Module 15
Pensions and Other Post-Employment Benefits
Pension plans
Post-employment benefits refer to promises made by a company to terminated or laid-off employees. These benefits include pensions, health-care benefits, unemployment pay, job-training, or employment counseling. Thus, the phrase “post-employment benefits” is broader than “post-retirement benefits.” However, post-retirement benefits are the most important of the post-employment benefits, and constitute the focus of this module. Pensions and health-care benefits are the two primary post-retirement benefits.
Statement of Financial Accounting Standard (SFAS) No. 87 provides guidance related to accounting for pension plans. Accounting for other post-retirement benefits other than pensions (primarily related to health care) is governed by SFAS No. 106.
Pension plans pay benefits to employees after retirement. There are two broad categories of pension plans
- Defined-contribution plan, and
- Defined-benefit plan.
In a defined-contribution plan, the employer contributes a known amount (usually based on a specified percent of employee salary) to a pension plan. The only obligation for the employer is to pay this amount each period, as long as the employee is working for the company. Usually, the employee also contributes some amount to the pension plan. The assets are invested in a variety of securities (such as stocks, bonds, money market funds, and real estate investment trusts). The account “belongs” to the employee who withdraws from the account after retirement. The widely popular 401-k plans are defined contribution plans.
The key point to note is that once the periodic payment is made, there is no other future financial obligation for the employer in a defined-contribution plan. That is, the risk associated with the plan is borne entirely by the employee. If the employee invests wisely and successfully, then he or she will have a comfortable pension during retirement. However, if the employee is not successful in his or her investment decisions, then there will be less money available during retirement.
From an accounting perspective, defined-contribution plans are very easy. There is only one journal entry each period. When the company makes a payment to the pension plan, there will be a debit to Wages (or Compensation) Expense and a credit to Cash. (Alternatively, the company may first credit a Payable account and then once the payment is made, credit the Payable account. That is, there may be two journal entries each period.)
The excellent performance of the stock market during the 1980s and 1990s also has contributed to the rising popularity of defined-contribution plans. In addition, as noted below, the employer has to bear the risks associated with defined-benefit plans. Hence, employers have become increasingly more likely to offer defined-contribution plans.
Defined Benefit Plans
In a defined-benefit plan, the ultimate pension benefit to be received by the employee is specified in the employment contract. The periodic payments are not specified in the contract. (Hence, the name –since it is the benefit that is defined, the plan is called “defined-benefit plan.”) Thus, the employer is responsible for making sure there is enough assets in the retirement plan to pay the specified amounts during retirement. That is, the risk associated with the plan rests with the employer. The employer has to make the investment decisions that will ensure there is enough money in the plan to pay for the specified retirement benefits. The rest of this module will focus on defined-benefit plans.
The usual formula for calculating the retirement benefits under a defined-benefit plan is as follows:
Annual pension = Number of years of service x Specified percent x Average salary
The percent specified is usually between two to three percent. In many plans, only the average of the salaries over the last few years (usually between two to five years) before retirement is used in the formula. Some plans use the average of the highest salaries received (that is, the average used may be the average of the three or five highest salaries received). (However, since salaries usually increase with time, the difference may not matter.)
Example.
Jim Jones retired from Webb Company on December 31, 2002, after working for 30 years. The Company’s defined-benefit pension plan specifies a credit of 2% for each year of service, and calculated benefits based on the average of the last three years’ salaries. Jones salaries for the years 2000, 2001, and 2002 were $48,500, $49,500 and $52,000, respectively. Calculate the annual pension that Jones will receive.
The average of the last three years’ salaries = $50,000 ([$48,500 + $49,500 + $52,000]/3).
Thus, the annual pension for Jones = 30 years x 2% per year x $50,000 = $30,000.
Jones will receive $30,000 a year as long as he lives.
Benefit Obligations (PBO and ABO)
The accounting issue for the employer is that the pension will be paid in the future, but it represents an obligation of the company today. Hence, the employer must calculate the present value of the future pension payments. The interest rate used for the present value calculation of the future pension obligation is known as the settlement rate. This interest rate is chosen by management, and can have a significant impact on the amount of the pension obligations recognized by the company.
Continuing with our Webb Company example, assume that Jim Jones is expected to live for 10 years after retirement. For the sake of simplicity, we assume that the first retirement check will be given on January 1, 2003 and that pension checks are mailed on January 1 of each year. Since the annual pension for Jim Jones was calculated to be $30,000 paid at the beginning of each year, the pension payments represent an annuity due of $30,000 per period for 10 periods. Also, assume that the settlement rate used by Webb Company is 8%. Then, the current obligation of Webb Company for the future pension payments to be made to Jim Jones is
= Present value of an annuity of $30,000 for 10 periods, 8% per period
= $30,000 x PV factor for annuity due of 10 periods, 8%
= $30,000 x 7.25
= $217,500.
Example.
As of December 31, 2002, Sally Jones has worked with Webb Company for 25 years. Sally is expected to retire on December 31, 2007, and live for 10 years after retirement. Her current annual salary is $40,000 but her average annual salary for the last three years before retirement is expected to be $50,000.
Note that Sally’s salaries during the last three years before retirement and her expected life are the same as that of Jim Jones. Further, as of the date she retires, she also will have the same 30 years of service with the Company as Jim Jones. Thus, her pension benefits will be exactly the same as that of Jim Jones, and the Company’s obligation with respect to her pension is the same as the obligation for the pension of Jim Jones.
The difference is that Sally is expected to retire not tomorrow (as will Jim Jones) but only five years from now. The present value of Sally’s future pension obligation to the Company also will be $217,500 but that is as of the date Sally retires. Since Sally will retire only five years from now, that amount has to be discounted back to the present. Thus, as of December 31, 2002, the present value of the future pension obligation related to Sally is:
= Present value of a single sum of $217,500, due five years from now
Since the discount rate used by the Company is 8%, the present value is
= $217,500 x PV of single sum, five years from now at 8%
= $217,500 x 0.68
= $147,900.
This amount is known as the projected benefit obligation (PBO). This is the present value of all pension benefits earned by Sally Jones based on her past service to the Company.
Note the difference between the situations of Jim Jones and Sally Jones. In the case of Jim Jones, only one present value calculation was needed. That is because Jim is retiring today, and the present value of his pension benefits as of today is needed. In the case of Sally Jones, there was a two-step process. In the first step, the expected future obligation to the Company as of the date she will retire was calculated. In the second step, since Sally’s retirement is in the future, the present value of that amount as of today was calculated. Note that only the pension represents an annuity. The amount calculated in the first step represents a “single-sum equivalent” as of the date the employee will retire, so only a single-sum discounting is needed in the second stage.
The PBO was calculated using EXPECTED FUTURE SALARIES. Instead of using expected salaries, the present value of pension benefits earned by Sally Jones can also be calculated using her CURRENT AND PAST SALARIES. This amount is known as the accumulated benefit obligation (ABO).
Thus, the only difference between the PBO and ABO is that the PBO uses expected future salary levels while the ABO uses current and past salary levels. Since salaries are usually increasing over time, the PBO will usually be higher than the ABO.
Interest Cost and Service Cost
The PBO is a discounted present value amount. Any present value number automatically increases over time. For example, assume that today is December 31, 2002. Consider a single sum of $1,000 due five years from now (on December 31, 2007). If the interest rate used for discounting is 8%, the present value factor for discounting is 0.68. Thus, the present value of the $1,000 due five years from now equals $680 ($1,000 x 0.68) now.
Assume that one year has elapsed. There are only four more years left before the $1,000 becomes due. The present value of the $1,000 as of December 31, 2003 can be obtained by discounting the $1,000. The discount factor for four years at 10% per period equals .735, so the present value of the $1,000 as of now (that is, December 31, 2003) is $735.
This amount can also be calculated as follows. The present value due as of December 31, 2002 was $680. Since one year has gone by, this amount has “earned” interest at 8% for one year. Hence the interest on the $680 for one year equals $55 (8% of $680, with a small adjustment for rounding), and the total amount due as of December 31, 2003 equals $735 ($680 due as of December 31, 2002 plus one year’s interest of $55).
Thus, the rule is that any present value amount increases simply with the passage of time as it earns interest. Since the PBO is a present value amount, there is interest associated with the PBO each year. The interest cost is calculated based on the beginning balance of the PBO, and the settlement rate is used to calculate the interest.
Continuing with the Webb Company example, as one year goes by Sally Jones has worked for one more year. Based on the pension plan, she receives a 2% credit for each extra year she works for the Company. The average of her three highest salaries was assumed to be $50,000. Thus, by working one more year up to December 31, 2003, the extra pension she receives will be
= $50,000 x 2% per year x one year
= $1,000 per year.
Thus, the pension annuity increases by $1,000 because Sally Jones works for one more year. Since this is in the future, the present value of this extra annuity must be calculated as of now. Since Sally is expected to live for 10 years in retirement, the total present value of this extra $1,000 pension annuity as of the date she will retire will be
= $1,000 x Present value factor for annuity due, 10 years, 8% per period
= $1,000 x 7.25
= $7,250.
However, this is the present value as of the date Sally will retire which is December 31, 2007 or four years from December 31, 2003. So the present value of this extra benefit as of now (that is, December 31, 2003 –remember Sally has now worked for one more year) will be
= $7,250 x Present value factor for single sum, four years, 8% per period
= $7,250 x 0.735
= $5,329 (rounded).
This amount is known as the service cost and is the present value of the benefits attributed by the pension plan because the employee has worked during the current year.
Note the difference between interest cost and service cost. Interest cost arises simply because of the passage of time, regardless of whether or not the employee has worked during the year. Thus, interest cost will be relevant for all employees covered by the pension plan, irrespective of whether they are still working or have retired or have been laid-off by the Company during the year. Service cost arises because the employee has worked for one more year. Service cost will not arise for retired employees or for employees who did not work during the current year.
Prior Service Cost and Pension benefits
Companies may introduce a new pension plan or make changes to their existing pension plan. For example, a company may decide to adopt a new pension plan and give credit to current employees. For example, assume that the Webb Company introduced the pension plan during the year 2002. The Company may decide that employees will receive credit for their previous years of service with the company, as opposed to starting the benefits for everyone from scratch. That is, someone like Sally Jones who has worked for 25 years with the Company may get the credit for her past service with the Company on the day that the pension plan is adopted. This in turn means the Company has assumed new obligations on the day the pension plan was adopted.
Companies also may decide to change the terms of their pension plan. For example, Webb Company may decide that employees will receive a credit of 3% (as opposed to 2%) for each year of service with the Company. Such a change increases the obligations for the Company related to the pension plan.
Thus, the pension obligations of the Company change as a result of adopting a new plan or making changes to an existing plan. The present value of such changes in the obligations of the Company are known as prior service costs. The Company grants such extra benefits in appreciation of services rendered in the past, and expects to receive benefits in the future (in the form of happier employees who may be more loyal and work better). Thus, the extra benefits granted to the employees are accounted for as assets (because they are expected to provide future benefits). Hence, when pension benefits are newly granted or increased the obligations increase and an asset is recognized.
The journal entry when new pension benefits are granted is:
Debit Prior Service Costs (Asset)
Credit Projected Benefit Obligation (Liability)
Prior Service Cost is an intangible asset. Hence, it is amortized each period. The asset is amortized over the estimated useful service life of the employees, using the straight-line method. Assume that the Prior Service Cost when Webb Company introduced a new pension plan was $500,000 and that the estimated average remaining service life of the employees is 20 years. Then, the annual amortization of the Prior Service Cost will be $25,000 ($500,000 divided over 20 years). The journal entry for amortizing Prior Service Cost each period is
Debit Amortization Expense
Credit Prior Service Costs
Pension benefits are paid to employees after they retire. As the benefits are paid, the obligations of the company decrease. Hence, the PBO will decrease by the amount of pension benefits paid.
Recall that the PBO is a present value discounted number, and hence will increase with the passage of time. This is the interest cost associated with the PBO. Further, the PBO will increase during a period by the amount of the service cost.
This gives the following relationship:
PBO at the end of a year= PBO at the beginning of the year +
Current period service costs +
Interest cost on PBO for the period –
Benefits paid in current period
Review Question 1
- In a ______pension plan, the employer contributes a known amount (usually based on a specified percent of employee salary) to a pension plan.
- In a ______pension plan, the payments to be received by the employee is specified in the employment contract.
- The ______is the present value of all pension benefits earned by employees based on past service to a Company, using current and past salary levels.
- ______is a cost which arises each period merely because of the passage of time.
- ______is a cost which arises each period because the employee has worked for one more year.
- The ______is the present value of all pension benefits earned by employees based on past service to a Company, using expected future salary levels.
Answers
1. Defined contribution2. Defined benefit3. Accumulated benefit obligation
4. Interest cost5. Service cost6. Projected benefit obligation
Pension funding and Pension expense
Recall that defined-benefit pension plans specify the benefits but are silent about the funding each period. However, the Employee Retirement Security Act (ERISA) of 1974 specifies minimum funding standards. Management decides the amount of funding for the pension plan, subject to the requirements of ERISA.