💰Intermediate Financial Accounting II Unit 4 – Pensions and Post-Employment Benefits

Key Concepts and Definitions

• Pension plans are arrangements whereby an employer provides benefits to employees after they retire
• Post-employment benefits are non-pension benefits paid to employees after employment ends (health insurance, life insurance)
• Defined contribution plans specify the amount of contributions to be made by the employer to the pension fund
  • Employer's obligation is limited to making the specified contributions
  • Employees bear the investment risk and receive benefits based on contributions and investment returns
• Defined benefit plans specify the benefits that employees will receive when they retire
  • Employer bears the investment risk and must provide the promised benefits regardless of the performance of the pension fund
• Vested benefits are pension benefits that an employee has earned the right to receive, even if employment is terminated before retirement
• Accumulated benefit obligation (ABO) represents the actuarial present value of vested and non-vested benefits earned by employees as of a specific date
• Projected benefit obligation (PBO) represents the actuarial present value of vested and non-vested benefits earned by employees to date, considering expected future salary increases

Types of Pension Plans

• Defined contribution plans (401(k), 403(b)) specify the contributions made by the employer to individual employee accounts
  • Employer contributions are usually a percentage of the employee's salary or a match of employee contributions
  • Benefits paid to retirees depend on the amounts contributed and the investment returns earned on those contributions
• Defined benefit plans promise a specified monthly benefit at retirement, often based on factors such as salary and years of service
  • Employer is responsible for ensuring that the plan has sufficient assets to pay the promised benefits
  • Benefits are typically paid as an annuity over the retiree's lifetime
• Cash balance plans are a hybrid between defined contribution and defined benefit plans
  • Employer credits a specified percentage of an employee's salary to a hypothetical account each year, along with interest at a guaranteed rate
  • Account balance is converted to an annuity or lump sum payment at retirement
• Supplemental executive retirement plans (SERPs) provide additional benefits to high-level executives whose pension benefits may be limited by tax laws

Accounting for Defined Contribution Plans

• Accounting for defined contribution plans is straightforward since the employer's obligation is limited to making the specified contributions
• Employer contributions are recognized as pension expense in the period in which the contribution is due
  • Contributions are typically a percentage of covered employees' salaries
• Employer liabilities are recognized for any unpaid contributions at the end of the reporting period
• No further accounting is required for investment returns or benefits paid to retirees, as these are the responsibility of the employees
• Disclosures include the amount of pension expense recognized and any outstanding liabilities for unpaid contributions

Accounting for Defined Benefit Plans

• Accounting for defined benefit plans is complex due to the need to estimate future benefit payments and the fair value of plan assets
• Pension expense is recognized in the income statement and includes several components:
  • Service cost: actuarial present value of benefits earned by employees during the period
  • Interest cost: increase in the projected benefit obligation due to the passage of time
  • Expected return on plan assets: offset to pension expense based on the expected long-term rate of return on plan assets
  • Amortization of prior service cost: cost of retroactive benefits granted in a plan amendment, recognized over the remaining service period of active employees
  • Amortization of gains and losses: deferred recognition of differences between actual and expected returns on plan assets and changes in actuarial assumptions
• Employer's net pension liability or asset is recognized on the balance sheet
  • Projected benefit obligation (PBO) represents the present value of future benefit payments
  • Plan assets are measured at fair value
  • Net pension liability = PBO - Plan assets (if PBO > Plan assets)
  • Net pension asset = Plan assets - PBO (if Plan assets > PBO)

Pension Obligations and Plan Assets

• Projected benefit obligation (PBO) represents the actuarial present value of vested and non-vested benefits earned by employees to date, considering expected future salary increases
  • Determined using the projected unit credit method, which attributes benefits to periods of service under the plan's benefit formula
  • Actuarial assumptions (discount rate, salary increases, mortality rates) are used to calculate the PBO
• Accumulated benefit obligation (ABO) represents the actuarial present value of vested and non-vested benefits earned by employees as of a specific date, based on current salaries
  • Used to determine the minimum pension liability that must be recognized on the balance sheet
• Plan assets are investments held by the pension fund to provide benefits to retirees
  • Measured at fair value as of the balance sheet date
  • Actual return on plan assets is the change in fair value during the period, including realized and unrealized gains and losses
• Funded status of a pension plan is the difference between the PBO and the fair value of plan assets
  • If PBO > Plan assets, the plan is underfunded and a net pension liability is recognized
  • If Plan assets > PBO, the plan is overfunded and a net pension asset is recognized

Post-Employment Benefits Other Than Pensions (OPEB)

• OPEBs are benefits other than pensions that are provided to employees after retirement (health insurance, life insurance)
• Accounting for OPEBs is similar to that for defined benefit pension plans
  • Employer recognizes a liability for the actuarial present value of future OPEB payments (accumulated postretirement benefit obligation or APBO)
  • OPEB expense includes service cost, interest cost, expected return on plan assets (if any), and amortization of prior service cost and gains/losses
• Key differences between OPEB and pension accounting:
  • OPEBs are typically unfunded, meaning there are no dedicated plan assets to offset the APBO
  • Actuarial assumptions for OPEBs include healthcare cost trend rates in addition to discount rates and mortality rates
  • OPEBs may be amended or terminated more easily than pension benefits, which are often legally protected
• Employers may elect to recognize the unfunded APBO as a liability on the balance sheet or to disclose it in the notes to the financial statements

Financial Statement Presentation and Disclosure

• Pension and OPEB disclosures are required in the notes to the financial statements
• Disclosures include:
  • Description of the plan(s) and the benefits provided
  • Funding policy and changes in the policy during the period
  • Components of net periodic pension/OPEB cost
  • Reconciliation of the PBO/APBO and plan assets, showing beginning and ending balances, service cost, interest cost, contributions, benefits paid, and actuarial gains/losses
  • Funded status of the plan(s) and amounts recognized on the balance sheet
  • Weighted-average assumptions used to determine benefit obligations and net periodic cost (discount rate, salary increases, expected return on plan assets, healthcare cost trend rates)
  • Sensitivity analysis showing the effect of a one-percentage-point change in assumed healthcare cost trend rates on the APBO and service/interest cost
• Employers may also elect to present additional information, such as the ABO for pension plans or the fair value of plan assets by asset category

Current Issues and Trends in Pension Accounting

• Defined benefit plans have become less common as employers shift towards defined contribution plans to reduce risk and cost
  • Many employers have frozen their defined benefit plans, meaning no new participants are allowed and/or no additional benefits are accrued
• Low interest rates have increased pension liabilities by reducing the discount rates used to calculate the PBO
  • This has led to higher pension expense and required contributions for many employers
• Changes in mortality assumptions (longer life expectancies) have also increased pension liabilities
• Some employers have offered lump-sum payouts to retirees in lieu of lifetime annuity payments to reduce pension obligations
• Accounting standards for pensions and OPEBs continue to evolve
  • Recent updates have required the recognition of net pension/OPEB liabilities on the balance sheet (previously, only a minimum liability was required)
  • Disclosure requirements have been expanded to provide more transparency about plan assumptions and risks
• Convergence between U.S. GAAP and IFRS pension accounting standards is an ongoing process, with the goal of reducing differences and improving comparability across jurisdictions