A pension plan is an agreement between the employer and the employees such that, under prespecified conditions, the employer provides for cash payments to the employees when they retire. Because of abuses against workers, Congress passed the Employee Retirement Income Security Act (ERISA) in 1974. In turn, ERISA created the Pension Benefit Guaranty Corporation (PBGC), which oversees certain aspects of pension plans; for example, it ensures that corporations with certain types of pension plans contribute at least minimum amounts to those plans. The OPEBs address other benefits— in practice, these benefits primarily involve health plans—but there is no law governing corporate use of OPEBs in the way that ERISA impacts pension plans.
Below exhibit displays a schematic for a typical pension plan:
Business Enterprise–[Cash Contributions]–> Pension Plan–[Payments]–> Retirees
The business enterprise constructs a plan with its employees and lays out the details with them. The employees may be organized in a union, in which case the pension plan likely results from a negotiation process between the business enterprise and the union. Here we assume that the plan has been approved between the two parties.
The employer or business enterprise carries out two main functions. The recording function determines in the aggregate the amount of the pension expense, the pension assets, and the pension liabilities. Once these items are computed, the firm records some of them in its books and reports them in the financial statements. The company also decides how much cash to contribute to the pension plan. Keep in mind that the corporation does not directly pay the employees; rather, the entity contributes cash to the pension plan, which in turn pays the retired workers whatever the agreement says. The PBGC and ERISA specify the minimum amount that the corporation must contribute to the pension plan. Of course, the corporation records the cash flow to the pension plan in its own books.
The pension plan is itself a business entity. It receives cash from the employer, and it invests this money in stocks and bonds and other investments. ERISA requires these investments to be placed into low-risk assets so that employee pension funds will be protected. Earnings from these investments are added to the pension assets. The pension fund also has the responsibility to pay out funds to retirees. Of course, the plan must account for these transactions between itself and the employer, its investments and its returns on the investments, and those transactions between itself and the qualified former employees. Reports of many pension plans must be filed with the SEC.
The retirees, of course, receive the cash benefits from the pension plan. As stated before, the corporation establishes these amounts in the terms of the pension contract. Healthcare plans and other OPEBs usually are not structured like the pension plan in the above exhibit. Instead, the firm either determines and makes the payments to the employees, or it outsources this activity to some independent firm, such as an insurance firm. There are no special reporting requirements for healthcare plans.
Types of Pension Plans
Employees become vested in a pension plan when they earn the right to receive funds from the company upon retirement. If the plan does not require the employees to ante up money into the pension fund, the plan is noncontributory. Those plans that require some payment by the employees are termed contributory plans. In a funded retirement plan, the employer sends money to an independent entity, which then handles the investments and the disbursements of funds to employees. If the employer keeps control over the pension funds, the plan is called unfunded. Note that these latter terms should not be confused with funding policy, which refers to the employer’s decisions about the amounts and the timing of disbursing funds to the pension plan. The plan is overfunded if the pension assets exceed the pension liabilities but underfunded when the reverse is true.
There are two major types of pension plans: “defined contribution plans” and “defined benefit plans“:
Defined Contribution Plans
In a defined contribution plan, the employer (and sometimes the employee as well) promises to contribute so much money into the pension fund, the amounts and The timing determined by the arrangement between employer and employees. The pension plan uses the funds to make investments until the employee retires. How much money the employee receives upon retirement depends on how much money the employer contributed to the plan and how well the plan managed its investments. There is no guaranteed amount of money to be received by the retiree.
Accounting for and reporting on defined contribution plans are easy. The accountant ascertains how much the employer needs to contribute to the plan and records this short-term payable. The firm then pays this cash to the pension plan, and the accountant records the cash outflow and the reduction in the short-term payable. The key point is that the business enterprise has no long-term payable for how much the retired employees deserve, for the firm has incurred no such obligation.
Below exhibit shows the disclosure by Starbucks about its defined contribution plan:
Defined Contribution Plan Disclosure [from Starbucks 10K Dated September 30, 2001]
Starbucks maintains voluntary defined contribution plans covering eligible employees as defined in the plan documents. Participating employees may elect to defer and contribute a percentage of their compensation to the plan, not to exceed the dollar amount set by law.
For certain plans, the Company matches 25 percent of each employee’s eligible contribution up to a maximum of the first 4 percent of each employee’s compensation. The Company’s matching contributions to the plans were approximately $1.6 million, $1.1 million, and $0.9 million for fiscal 2001, 2000, and 1999, respectively.
Starbucks supplies a brief description about the mechanics of the pension plan and reveals the amounts of the cash contributions to the pension plan. That tells the whole story under a defined contribution plan. Because these plans do not involve hidden debt, I say little more about them.
Defined Benefit Plans
A defined benefit plan is one in which the employer promises to pay so much when employees retire, the amounts determined by the arrangement between the employer and the employees. The employer has considerable flexibility in deciding how much and when the cash contributions are paid to the pension plan, of course subject to the requirements of ERISA and PGBC. Unlike defined contribution plans, defined benefit plans encumber employers with long-term liabilities because they are in fact promising to pay their employees certain guaranteed amounts. Measuring this liability and the year-to year costs is a major challenge to accountants. Appreciating this pension debt is critical to investors and creditors, who also need to comprehend some of the arbitrary rules concerning pension costs and concerning the inappropriate netting of pension assets and pension liabilities.
To quickly grasp the enormous difference between defined contribution plans and defined benefit plans, read the disclosure by General Mills below:
Defined-Benefit Plan Disclosure [from General Mills 10K Dated May 25, 2002]
We have defined-benefit retirement plans covering most employees. Benefits for salaried employees are based on length of service and final average compensation. The hourly plans include various monthly amounts for each year of credited service. Our funding policy is consistent with the requirements of federal law. Our principal retirement plan covering salaried employees has a provision that any excess pension assets would vest in plan participants if the plan is terminated within five years of a change in control.
We sponsor plans that provide health-care benefits to the majority of our retirees. The salaried health-care benefit plan is contributory, with retiree contributions based on years of service. We fund related trusts for certain employees and retirees on an annual basis. Trust assets related to the above plans consist principally of listed equity securities, corporate obligations and U.S. government securities.
Note the complexity of this disclosure versus the simple disclosure by Starbucks in the first exhibit. In this footnote to its annual report (10K), General Mills describes briefly its defined benefit plan. Afterward, it divulges the fair value of the pension assets and the projected benefit obligation, including their components, and then nets them to what is called the “funding status” of the pension plan. General Mills then provides three line items unrecognized in the accounts. Later it discloses the assumptions it made when computing these various components. Last, the firm states what it recognizes as pension cost, showing the various details behind that calculation.
Accounting for OPEBs is virtually the same as the accounting for defined benefit pension plans. Most U.S. companies do not set aside cash for these healthcare and other plans, so the fair value of the assets is zero; General Mills is an exception to this observation. Exhibit 5.3 also contains a typical set of disclosures. Notice that since the accounting for OPEBs is so much like that of defined benefit pension plans, the two can be reported together in the footnote schedules.
The fundamental difference between these two types of plans is who bears the risks of not having enough assets in the plan when workers retire. In defined benefit plans, the corporation bears the risk. If there is a shortfall, the employer must make up the difference. In defined contribution plans, the employees bear the risk. When there is a shortfall, then the workers obtain less cash during their retirement years.
Corporate Pension Highlights
These remarks help us understand recent corporate events with respect to pensions and OPEBs. Pension costs are a function of what the firm promises to its employees, the interest rate, and changes to the pension plan. In addition, as the pension fund generates returns, these gains reduce the pension cost. (Losses, of course, would increase the pension cost.) Afew months ago, Northwest Airlines reported that its pension costs would exceed $700 million in the fourth quarter. Chevron Texaco will take a pension hit of $500 million. In particular, the weak financial markets will depress earnings by pension funds and thus boost pension costs.
The balance sheets are also under attack. The PBGC states that unfunded pension liabilities increased from $26 billion in 2000 to $111 billion in 2001. This fourfold increase in pension debts foreshadows some potentially dramatic problems in corporate America and on Wall Street unless either business enterprises can pump cash into the pension plans or the economy rebounds sufficiently to produce good returns on the pension assets.
The cash flow statement can be severely impacted as well, as General Motors recently added $2.6 billion into its pension fund.
IBM has contributed close to $4 billion, Ford will put up almost $1 billion, and many other corporations will have to make up the shortfalls. These ideas also help us understand why so many companies in recent years have modified their pension plans. For example, IBM announced in 2000 that it would shift from its traditional defined benefit pension plan to a cash-balance plan.
Recently Delta Air Lines did the same. Traditional defined benefit plans determine the pensions as a function of the employees’ last years of work, while cash-balance plans compute the pension payments on the basis of the average salary earned over the employee’s entire career with the firm. This change reduces the benefits to the workers and so reduces pension costs to the firms.
Yet another tactic is tapping an underfunded pension plan by selling it the firm’s stock, which Navistar recently did. This is an interesting way of taking a weak pension plan and making it weaker. Not only does management take cash out of the pension plan so less cash is available to the retirees, but also the pension plan is left with the less valuable and undiversified stock of the company.
Basic Example Of Pension Accounting
This spost continues to focus on defined benefit plans, and I develop the concepts through an example:
No. 1 Finance begins operations with one employee named Lie Dharma. Management offers Lie Dharma suitable compensation plus a defined benefit pension package. The firm estimates that Lie Dharma will work for five years, retire, and then live another five years. These projections have to be made so that the company can estimate how much it will owe him for the promised pension and estimate the cost to the business enterprise. For each year of work Lie Dharma will receive $1,000 at the end of each year during retirement. No. 1 Finance estimates an interest rate on pension obligations of 6 percent and that it can earn 10 percent on its pension assets. The funding policy of No. 1 Finance is to contribute $2,000 at the end of each year that Lie Dharma works for the company.
The service cost is the cost to the employer incur Lie Dharma as the result of the employee’s working for the firm and earning pension benefits upon retirement. In the case of No. 1 Finance, for each year that Lie Dharma works, the company must pay him $1,000 per year during retirement, which we assume lasts five years.
These cash flows constitute an ordinary annuity. With an interest rate of 6 percent, No. 1 Finance would compute this present value as $4,212. But this present value is as of the date Lie Dharma retires, when time t = 0. When No. 1 Finance prepares its income statement for the year ending at t = ?4, it will need to discount this amount back another four years. Treat the $4,212 as a single sum and discount it back four years at 6 percent, and the present value is $3,337; this is the service cost for that year. When Lie Dharma works a second year, he will earn another pension benefit of a second $1,000 each year during retirement. To obtain the service cost for the next year, No. 1 Finance will discount the $4,212 back to the year ending at t = ?3, so the present value is $3,537. In like manner, No. 1 Finance establishes that the service cost for Lie Dharma’s third, fourth, and fifth years of work is $3,749, $3,974, and $4,212.
Note: Projected benefit obligation measures how much the business enterprise will have to pay out for the employee’s pension in today’s terms. Projected benefit obligation and service cost are similar inasmuch as the entity determines the present value of the ordinary annuity at the date of retirement and then the present value of this amount for both constructs. The projected benefit obligation differs from the service cost because service cost quantifies the effects of only that year’s impact on the pension commitments, while the projected obligation assesses the cumulative effect from all the years worked by the employees.
Consider Lie Dharma’s second year of work. The service cost measures the present value of the incremental $1,000 per year he will receive during retirement, and this service cost is $3,537. To measure the projected benefit obligation, we must realize that Lie Dharma will get $2,000 per year during retirement since he has worked two years for No. 1 Finance, each year earning him $1,000 per year during retirement. The projected benefit obligation is a present value of $2,000 per year for five years, and this present value is $8,424 at time t = 0. Discounting this back for the financial statements ending time t = ?3, the projected benefit obligation is $7,074. An easy shortcut for computing this is to multiply the numbers of years worked by the current year’s service cost (2 times $3,537 equals $7,074). Similarly, the projected benefit obligation for the next three years is $11,247, $15,896, and $21,062, respectively.