Financial Accounting II Unit 8 Review: Pensions & Postretirement Benefits

Key Concepts

• Pensions provide employees with retirement income based on factors such as years of service and compensation levels
• Postretirement benefits include health care, life insurance, and other benefits provided to retired employees
• Defined benefit plans specify the benefits an employee will receive upon retirement, with the employer bearing the investment risk
• Defined contribution plans specify the contributions made by the employer, with the employee bearing the investment risk (401(k) plans)
• Pension obligations represent the present value of future benefits earned by employees
  • Actuarial assumptions (discount rates, life expectancy) are used to calculate pension obligations
• Pension expenses include service cost, interest cost, and amortization of prior service cost and actuarial gains/losses
• Plan assets are investments held by the pension fund to meet future benefit payments
• Funded status is the difference between plan assets and pension obligations, reported on the balance sheet

Types of Pension Plans

• Defined benefit plans provide a specified benefit to employees upon retirement, based on factors such as years of service and compensation levels
  • Employer bears the investment risk and must fund any shortfall in plan assets
  • Benefits are typically paid as an annuity over the employee's retirement years
• Defined contribution plans specify the contributions made by the employer to individual employee accounts (401(k), 403(b))
  • Employee bears the investment risk and receives the balance in their account upon retirement
  • Employer's obligation is limited to making the specified contributions
• Cash balance plans are a hybrid between defined benefit and defined contribution plans
  • Employer credits a specified percentage of an employee's compensation to a hypothetical account each year
  • Account balance grows based on a guaranteed rate of return, providing a predictable benefit to employees

Accounting for Defined Benefit Plans

• Pension obligations are measured using the projected unit credit method, which attributes benefits to periods of employee service
• Service cost represents the present value of benefits earned by employees during the current period
• Interest cost is the increase in the pension obligation due to the passage of time, calculated using the discount rate
• Actuarial gains and losses result from changes in actuarial assumptions or differences between actual and expected experience
  • Gains and losses are amortized over the average remaining service period of active employees
• Prior service cost arises when a plan is initiated or amended, and is amortized over the remaining service period of affected employees
• Plan assets are measured at fair value, with actual returns recognized in the period they occur

Pension Obligations and Expenses

• Projected benefit obligation (PBO) is the present value of future benefits attributed to employee service rendered to date, considering future salary increases
• Accumulated benefit obligation (ABO) is the present value of benefits earned to date, based on current salaries
• Pension expense includes the following components:
  • Service cost: Present value of benefits earned during the current period
  • Interest cost: Increase in PBO due to passage of time
  • Expected return on plan assets: Offset to pension expense based on expected long-term rate of return
  • Amortization of prior service cost: Portion of cost from plan initiation or amendment recognized in current period
  • Amortization of actuarial gains/losses: Portion of gains/losses outside the "corridor" recognized in current period
• Net periodic pension cost is the sum of the above components, recognized as an expense in the income statement

Plan Assets and Funding

• Plan assets are investments held by the pension fund to meet future benefit obligations
  • Assets may include stocks, bonds, real estate, and other investments
  • Actual returns on plan assets are recognized in the period they occur
• Funded status is the difference between plan assets and the projected benefit obligation
  • Overfunded plans have assets exceeding the PBO, resulting in a net pension asset on the balance sheet
  • Underfunded plans have a PBO exceeding assets, resulting in a net pension liability on the balance sheet
• Employers may make contributions to pension plans to maintain adequate funding levels
  • Minimum contributions are required by law to avoid penalties
  • Employers may make additional discretionary contributions to improve funded status or reduce future pension expense

Actuarial Assumptions and Calculations

• Discount rate is used to calculate the present value of future benefit payments
  • Typically based on high-quality corporate bond yields with maturities matching the timing of expected benefit payments
• Expected long-term rate of return on plan assets is used to calculate the expected return component of pension expense
  • Based on the composition of plan assets and long-term capital market assumptions
• Mortality rates and life expectancy assumptions affect the projected benefit payments
  • Longevity improvements may increase pension obligations over time
• Salary increase assumptions are used to project future benefit levels for plans based on final or average pay
• Actuarial cost methods, such as the projected unit credit method, attribute benefits to periods of employee service
  • Different methods may result in different patterns of cost recognition over time

Postretirement Benefits Other Than Pensions

• Other postretirement benefits (OPEBs) include health care, life insurance, and other benefits provided to retired employees
• Accounting for OPEBs is similar to pensions, with obligations measured using actuarial assumptions and attributed to periods of service
  • Key differences include the impact of health care cost trends and the absence of plan assets in most cases
• Accumulated postretirement benefit obligation (APBO) represents the present value of future benefits attributed to service rendered to date
• Net periodic postretirement benefit cost includes service cost, interest cost, and amortization of prior service cost and actuarial gains/losses
• Employers may fund OPEBs through contributions to a trust or on a pay-as-you-go basis
  • Funded status is reported on the balance sheet as the difference between the APBO and any plan assets

Financial Statement Reporting and Disclosures

• Balance sheet reports the funded status of pension and OPEB plans as a net asset or liability
  • Overfunded plans result in a net asset, while underfunded plans result in a net liability
• Income statement reports the net periodic pension cost and net periodic postretirement benefit cost as components of operating expenses
• Comprehensive income reports actuarial gains and losses, prior service costs, and other changes in plan assets and obligations not yet recognized in net periodic cost
• Footnote disclosures provide detailed information about pension and OPEB plans, including:
  • Description of the plans and benefits provided
  • Actuarial assumptions used in measuring obligations and costs
  • Changes in benefit obligations, plan assets, and funded status during the period
  • Components of net periodic cost and expected future benefit payments
  • Sensitivity of obligations and costs to changes in key assumptions (discount rate, health care cost trends)