Employee future benefits and pensions

Northlake's employees earn more than salary while they work. Many will receive pensions after they retire, some will keep health and dental benefits in retirement, and all have earned vacation and other benefits that will be paid later. These promises are compensation for service rendered now, so their cost belongs in the periods when employees work, not when cash is eventually paid decades later. Measuring that cost is hard: it depends on how long employees will work, how much their salaries will rise, how long they will live and what interest rates and investment returns will be. This lesson explains how pension and other post-employment benefits are accounted for, focusing on defined benefit plans, where the frameworks differ most.

Defined contribution and defined benefit plans

In a defined contribution plan, the employer promises only to contribute a specified amount, for example 5 per cent of salary, to an account for each employee. The employee's eventual pension depends on the contributions and the investment returns earned on them; the employee bears the investment risk. Accounting is simple: the employer recognizes the required contribution as an expense in the period the employee works, and a liability for any contribution not yet paid. Most new private-sector plans in both countries are defined contribution plans, including group registered retirement savings plans in Canada and 401(k) plans in the United States.

In a defined benefit plan, the employer promises a specified pension at retirement, typically based on years of service and final or average salary, for example 2 per cent of the average of the best five years' salary for each year of service. The employer bears the investment and longevity risk: if plan assets earn less than expected or retirees live longer, the employer must contribute more. Defined benefit plans remain common in the public sector, in large unionized companies and among older employers. Their accounting requires actuarial estimates and is the subject of the rest of this lesson.

In Canada, registered pension plans are regulated by provincial pension standards acts or, for federally regulated employers, the Pension Benefits Standards Act, 1985. These set funding rules, typically requiring going-concern and solvency valuations at least every three years, which determine the cash contributions required. The accounting cost is measured separately and usually differs from the funding contribution. Canada Pension Plan and Quebec Pension Plan contributions (lesson 1) are payroll taxes, not employer pension plans.

Measuring a defined benefit obligation

The defined benefit obligation (called the projected benefit obligation in US GAAP) is the present value of the benefits employees have earned to date, taking into account expected future salary increases. Actuaries measure it using the projected unit credit method: each year of service earns one unit of benefit, projected to retirement using expected salary growth, and discounted to the present. The main assumptions are demographic (employee turnover, retirement age, mortality, using tables such as the Canadian Pensioners' Mortality tables or the US Pri-2012 tables with improvement scales) and financial (salary growth, inflation and the discount rate).

IAS 19, Employee Benefits, requires the discount rate to be determined by reference to market yields at the end of the reporting period on high-quality corporate bonds, usually interpreted as bonds rated AA, with currency and term consistent with the obligation. Because the obligation is long-dated, small changes in the discount rate have large effects: a one-point fall in the rate can increase the obligation of a mature plan by 12 to 15 per cent. Plan assets, the investments held in a separate trust to pay benefits, are measured at fair value. The net defined benefit liability (or asset) is the obligation minus plan assets; a surplus is limited by the asset ceiling, the present value of economic benefits available as refunds or reductions in future contributions.

Recognizing the cost under IAS 19

IAS 19 splits the change in the net defined benefit liability into three components. Service cost, the present value of benefits earned in the year plus any past service cost from plan amendments and gains or losses on settlements, is recognized in profit or loss. Net interest on the net defined benefit liability, the discount rate times the net liability at the start of the year (adjusted for contributions and benefits during the year), is recognized in profit or loss. Because net interest uses the discount rate for both the obligation and the assets, IAS 19 does not reward a company for assuming high investment returns. Remeasurements, actuarial gains and losses on the obligation from changes in assumptions and experience, and the difference between the actual return on plan assets and the interest income included in net interest, are recognized in other comprehensive income and never reclassified to profit or loss. They may be transferred within equity, for example to retained earnings.

# One year of a defined benefit plan: IAS 19 compared with ASC 715
dbo0, assets0, rate = 10_000_000, 8_500_000, 0.05
service, contrib, benefits = 600_000, 700_000, 400_000
actual_return, actuarial_loss = 300_000, 250_000
expected_rate, aoci_loss0, service_years = 0.065, 1_400_000, 10

dbo1 = dbo0 + service + dbo0 * rate - benefits + actuarial_loss
assets1 = assets0 + actual_return + contrib - benefits
print(f"Closing obligation {dbo1:,.0f}; closing assets {assets1:,.0f}; net liability {dbo1 - assets1:,.0f}")

# IAS 19
net_interest = rate * (dbo0 - assets0)
remeasure = actuarial_loss + (assets0 * rate - actual_return)
print(f"IAS 19: profit or loss {service + net_interest:,.0f} (service {service:,} + net interest {net_interest:,.0f}); OCI loss {remeasure:,.0f}")

# ASC 715
interest_cost = dbo0 * rate
expected_return = assets0 * expected_rate
corridor = 0.10 * max(dbo0, assets0)
amort = max(0, aoci_loss0 - corridor) / service_years
npc = service + interest_cost - expected_return + amort
oci_loss = actuarial_loss + (expected_return - actual_return)
print(f"ASC 715: net periodic cost {npc:,.0f} (operating {service:,}, other {npc - service:,.0f})")
print(f"ASC 715: OCI loss {oci_loss:,.0f}; amortization out of AOCI {amort:,.0f}; closing AOCI loss {aoci_loss0 + oci_loss - amort:,.0f}")

Closing obligation 10,950,000; closing assets 9,100,000; net liability 1,850,000
IAS 19: profit or loss 675,000 (service 600,000 + net interest 75,000); OCI loss 375,000
ASC 715: net periodic cost 587,500 (operating 600,000, other -12,500)
ASC 715: OCI loss 502,500; amortization out of AOCI 40,000; closing AOCI loss 1,862,500

The program confirms that both frameworks report the same net liability, $1,850,000, because both recognize the funded status in full. They differ in how much goes through profit or loss. IAS 19 charges $675,000 to profit or loss and $375,000 to OCI, and the OCI amount never returns to profit or loss. ASC 715 charges $587,500 to net income, lower because the 6.5 per cent expected return exceeds the 5 per cent discount rate, and records a $502,500 loss in OCI, of which a portion will be amortized into future pension cost through the corridor. The choice of expected return is a management assumption under US GAAP, which is why analysts scrutinize it; IAS 19 removed that judgement from profit or loss in 2013.

Past service cost, settlements and curtailments

When a plan is amended to increase or reduce benefits for past service, the change in the obligation is past service cost. IAS 19 recognizes it immediately in profit or loss, at the earlier of when the amendment or curtailment occurs and when related restructuring costs or termination benefits are recognized. A settlement, such as buying annuities from an insurer to transfer the obligation for a group of retirees, produces a gain or loss equal to the difference between the obligation settled and the price paid, also recognized in profit or loss. Before measuring past service cost or a settlement, the net liability is remeasured using current assumptions.

Other post-employment and long-term benefits

Post-employment benefits other than pensions, such as retiree health, dental and life insurance, are accounted for like defined benefit pensions under IAS 19, using actuarial assumptions about health cost trends. Because Canada's public health system covers hospital and physician care, these plans usually cover drugs, dental and supplementary care, so they are smaller than in the United States but still material for many employers. Other long-term employee benefits, such as long-service leave and long-term disability, are measured similarly, but all remeasurements go to profit or loss. Termination benefits are recognized when the entity can no longer withdraw the offer or recognizes related restructuring costs (lesson 2).

Employee future benefits under ASPE

ASPE Section 3462, Employee Future Benefits, requires a private enterprise to recognize the full defined benefit obligation less plan assets on its balance sheet, as under IAS 19, but with all remeasurements and other items recognized immediately in net income rather than OCI, because ASPE has no OCI. A private enterprise may measure the obligation using the most recent funding valuation prepared for regulators, rather than a separate accounting valuation, which saves cost but usually produces a different number because funding valuations use different assumptions. Multi-employer plans, such as many union plans, are often accounted for as defined contribution plans when the employer cannot obtain enough information.

Reading pension disclosures

Pension notes are long but informative. They show reconciliations of the obligation and plan assets, the components of cost, the major assumptions and a sensitivity analysis showing how the obligation would change if the discount rate, salary growth or life expectancy changed. Readers should compare the discount rate with those of peers, check whether the plan's deficit is growing, and look at expected contributions for the coming year, which affect cash flow. A large deficit is effectively debt: analysts often add the net pension liability, after tax, to borrowings when computing leverage.