I agree to make payments into a fund for future retirement benefits for employee services. I am the employee for whom the pension plan provides benefits. Nature of Pension Plans Sponsor Participant
Nature of Pension Plans • For a pension plan to qualify for special tax treatment it must meet the following requirements: • Cover at least 70% of employees. • Cannot discriminate in favor of highly compensated employees. • Must be funded in advance of retirement through a trust. • Benefits must vest after a specified period of service. • Complies with timing and amount of contributions.
The right to receive earned pension benefits vest (vested benefits) when it is no longer contingent on continued employment. Nature of Pension Plans
Learning Objectives Explain the fundamental differences between a defined contribution pension plan and a defined benefit pension plan. LO1
Defined Contribution Plans 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 Pension Plans Defined contribution pension plans are becoming increasingly popular vehicles for employers to provide retirement income without the paperwork, cost, and risk generated by the more traditional defined benefit plans. These plans promise defined periodic contributions to a pension fund, without further commitment regarding benefits at retirement.
Defined Contribution Pension Plans Accounting for these plans is quite simple. Let’s assume that an annual contribution of employee salaries is to be 4% of gross earnings. If employees earned $10,000,000 in salaries during the period, the company would make the following entry:
Defined Benefit Pension Plans 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.
Pension expense is measured by assigning pension benefits to periods of employee service as defined by the pension benefit formula. Defined Benefit Plan 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
Learning Objectives Distinguish among the vested benefit obligation, the accumulated benefit obligation, and the projected benefit obligation. LO2
Defined Benefit Plan You go to work for Matrix, Inc. on 1/1/07. 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 will 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.
Defined Benefit Plan At December 31, 2007, the end of your first year of service, the actuary must calculate the present value of the pension benefits earned by you during 2007. 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 × 8.559481× .0497132 Service cost = $1,277 1Present value of an ordinary annuity at 8% for 15 years. 2Present value of $1 at 8% for 39 years.
Pension Obligation 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
Pension Obligation The Projected benefit obligation (PBO) differs from the ABO by using your salaryprojected at retirement rather than your current salary. The actuary calculates your Projected benefit obligation (PBO) as follows: Retirement benefits = .015 × 1 yr × $200,000 Retirement benefits = $3,000 PBO = $3,000 × 8.55948 × .049713 PBO = $1,277
Pension Obligation A reconciliation of the VBO, ABO and PBO would look like this: VBO $ 32 Non-vested benefits 128 ABO $ 160 Adjustment for future salary 1,117 PBO $ 1,277
Pension Obligation Projected Benefit Obligation Present value of additional benefits related to projected pay increases. Present value of nonvested benefits at present pay levels. Accumulated Benefit Obligation Present value of benefits at present pay levels. Vested Benefit Obligation
Learning Objectives Describe the five events that might change the balance of the PBO. LO3
Pension Obligation Service cost is the increase in the PBO attributable to employee service performed during the period.
Pension Obligation Interest cost is the interest on the PBO during the period.
Pension Obligation Prior service costeffects result from changes in the pension benefit formula or plan terms.
Pension Obligation Loss or gain on PBOresults from required revisions of estimates used to determine PBO.
Pension Obligation Retiree benefits paidare the result of paying benefits to retired employees.
Learning Objectives Explain how plan assets accumulate to provide retiree benefits and understand the role of the trustee in administering the fund. LO4
Pension plan assets (like the PBO) arenotspecifically reported in the balance sheet. Atrusteemanages the pension plan assets. Pension Plan Assets
Pension Plan Assets Plan assets change as (a) the investments generate dividends, interest, capital gains, etc., (b) additional cash contributions are added by the employer, and (c) payments are made to retired employees. Assume the following balances and changes for Matrix: ($ in millions)
Learning Objectives Describe the funded status of pension plans and how that amount is reported. LO5
OVERFUNDED Market value of plan assets exceeds the actuarial present value of all benefits earned by participants. Funded Status of the Pension Plan UNDERFUNDED Market value of plan assets is below the actuarial present value of all benefits earned by participants.
Funded Status of the Pension Plan Projected Benefit Obligation (PBO) - Plan Assets at Fair Value Underfunded / Overfunded Status This amount is reported in the balance sheet as a Pension Liability if underfunded or a Pension Asset if overfunded.
Learning Objectives Describe how pension expense is a composite of periodic changes that occur in both the pension obligation and the plan assets. LO6
Actuaries have determined that Matrix, Inc. has service cost of $150,000 in 2007 and $155,000 in 2008. We can begin the process of determining pension expense for the company. Pension Expense
Interest costis the growth in PBO during a reporting period due to the passage of time. Interest cost is calculated as: PBOBeg × Discount rate Interest Cost
Actuaries determined that Matrix, Inc. had PBO of $500,000 on 1/1/07, and $640,000 on 1/1/08. The actuary uses a discount rate of 10%. Interest Cost
Interest Cost 2007: PBO 1/1/07 $500,000 × 10% = $50,000 2008: PBO 1/1/08 $640,000 × 10% = $64,000
Actual Return Expected Return The dividends, interest, and capital gains generated by the fund during the period. Trustee’s estimate of long-term rate of return. Return on Plan Assets
Return on Plan Assets The plan trustee reports that plan assets were $450,000 on 1/1/07, and $600,000 on 1/1/08. The trustee uses an expected return of 9% and the actual return is 10% in both years.
2008 2007 Return on Plan Assets
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 by that amount. 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. 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. 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. Amortization of Prior Service Cost
Effective 1/1/08, 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 1/1/08, is $60,000. The average remaining service life of the active employee group is 12 years. Amortization of Prior Service Cost
Amortization of Prior Service Cost Since the amendment was not effective until the beginning of 2008, pension expense for 2007 is not affected. 2008: $60,000 PSC ÷ 12 = $5,000
Amortization is not required if the net unrecognized gain or loss at the beginning of the period is a minimum amount (corridor amount). Corridor Amount