II - Provisions: Specific points and Examples
2. Employee Benefits
2.2. Accounting for Post-Employment Benefits
2.2.3. Defined Benefit Obligation
Expected Return on Plan Assets
2.2.3.1. Defined Benefit Obligation (DBO)
- Commitment made by employer to pay benefits to participants in the future, means employer has a “liability”
- Is calculated by the plan actuary:
- using actuarial techniques
- using assumptions
- following IAS 19 requirements
- Depends on, for example:
- level of benefits (e.g. formula)
- expected date of leaving
- current salary projected into the future
- life expectancy
- IAS 19 requires use of Projected Unit Credit (“PUC”) actuarial cost method to value liabilities
- Project total expected benefits for all members
- based on expected future salary increases
- allowing for probabilities of all future events (turnover, mortality etc.)
- Calculate present value of total obligation using discount rate
- Liability (Defined Benefit Obligation - DBO) is the portion of the present value of total expected benefits allocated to the past, based on service rendered to date
- Meaning of “allocated” depends on required attribution
- attribute benefit to periods of service under plan’s benefit formula, UNLESS
- plan is “backloaded”: Service in later years will lead to a “materially higher level of benefit” than in earlier years, in which case: attribute benefit on a “straight-line basis”.
- Project total expected benefits for all members
- DBO = Projected Benefit Obligation (PBO) = Actuarial present value of the projected benefits (i.e. based on projected salaries) allocated to years prior to the current year.
Example:
2.2.3.2. Asset - Fair Value of plan Assets (FVA)
- Today’s market value of assets (shares, bonds, property) set aside for meeting payment of post-employment benefits
- The assets must:
- be in a fund separate from the company
- only be available to pay participants’ benefits
- not available to creditors
- If they don’t meet these criteria
- including receivables; investments earmarked but available for other purposes; then
- “unfunded” and Fair Value of plan Assets is ZERO
- Employer stock held by plan is plan asset as long as stock is transferable, i.e., it can be sold on open market.
2.2.3.3. Unrecognized Past Service Costs
- If a company improves (or worsens) past service-related benefits, the amount of commitment to pay benefits to participants changes.
- IAS 19 requires companies to:
- recognize vested (= already occured) component immediately in P&L
- recognize the remainder (unvested component) over average period of vesting
- The vested component is the one which is not conditional on future employment
- “Unrecognized Past Service Cost” is the unvested amount, i.e. that which has yet to be recognized in P&L
- Uncommon in practice (i.e. most pension benefit changes are fully vested)
- Crucial to be aware of potentially significant one-off impact on P&L
- Examples of Unrecognized Past Service Costs:
- Fully vested past service cost: èOne-off increase to annual pension amounts for current pensioners in excess of valuation assumptions. For example:
- no allowance for pension increases in DBO
- one-off pension increase of 3% granted
- DBO increases by 100 MEUR
- This year’s pension expense (P&L charge) increases by 100 MEUR, i.e. fully recognized
- Unrecognized Past Service Cost = 0
- Partially vested past service cost: èChanges in a post-retirement medical plan
- Fully vested past service cost: èOne-off increase to annual pension amounts for current pensioners in excess of valuation assumptions. For example:
2.2.3.4. Asset Ceiling
- If plan assets > DBO, it's not allowed to recognize the Net Liability (... which is an asset in such a case)
- Idea is to recognize a surplus (FVA – DBO) on the balance sheet only to the extent that it is “available” to the company (represents economic value)
- Irrecoverable Surplus = IAS 19 Surplus – Present Value (PV) of Economic Benefits from the surplus. Irrecoverable Surplus (usually) leads to an immediate reduction in balance sheet asset (“reserve against prepaid”).
This surplus is recorded in OCI (Equity). - Read more on Asset Ceiling
2.2.3.5. Net Liability
- Is the difference between the DBO and the other components
- What elements are impacting a change in the Net Liability:
- Service cost
- Interest costs
- Expected Return on Plan Assets
- Expected Employer Contributions
- Actuarial Gains and Losses
- "Special Events"
Service cost
= Actuarial present value of the projected benefits allocated to the current year; or in other words, the cost of one-year’s pension plan benefit accrual, taking into account future salary increases/inflation.
- Is calculated by the plan actuary
- using actuarial techniques and assumptions
- following IAS 19 requirements
- Depends on factors such as:
- level of benefits (e.g. formula)
- expected date of leaving
- current salary projected into the future
- life expectancy
- Is an expense item
Interest costs
= Growth in DBO during current year due to time value of money.
- Generally includes interest cost on service cost
- Discount rate x DBO at beginning of year
- Factor out effect of expected benefit payments
- Factor in benefits earned during year
- Is an expense item
Expected Return on Plan Assets
= Increase in value of plan assets due to expected investment returns during current year
- Expected rate of return x Plan Assets at beginning of year
- Factor out effect of expected benefit payments
- Factor in expected contributions
- Gives credit for returns expected to be earned by any assets owned by the plan
- Is an income item
- Apply long-term expected returns to P&L this year
- Can have large impact on P&L expense
- Subject to increasing scrutiny
Expected Employer Contributions
= Amount of money expected to be paid into the plan by participants over the year
- Applies where Defined Benefit plans require participants to contribute at a specified rate, with company paying the balance of the cost
- Is an income item
- Excludes additional voluntary contributions
- Do not normally “true-up” for actual amount at end of year, unless material effect on Employer Benefit Expense
Actuarial Gains and Losses
- Long-term actuarial assumptions are made at the beginning of the year
- These actuarial assumptions are used to project the year end DBO and FVA
In reality, these projections will not be correct because for example:- financial experience differs from assumptions:
- actual salary increases higher / lower than expected (DBO)
- investment returns higher / lower than expected (FVA)
- pension increases higher / lower than expected (DBO)
- demographic experience differs from assumptions:
- persons retired lived longer than expected (DBO)
- actuarial assumptions change from beginning of year to end of year: §1% fall in discount rate (DBO)
- Gains/losses are the difference between actual and expected DBO and FVA.
- financial experience differs from assumptions:
- IAS 19 Revised:
- Actuarial gains and losses are recognized in OCI for Post-Employment Benefits
- Gains and losses for Other Long-Term Employee Benefits and Termination Benefits continue to be recognized immediately in P&L, i.e. in the period in which they occur
"Special Events"
= Curtailment (often linked to restructuring) and Settlements (rare)
Everything that is covered so far assumed that a plan’s development over time is going “smooth”
- assumptions driven by principle of “ongoing plan”
- stable or slow changing populations
This is violated if the company either:
- reduces or eliminates benefits/liabilities, or
- changes the form of benefits (DB to DC)
IAS 19 then requires special treatment:
- Further calculations and further components of Employer Benefit Expense
- Impact is always on P&L
The concept is to recognize the one-off event as a one-off charge or credit to P&L, rather than slowly over time.
Curtailment
- A curtailment occurs whenever an enterprise either:
- demonstrably commits to making a material reduction in the number of employees covered by a (DB) plan, or
- amends the terms of a DB plan such that a material element of future service by current employees will
- no longer qualify for (DB) benefits, or
- only qualify for reduced (DB) benefits
- A curtailment only affects DBO-related items, NOT assets.
- Recognition of one-off curtailment charge/credit: At the date of curtailment on the company's P&L and balance sheet.
- Examples of curtailment
- Plant closing
- Sale of a division/plant
- Restructuring
- Plan amendment freezing benefits or suspending the plan
- Conversion of DB to DC for future service
- It's NOT a curtailment if:
- There is a successor DB plan (depending on level of benefits provided)
- Benefits are reduced or eliminated only for future participants
- Benefits are reduced or eliminated for past service (past service credit)
Settlements
- A settlement eliminates all further legal or constructive obligation for part or all of the benefits provided under a defined benefit plan
- No legal or constructive obligation to make future benefit payments regarding employee service in current and prior periods
- Recognition of one-off settlement charge/credit: At the date of settlement on the company's P&L and balance sheet.
- Examples of settlements
- Divestiture: Past service related benefit obligation assumed by buyer
- Replace DB plan with DC plan for past service
- Purchase non-participating annuities
- No dividends received by employer
- No obligation to make future payments or contributions if insurer’s returns are poor
- It's NOT a settlement if:
- There is a refund of surplus from fund to company; this is a negative contribution
- Employer retains “participation rights” (& obligations)
- Only part of the obligation for a participant is “settled”, e.g.
- UK tax-free lump sum commutation
- advance payments for termination/retirement indemnities
Curtailment and Settlements summary
