Accounting For Pensions

So far I wrote about accounting for debt, leases, taxes, and stock compensation. You can find them all here. Some companies pay its retired employees for services they provided in their working years. These payments are called as pensions, which is the topic of this post. In every pension plan, three entities are involved (1) company or employer who sponsors the pension plan (2) fund or plan that receive contributions from the company and invests them to generate earnings (3) retired employees who receives the benefit payments from the fund. The diagram from the book Intermediate Accounting shows the relationship between these entities.

1. Defined Contribution and Benefit Plans

The two most common types of pension plans are defined contribution plans and defined benefit plans. In a defined contribution plan, the company contributes to a pension trust a certain sum each period. The best example of a defined contribution plan is a 401K account. In this arrangement, an employee contributes up to $17,500 pretax to his 401K account. The company in turn will agree to match some percentage of this amount.

For example, some companies does 50% match. This means that if an employee contributes $17,500 to his 401K account then the company contributes $8,750. Once the company does the contribution it’s off the hook. It does not promise any future benefit to its employees. And it’s the responsibility of the employee to bear all the investment risk.

The accounting for a defined contribution plan is straightforward. The employee gets the benefit of gain (or the risk of loss) from the assets contributed to the pension plan. The employer simply contributes each year based on the formula established in the plan. As a result, the employer’s annual cost (pension expense) is simply the amount that it is obligated to contribute to the pension trust. The employer reports a liability on its balance sheet only if it does not make the contribution in full. The employer reports an asset only if it contributes more than the required amount. – Intermediate Accounting

In a defined benefit plan, the company must determine what it should contribute today so that it will have sufficient funds to pay the retirees in the future. The amount of pension each employee will receive in the future is a function of (1) length of service (2) pay in the last few years before the retirement. But this information deals with future which is unknowable in the present. Then how does the company know what it’s future obligations are going to be? The honest answer is it doesn’t.

But it makes an educated guess by using actuaries. An actuary is a business professional who deals with the financial impact of risk and uncertainty. So the actuary has to guess many future variables including employee turnover, mortality, length of service and compensation levels. This future obligation is discounted back to present using an appropriate interest rate. In a defined benefit plan the company is responsible for meeting future obligations and bears all the investment risk. Don’t worry if this is not clear. In the next section I will clarify it with a working example. For now think of defined benefit plans as Promise-Now-Pay-Later.

Because a defined benefit plan specifies benefits in terms of uncertain future variables, a company must establish an appropriate funding pattern to ensure the availability of funds at retirement in order to provide the benefits promised. This funding level depends on a number of factors such as turnover, mortality, length of employee service, compensation levels, and interest earnings. Employers are at risk with defined benefit plans because they must contribute enough to meet the cost of benefits that the plan defines. – Intermediate Accounting

Defined contribution plans are much cheaper costing 3% of payroll than defined benefit plans which costs 6%. Hence several companies have ditched defined benefit plans in favor of defined contribution plans.

2. Defined Benefit Plan – A Working Example

On 01-Jan-2013, TestCo announced a defined benefit plan for its full time employees. Under this plan (1) an employee will receive pension for 20 years starting at the age of 65 (2) an employee should have worked for at least 10 years to become eligible for receiving pension (3) for each year of service the employee will receive $1,000 per annum as pension. TestCo has only one employee and he joined on 01-Jan-2013. At the time of joining he was 45 years old. During the year TestCo contributed $1,000 to its pension fund. Using this information let us find out what is the pension obligation of TestCo on 31-Dec-2013.

At the end of 2013, we know that the employee completed one year of service. Let us assume that the employee will stay with TestCo until his retirement. If that is the case then TestCo should pay $1,000 each year for 20 years starting from 01-Jan-2033. Using a 10% discount rate, the present value for this future annuity stream is $1,392.04. I came up with this value by using the excel function [ -PV(0.10, 20, $1,000) / (1.1)¹⁹ ]. Make sure you really understand the math behind this. This cost of $1,392.04 is called as service cost which is the present value of the projected retirement benefits earned by the employees in the current period. How did TestCo come up with a 10% discount rate? It was the prevailing interest rate during 2013.

At the end of 2013, TestCo will prepare a pension worksheet which is given below. Few things to note are (1) service cost of $1,392.04 increases its pension liability by that amount (2) contributions of $1,000 increases the plan asset by that amount (3) total pension expense of $1,392.04 is reported as an expense in the income statement (4) the difference between its obligations and assets comes to $392.04 and it is kept as a liability in the balance sheet. At the end of 2013, TestCo’s pension liability exceeds the pension asset by $392.04 [$1,392.04 – $1,000]. Hence the pension plan is underfunded. Had pension assets exceeded the pension liabilities then the plan would have been overfunded.

At the end of 2013 the company will post the following journal entry. The details about the plan assets and its obligations are kept out of the financial statements. Hence they are called as off balance sheet items. The only items that you will see in the financial statements are (1) pension expense of $1,392.04 in the income statement (2) difference between pension liability and asset of $392.04 in the balance sheet as a liability.

31-Dec-2013 Dr. Pension Expense $1,392.04        -- Goes to the income statement
               Cr. Cash                $1,000.00
               Cr. Pension Liability     $392.04 -- Goes to balance sheet as a liability

In the year 2014, TestCo invested its plan assets in equities and earned a decent return of 15%. Also it contributed $1,200 to its pension fund. Using this information let us find out what is the pension obligation of TestCo on 31-Dec-2014. At the end of 2014, TestCo’s only employee would have completed one more year of service. So the present value of his service cost will be $1,531.24. I came up with this value by using the excel function [ -PV(0.10, 20, $1,000) / (1.1)¹⁸ ]. The only difference between this and the previous calculation is that the number of years is reduced from 19 to 18 as the employee is one year closer to his retirement.

At the start of 2014, TestCo had a pension liability of $1,392.04. At the end of 2014, this liability will incur a cost of $139.20 at 10% interest. Why is that? Because TestCo defers paying the liability until maturity, it records it on a discounted basis. The liability then accrues interest over the life of the employee. Take a look at the calculations given below which explains this concept in greater detail. This cost of $139.20 is called as an interest cost.

Case 1:

Pension obligation on 01-Jan-2014 = $1,392.04
Service cost for 2014             = $1,531.24 +
Interest cost for 2014            =   $139.20 +
                                    ---------
Pension obligation on 31-Dec-2014 = $3,062.48
                                    ---------

Case 2:

Employee completed 2 years of service       = $2,000 for 20 years from 01-Jan-2033
Value of this annuity stream on 01-Jan-2033 = $17,027.13
Discounting $17,027.13 to 31-Dec-2014       = $3,062.48 [$17,027.13 / (1.1)18]

You can see that Case 1 and 2 are the same.
But FASB wants all the companies to follow Case 1, rightly so.
This way we can see the service cost and interest cost separately.

At the end of 2014, TestCo will prepare a pension worksheet which is given below. Few things to note are (1) total pension expense of $1,520.44 will be reported in the income statement (2)  return on plan assets of $150 increases the plan assets and reduces the pension expense by that amount (3) the pension plan is underfunded by $712.48 which will be shown in the balance sheet as a liability. The journal entry given below should be self explanatory. Spend some time to make sure you really understand the worksheet and the journal entry.

31-Dec-2014 Dr. Pension Expense $1520.44        -- Goes to the income statement
               Cr. Cash               $1,200.00
               Cr. Pension Liability    $320.44 -- Added as liability in the balance sheet

In the table given below, I have summarized the effects caused by each item on pension expense, assets and obligations.

3. Smoothing and Corridor Amortization

In the last example, TestCo’s pension plan assets returned 15% as the equity markets did very well. What would have happened if the markets went down instead? It would have resulted in a loss which in turn would have reduced the net income. We all know that capital markets are very volatile. If the companies used the actual capital market returns then its net income will be very volatile. FASB didn’t want this volatility. So it introduced a concept called as smoothing. In this every company will come up with an expected return (incentive caused bias) on plan assets which will be shown in the income statement. The difference between expected return and actual return will be kept in accumulated other comprehensive income (AOCI) as a gain or loss. Don’t worry if you didn’t get the last line. I will clarify this with an example.

Let us assume that in 2014, TestCo assumed an expected rate of return on plan assets at 10%. But the actual return came out to be 50%. Take a look at the worksheet which handles this difference. Few things to note are (1) the capital markets returned $500. But from the pension expense, only the expected return of $100 is deducted (2) the excess gain of $400 is kept in another account called as AOCI (3) the excess gain of $400 increases the fund assets and this in turn brings down the fund liability. The plan is still underfunded by $362.48 and this amount is kept in the balance sheet on the liability side. The journal entry given below should be self explanatory. Spend some time to make sure you really understand the worksheet and the journal entry.

31-Dec-2014 Dr. Pension Expense $1,570.44
            Dr. Pension Asset      $29.56
              Cr. Cash                       $1,200.00
              Cr. Other Comprehensive Income   $400.00

The difference between expected and actual gains/losses will offset each other over a very long period. But, it is possible that no offsetting will occur and the balance in the AOCI account related to gains and losses will continue to grow. In order to avoid this FASB invented the corridor approach. Let me explain this concept with an example.

To limit the growth of the Accumulated OCI account, the FASB invented the corridor approach for amortizing the account’s accumulated balance when it gets too large. How large is too large? The FASB set a limit of 10 percent of the larger of the beginning balances of the projected benefit obligation or the market-related value of the plan assets. Above that size, the Accumulated OCI account related to gains and losses is considered too large and must be amortized. – Intermediate Accounting

In the year 2015, TestCo invested its plan assets in equities and its expected return matched the actual return of 10%. Also it contributed $2,000 to its pension fund. Using this information let us find out what is the pension obligation of TestCo on 31-Dec-2015. In the worksheet given below most of the items are self explanatory except the amortization of gain. The calculations for how I arrived at the amortization gain of $5.51 is given below. The pension plan is still underfunded by $83.09 and this amount is kept in the balance sheet on the liability side.

Corridor Rule:

Max (Pension Benefit Obligations, Plan Assets)
Max ($3,062.48, $2,700) => $3,062.48
10% of 3,062.48 => $306.25

AOCI Pension gain is $400 which is greater than $306.25
Difference ($400.00, 306.25) => $93.75

Amortizing $93.75 over the remaining 17 year employee service period => $5.51

31-Dec-2015 Dr. Pension Expense            $1,715.10
            Dr. Other Comprehensive Income     $5.51
            Dr. Pension Asset                $279.39
                    Cr. Cash                       $2,000.00

4. Looking at Pensions of Berkshire Hathaway

Pension accounting involves lots of assumptions about the future. But the truth is that nobody knows the future. As an investor we need to look at management assumptions for three key variables. They are (1) discount rate; higher rates decreases pension liabilities and expense (2) rate of salary increase; lower rates decreases pension liabilities and expense (3) expected return on plan assets; higher rates decreases pension expense.

How did Berkshire do on these variables? From the chart given below you can see that Berkshire has been very conservative in their estimates. It’s discount rate has been trending down which matches with the low interest rate environment. This will result in higher pension obligations and expense. It’s rate of compensation increase is almost flat at 3.5% trending the long term inflation rates. It’s expected return on assets stayed flat at around 6.8%. Berkshire pension accounting is the gold standard using which one should compare the conservativeness of other companies.

The next important thing one should check for is the pension plan status. That is we need to know if the plan is underfunded or overfunded. If it’s underfunded, we need to know by how much. From the table given below we can clearly see that Berkshire’s pension plan is underfunded by $2,521 million. I would not worry about this as Berkshire has boatloads of cash in its balance sheet.

Closing Thoughts

It took a lot of time for me to assimilate the concepts behind pension accounting. I learnt all this from three major sources (1) Berkshire annual letter 2013; page 120 (2) Investopedia; Advanced Financial Statement Analysis (3) Chapter 20 from the book Intermediate Accounting. In order to keep the post relatively short, I skipped some of the items like prior service cost, benefits, and changes to pension liabilities. With this post, I am concluding the series on arcane accounting concepts. While writing this post, I ordered the fantastic book given below. Some time back Buffett advised a teenager to take up a course on accounting. If you believe in the advice then sign up for a free accounting course.