How to Account for Pension Benefits – Part 1 – …definitions!
CFA Level 2 – Financial Reporting & Analysis; Study Session 6, Reading 24 in 2011 textbook/Reading 22 in 2010 textbook.
Part 1 of 2 – Types of Pensions Plans, Assumptions of Pension Plans, Impact of Assumptions on Obligations
Terminology & Formula
1. I/S = Income Statement, B/S = Balance Sheet, C/F = Statement of Cash Flows
2. PBO = Projected Benefit Obligation, ABO = Accumulated Benefit Obligation, VBO = Vested Benefit Obligation
Defined Benefit vs. Defined Contribution
|Defined Contribution||Defined Benefit|
|Asset Ownership||Employee owns assetsEmployer acts as agent||Employer owns assets via TrustEmployee is beneficiary|
|Who manages assets?||Employee||Employer via Investment Manager|
|Pre-funding||n/a||Contributions to Pension Trust|
|Income Statement||Employer Contribution = Expense||Expense Contribution|
|Balance Sheet||Exists on B/S only if there is Excess/Shortfall in payments relative to specified contribution|
|Issues for Analyst||None||Headache!|
Types of Defined Benefits
|PV of future pension benefits earned to date based on expected salaries over time||PV of future pension benefits earned to date based on current salary||Portion of ABO that has vested (full pension is not always offered on day 1 of employment)|
|Assumes employee works till retirement|
|Estimate of liability on a going concern basis||Estimate of liability on a liquidation basis|
PBO is by far the most important and the rest of this reading focuses on PBO.
Components of PBO
· Service cost – PV of pension benefits earned for 1 extra year… i.e. pension benefits earned this year.
· Interest cost – increase in PBO resulting from passage of time… e.g. interest earned on prior year’s PBO
· Actuarial Gains/Losses – resulting from change in actuarial assumptions like retirement age, discount rate, rate of salary increase, mortality, etc
Impact of Assumptions on PBO
The above three assumptions are required to be disclosed in the financials.
Assumptions should be consistent internally and over time i.e.
1. Compensation growth rate should be in line with inflation rate
2. Discount rate should be inline with expected rate of return on assets