• Plan Settlement/Curtailment
 Defined Benefit vs. Defined Contribution
Defined Contribution Plan:
• The firm's contributions are set according to a specific
formula.
• Contributions can be a fixed dollar amount, a percentage
of salary, a percentage of profits etc.
• The contributions are invested in assets.
• Upon retirement the employee receives their share of the
assets in the fund.

Defined Benefit Plan:

• The employee's retirement benefits are set according to a
specific formula.
• The formula is usually a variation of this equation:
• Contract % x # Years of Service x Future Salary
• The Firm is required to fund the plan (make
contributions) such that the funds are sufficient to pay
their liability.
• Plans are formed according to ERISA and subject to
regulation by the PBGC.

What are the pros and cons of the two plans?

 Defining the Pension Obligation

The Pension obligation (liability) should be the present

value of the future payments.

Projected Benefit Obligation: Present value of the expected

future payments based upon projected future salaries.

Example: Assume that the annual benefit is:

2% x # of years of service x Final Salaries

If you expect an employee to retire in 5 years after a total

of 20 years of service at a final salary of $100,000, the
expected annual benefit is 20 x 2% x $100,000 = $40,000.
If you further expect individuals to receive 15 years after
retirement, then:

The Projected Benefit Obligation is equal to the present

value of the fifteen payments of $40,000 discounted back
an additional five years.

Using an 8% discount rate, the PBO at 12/31/00 is:

Pv(8%,5,,pv(8%,15,40000)) = $233,017.
 Changes in the Benefit Obligation
The Projected Benefit Obligation is affected by:

Service Cost: Value of benefits earned by employees

during the period.

Interest Cost: Interest accrued on unpaid benefits.

Prior Service Cost: Change in benefits resulting from a

change in the pension contract.

Actuarial/experience gains/losses: Change in benefits

resulting from changes in actuarial estimates (or differences
between actual and expected values).

Payment of benefits.
Example: Using the example above and using an 8%
discount rate, the PBO as of 1/1/00 would be:

Pv(8%,6,,pv(8%,15,38000)) = $204,969.
Service cost = Pv(8%,5,,pv(8%,15,2000)) = $11,651
Interest cost = $204,969 x 8% = $16,398
The PBO at 12/31/00 would be: $204,969 + $11,651 +
$16,398 = $233,018.

Example of PSC: Let's say that on 1/1/00 the contract was

changed so that the benefit percentage is now 2.5%. Now
the annual benefit is 19 x 2.5% x $100,000 =$47,500. The
PBO after the change is Pv(8%,6,,pv(8%,15,47500)) =
$256,211.
256,211 - $204,969 = $51,242

Beginning PBO = $204,969

Service cost = 14,564
Interest cost = 20,497
Prior service cost = 51,242
Ending PBO = 291,272
Example of Actuarial Loss:

Assume that on 1/2/00, the company changes the expected

final salary from $100,000 to $120,000. Now the annual
benefit is 19 x 2.5% x $110,000 = $52,250. The revised
PBO is Pv(8%,6,,pv(8%,15,52250) = 281,833 and the
actuarial loss is $281,833-256,211 = $25,622

Beginning PBO = $204,969

Service cost = 16,020
Interest cost = 22,547
Prior service cost = 51,242
Actuarial loss = 25,622
Ending PBO = 320,400
 Pension Expense

Pension Expense consists of:

Service Cost
Interest Cost
Amortization of prior service cost
Amortization of unrecognized gains/losses
Reduced by the expected return on plan assets

Note that the expected return is sometimes listed as the

actual return less the unexpected return.

Prior service cost is like prepaid wages and is amortized

over the average remaining service period of employees.

Unrecognized gains and losses include actuarial

gains/losses, experience gains/losses, and the unexpected
return on plan assets. They are generally amortized in the
period after they are created.
 Why do we defer unexpected returns?

GM's Pension Cost Actual Returns vs. Expected

Returns

$7,000
$6,000
$5,000
$4,000
$3,000
Expected
$2,000
$1,000 Actual

$0
($1,000)
($2,000)
($3,000)
1988

1989

1990

1991

1992

1993
Funding:

Firms net the amount of the pension obligation against the

value of assets set aside to pay the obligation. The
difference between the value of the obligation and the value
of the assets represents the extent to which the pension plan
is over or under funded.

Once the funding level is determined, the firm must

reconcile the funding to the balance sheet asset or liability.

The difference is that various costs/gains/losses are

deferred (not recognized) according to GAAP.
Assume that at 1/1/00 the pension plan had assets of
$200,000, and an expected rate of return of 10%. During
the year, the firm earned 15% on its assets and made an
additional contribution of $25,000 to the plan.

Fair Value of Plan Assets:

Beginning Balance $200,000
Actual return 30,000
Contribution 25,000
Ending Balance $250,000

Assume that the firm had net unrecognized gains at 1/1/00

of $50,000 and amortized $3,000 of the gains in 2000.

Unrecognized Gains/Losses
Beginning Balance $50,000
Unexpected gain on plan assets 10,000
Actuarial Loss (25,622)
Amortization (13,000)
Ending Balance 21,378
 Example of Pension Disclosures
Pension Expense:
Service Cost $16,020
Interest Cost 22,547
Actual Return on assets (30,000)
Deferral of unexpected gain 10,000
Amortization of PSC 6,405*
Amortization of Unrec g/l (13,000)
Annual Expense 57,973

*Assumes an 8-year average remaining service period.

Reconciliation of Accrued Pension Cost

PBO in excess of Plan Assets $70,400
Unrecognized PSC ($44,837)
Unrecognized gains 21,378
Pension Liability 46,941

Pension Journal Entries:

Dr. Pension Expense 57,973
Cr. Accrued Pension Cost 57,973
Dr. Accrued Pension Cost 25,000
Cr. Cash 25,000
 Minimum Pension Liability

The ending pension liability on the balance sheet needs to

be at least equal to the unfunded Accumulated Benefit
Obligation (the PBO without any adjustment for future
salaries).

Assume that the ABO at 12/31/00 is $300,000. Then the

unfunded portion of the ABO is 300,000-250,000 =
$50,000.

Because the accrued pension cost (46,941) is less than the

minimum liability (50,000) the firm must record an
additional minimum pension liability adjustment.

PBO in excess of Plan Assets $70,400

Unrecognized PSC ($44,837)
Unrecognized gains 21,378
Additional minimum liability adjustment 3,059
Pension Liability 50,000
Example of Pension Disclosures: Gillette Corporation.
PENSION PLANS AND OTHER RETIREE BENEFITS
(Millions) 1999 1998 1997
COMPONENTS OF NET BENEFIT EXPENSE:
Service cost-benefits earned $69 $67 $64
Interest cost on benefit obligation 116 123 115
Estimated return on assets (166) (157) (118)
Net amortization 13 6 6
Plan curtailments and other (7) -- --
Total benefit expense 25 39 67

The funded status of the Company's principal defined benefit and other
retiree benefit plans and the amounts recognized in the balance sheet at
December 31follow.
(Millions) 1999 1998
CHANGE IN BENEFIT OBLIGATION:
Balance at beginning of year $2,022 $1,790
Benefit payments (97) (105)
Service and interest costs 185 191
Amendments 5 48
Actuarial (gains) losses 16 88
Plan settlements and other items (99) --
Currency translation adjustment (76) 10
Balance at end of year 1,956 2,022

CHANGE IN FAIR VALUE OF PLAN ASSETS:

Balance at beginning of year 1,957 1,540
Actual return on plan assets 275 204
Employer contribution 39 299
Benefit payments (78) (86)
Plan settlements (91) --
Currency translation adjustment (50) --
Balance at end of year 2,052 1,957
(Millions) 1999 1998
Plan assets greater (less) than benefit obligation 96 (65)
Unrecognized prior service cost and transition obligation 50 57
Unrecognized net loss (gain) (56) 54
Minimum liability adjustment included in:
Intangible assets (13) (17)
Stockholders' equity (30) (47)
Net prepaid (accrued) benefit cost included in consolidated
Balance sheet $47 $(18)
 Textbook Review Problems

Pension accounting can be a bit complicated due to the

terminology employed and the deferred recognition of
gains and losses. The best way to learn the concepts is
through repetition and working your way through problems
on your own. A few problems are listed below. You are
encouraged to also do additional problems in the text and
the text supplements

P17-2, P17-3, P17-4, P17-11, E17-14