Study Session 5
EXAM FOCUS
This is a complicated topic, but don’t be intimidated. Accounting for pension plans may be complex, but the economic reasoning is not too difficult to grasp. Despite convergence between U.S. GAAP and IFRS, significant differences remain, particularly with respect to recognition of periodic pension cost in income statement versus in OCI. You should be able to explain how reported results are affected by management’s assumptions. You should also be able to adjust the reported financial results for economic reality by calculating total periodic pension cost. Share-based compensation is also introduced. Compensation expense is based on fair value on the grant date, and it is often necessary to use an option pricing model to estimate fair value. Make sure you understand the effects of changing the model inputs on fair value.
MODULE 14.1: TYPES OF PLANS
LOS 14.a: Describe the types of post-employment benefit plans and implications for financial reports.
CFA® Program Curriculum, Volume 2, page 64
A pension is a form of deferred compensation earned over time through employee service.
The most common pension arrangements are defined-contribution plans and defined benefit plans.
A defined contribution plan is a retirement plan whereby the firm contributes a certain sum each period to the employee’s retirement account. The firm’s contribution can be based on any number of factors including years of service, the employee’s age, compensation, profitability, or even a percentage of the employee’s contribution. In any event, the firm makes no promise to the employee regarding the future value of the plan assets. The investment decisions are left to the employee, who assumes all of the investment risk.
The financial reporting requirements for defined-contribution plans are straightforward.
Pension expense is simply equal to the employer’s contribution. There is no future obligation to report on the balance sheet. The remainder of this topic review will focus on accounting for a defined-benefit plan.
In a defined-benefit plan, the firm promises to make periodic payments to the employee after retirement. The benefit is usually based on the employee’s years of service and the employee’s compensation at, or near, retirement. For example, an employee might earn a
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retirement benefit of 2% of her final salary for each year of service. Consequently, an employee with 20 years of service and a final salary of $100,000 would receive $40,000 ($100,000 final salary × 2% × 20 years of service) each year upon retirement until death.
Since the employee’s future benefit is defined, the employer assumes the investment risk.
Financial reporting for a defined-benefit plan is much more complicated than for a defined- contribution plan because the employer must estimate the value of the future obligation to its employees. This involves forecasting a number of variables such as future compensation levels, employee turnover, retirement age, mortality rates, and an appropriate discount rate.
A company that offers defined pension benefits typically funds the plan by contributing assets to a separate legal entity, usually a trust. The plan assets are managed to generate the income and principal growth necessary to pay the pension benefits as they come due.
The difference in the benefit obligation and the plan assets is referred to as the funded status of the plan. If the plan assets exceed the pension obligation, the plan is said to be
“overfunded.” Conversely, if the pension obligation exceeds the plan assets, the plan is
“underfunded.”
Other post-employment benefits, primarily health care benefits for retired employees, are similar to a defined-benefit pension plan: the future benefit is defined today but is based on a number of unknown variables. For example, in a post-employment health care plan, the employer must forecast health care costs that are expected once the employee retires.
Funding is an area where other post-employment benefit plans differ from defined-benefit pension plans. Pension plans are typically funded at some level, while other post-employment benefit plans are usually unfunded. In the case of an unfunded plan, the employer recognizes expense in the income statement as the benefits are earned; however, the employer’s cash flow is not affected until the benefits are actually paid to the employee.
MODULE QUIZ 14.1
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1. Which of the following statements about retirement plans is most accurate?
A. Total periodic pension cost is equal to the change in PBO minus the firm’s contributions.
B. In a defined-contribution plan, periodic pension cost is calculated as the difference in the contribution amount and the actual return on plan assets.
C. In a defined-benefit plan, the employer assumes the majority of the investment risk.
MODULE 14.2: DEFINED BENEFIT PLANS—
BALANCE SHEET
LOS 14.b: Explain and calculate measures of a defined benefit pension obligation (i.e., present value of the defined benefit obligation and projected benefit obligation) and net pension liability (or asset).
CFA® Program Curriculum, Volume 2, page 67 The projected benefit obligation (PBO) [known as present value of defined benefit
obligation (PVDBO) under IFRS] is the actuarial present value (at an assumed discount rate) of all future pension benefits earned to date, based on expected future salary increases. It
measures the value of the obligation, assuming the firm is a going concern and that the employees will continue to work for the firm until they retire.
From one period to the next, the benefit obligation changes as a result of current service cost, interest cost, past (prior) service cost, changes in actuarial assumptions, and benefits paid to employees.
Current service cost is the present value of benefits earned by the employees during the current period. Service cost includes an estimate of compensation growth (future salary increases) if the pension benefits are based on future compensation. In rare cases, the pension plan may have a provision for employees to share in the service cost. Current service cost in that case would only represent the employer’s share of the cost. Employee contributions would be added to both beginning PBO and beginning plan assets in PBO and FV plan asset reconciliation respectively.
Interest cost is the increase in the obligation due to the passage of time. Benefit obligations are discounted obligations; thus, interest accrues on the obligation each period. Interest cost is equal to the pension obligation at the beginning of the period multiplied by the discount rate.
Past (prior) service costs are retroactive benefits awarded to employees when a plan is initiated or amended. Under IFRS, past service costs are expensed immediately. Under U.S.
GAAP, past service costs are amortized over the average service life of employees.
Changes in actuarial assumptions are the gains and losses that result from changes in variables such as mortality, employee turnover, retirement age, and the discount rate. An actuarial gain will decrease the benefit obligation and an actuarial loss will increase the obligation.
Benefits paid reduce the PBO.
Consider the following example of calculating the PBO.
EXAMPLE: Calculating PBO
John McElwain was hired on January 1, 2016, as the only employee of Transfer Trucking, Inc., and is eligible to participate in the company’s defined-benefit pension plan. Under the plan, he is promised an annual payment of 2% of his final annual salary for each year of service. The pension benefit will be paid at the end of each year, beginning one year after retirement. McElwain’s starting annual salary is $50,000.
In order to calculate the PBO at the end of the first year, we will assume the following:
The discount rate is 8%.
McElwain’s salary will increase by 4% per year (this is called the rate of compensation growth).
McElwain will work for 25 years.
McElwain will live for 15 years after retirement and receive 15 annual pension benefit payments.
Answer:
Based on a starting salary of $50,000 in 2016 and 4% annual pay increases over 24 years, McElwain’s salary at retirement will be 50,000 × (1 + 0.04)24 = $128,165.21. (If McElwain works for 25 years, he will receive 24 pay increases.)
If McElwain is expected to earn $128,165.21 in his last year of employment (2040), he will be entitled to an annual end-of-year pension payment equal to 2% of his final salary for each year of service. Thus, at the end of one year of service, McElwain’s benefit is $2,563.30 per year from retirement until death
($128,165.21 × 2% × 1 year). Assuming he lives 15 years past retirement, the present value of the payments on the retirement date (2040) is $21,940.55 (PV of 15 year annuity of $2,563.30 at PMT = – 2,563.30; N = 15; I/Y = 8; FV = 0; CPT PV → 21,940.55). At the end of his first year of employment
(2016), the present value of the annuity that begins in 24 years is $3,460.01 ($21,940.55 discounted at 8%
for 24 years).
Therefore, the PBO at the end of 2016 (McElwain’s first year of employment) is $3,460.01. A table outlining these cash flows follows.
Calculation of the PBO at the End of 2016 Year Years of
Service
Projected Salary
Years in Retirement
Benefit Payment (end of year)
Present Value (end of year)
2016 1 $50,000.00 PBO = $3,460.01
2017 2 $52,000.00
2018 3 $54,080.00
2038 23 $118,495.94
2039 24 $123,235.78
2040 25 $128,165.21 $21,940.55
2041 1 $2,563.30
2042 2 $2,563.30
2043 3 $2,563.30
2054 14 $2,563.30
2055 15 $2,563.30
After two years of employment, McElwain’s benefit is $5,126.61 ($128,165.21 × 2% × 2 years). The present value of the payments on the retirement date (2040) is $43,881.09 (PV of 15 year annuity of
$5,126.61 at 8%). At the end of his second year of employment (2017), the present value of the annuity that begins in 23 years is $7,473.62 ($43,881.09 discounted at 8% for 23 years).
Therefore, the PBO at the end of 2017 (McElwain’s second year of employment) is $7,473.62. A table outlining these cash flows follows.
Calculation of the PBO at the End of 2017 Year Years of
Service
Projected Salary
Years in Retirement
Benefit Payment (end of year)
Present Value (end of year)
2016 1 $50,000.00
2017 2 $52,000.00 PBO = $7,473.62
2018 3 $54,080.00
2038 23 $118,495.94
2039 24 $123,235.78
2040 25 $128,165.21 $43,881.09
2041 1 $5,126.61
2042 2 $5,126.61
2043 3 $5,126.61
2054 14 $5,126.61
2055 15 $5,126.61
During 2017, the PBO increased $4,013.61. The increase is a result of current service cost and interest cost as follows:
2016 PBO $3,460.01
+ Current service cost 3,736.81 (PV of 15 payments of $2,563.30 beginning in 23 years) + Interest cost 276.80 ($3,460.01 × 8%)
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2017 PBO $7,473.62
The current service cost is the present value of the benefits earned during 2017 and the interest cost is the increase in the PBO due to the passage of time.
Balance Sheet Effects
Figure 14.1: Funded Status of a Pension Plan
The funded status reflects the economic standing of a pension plan:
funded status = fair value of plan assets − PBO
The balance sheet presentation under both U.S. GAAP and IFRS is as follows:
balance sheet asset (liability) = funded status
If the funded status is negative, it is reported as a liability. If the funded status is positive, it is reported as an asset subject to a ceiling of present value of future economic benefits (such as future refunds or reduced contributions).
PROFESSOR’S NOTE
An overfunded pension plan would lead to either lower future contributions (i.e., savings in contributions for employers) or future withdrawals (refunds). Both IFRS and U.S. GAAP limit the asset recognition to the present value of such refunds or reduced contributions.
MODULE QUIZ 14.2
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1. Which of the following components of the projected benefit obligation is most likely to increase every year as a direct result of the employee working another year for the company?
A. Current service cost.
B. Interest cost.
C. Benefits paid.
MODULE 14.3: DEFINED BENEFIT PLANS, PART 1—