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
Risk	Employee	Employer
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

PBO	ABO	VBO
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

Source: Schweser Level 2 2010

 

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

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