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 percent 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 percent 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 the United States, private pension plans are regulated by the Employee Retirement Income Security Act of 1974 (ERISA), which sets minimum funding standards, and are insured up to limits by the Pension Benefit Guaranty Corporation. Funding contributions are set under ERISA and the Internal Revenue Code and usually differ from the accounting cost. Social Security 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).

ASC 715, Compensation – Retirement Benefits, requires the discount rate to reflect the rates at which the benefits could be effectively settled, typically derived from a yield curve of high-quality (AA) corporate bonds matching the plan's expected cash flows. Because the obligation is long-dated, small changes in the discount rate have large effects. Plan assets are measured at fair value. The funded status, the projected benefit obligation minus plan assets, is recognized on the balance sheet as a liability (underfunded) or asset (overfunded); there is no asset ceiling as under IFRS.

Recognizing the cost under ASC 715

ASC 715 computes net periodic pension cost from several components: service cost; interest cost on the projected benefit obligation; minus the expected return on plan assets, using a long-term expected rate of return chosen by management; plus amortization of prior service cost from plan amendments; and plus amortization of net actuarial gains or losses. Actuarial gains and losses, including the difference between actual and expected returns on assets, are first recognized in other comprehensive income. They are amortized into net periodic cost only to the extent the cumulative net gain or loss in accumulated OCI exceeds a 'corridor' of 10 percent of the greater of the projected benefit obligation and the market-related value of plan assets at the start of the year, spread over the average remaining service period of active employees. Since ASU 2017-07, only service cost is presented in operating income; the other components are presented outside operating income.

# 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 percent expected return exceeds the 5 percent 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 judgment from profit or loss in 2013.

Past service cost, settlements and curtailments

When a plan is amended to grant benefits for past service, ASC 715 recognizes the cost in OCI as prior service cost and amortizes it into net periodic cost over the remaining service period of affected employees. Reductions in benefits create prior service credits treated similarly. Settlements and curtailments trigger recognition of part of the gains, losses and prior service cost held in AOCI. US GAAP therefore spreads the effect of plan amendments, while IFRS recognizes it at once. Large annuity purchases, often called pension risk transfers, have become common for US companies seeking to shrink their pension exposure.

Other post-employment and long-term benefits

Other post-retirement benefits (OPEB), such as retiree health care and life insurance, are accounted for under ASC 715-60 using the same approach as pensions, with assumptions about health care cost trend rates. Because many US employers historically promised retiree health coverage before Medicare eligibility at 65, OPEB obligations can be large, and many companies have cut or capped these benefits. Postemployment benefits for former employees before retirement, such as severance and disability, fall under ASC 712.

How IFRS and US GAAP compare

Both IFRS and US GAAP recognize the full funded status on the balance sheet, but their income statement effects differ. IFRS uses the discount rate for both interest cost and the return on assets (net interest), sends all remeasurements to OCI permanently and recognizes past service cost immediately. US GAAP uses an expected return on assets, amortizes gains and losses through the corridor and amortizes prior service cost. Canada's ASPE recognizes everything in net income and allows the funding valuation to be used. An IFRS reporter with the same plan usually reports higher pension cost in profit or loss than a US GAAP reporter when expected returns exceed the discount rate.

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.