Sign up  |  Log in

My dumbed down Accounting for Pension Expense.

btw sorry for a small offtopic, but what’s you strategy for the last week? :)

Kick start your CFA® Program prep with Top Instructors you’ll love and a course that offers free updates until you pass – We’ve got you covered.

kobi wrote:

btw sorry for a small offtopic, but what’s you strategy for the last week? :)

Just repeatedly doing fast revisions on Corporate Finance, Derivatives, and Fixed Income. I try to take note of points which appears that i have never seen before.

I spend 2 hours a day on Ethics

Dedicate the last two days to solving EOCs on Equity and FSA. –I think i have this two pretty much nailed down, but i need to commit them both to my memory before the exam.

My entire strategy is focussed on Corp, Derivatives, Fixed Income, Equity, FSA, Quants and Ethics.

I have a pretty solid understanding of Portfolio.

I haven’t studied Economics at all, and probably will not do so.  I understand triangular arbitrage, and that it is.

Alternatives could go either way for me

I’ve done FSA EOCs 3 times over last 4 month, I doubt it would provide sth new to me next time. EOCs generally seem a bit to lengthy. Ratio of new knowledge to time is too small I guess. I rather focus on revieving mock exams and my own notes (200 pages) + 30 qbank ethics a day. 

kobi wrote:

I’ve done FSA EOCs 3 times over last 4 month, I doubt it would provide sth new to me next time. EOCs generally seem a bit to lengthy. Ratio of new knowledge to time is too small I guess. I rather focus on revieving mock exams and my own notes (200 pages) + 30 qbank ethics a day. 

I have done them once, and i still consider them invaluable.  In the end, the questions are going to come right out of the CFAI textbooks, so my approach has been - why focus elsewhere?  I have studied entirely from the CFAI textbooks, and occasionally reverting to schweser.

I might be wrong, time will decide that.  But i find that my understand tends to improve a lot this way.  I have done some mocks, will do one or two more in this last week.

Americans Amortize

I’m building a StumbleUpon Clone

bloodline wrote:

kobi wrote:

I’ve done FSA EOCs 3 times over last 4 month, I doubt it would provide sth new to me next time. EOCs generally seem a bit to lengthy. Ratio of new knowledge to time is too small I guess. I rather focus on revieving mock exams and my own notes (200 pages) + 30 qbank ethics a day. 

I have done them once, and i still consider them invaluable.  In the end, the questions are going to come right out of the CFAI textbooks, so my approach has been - why focus elsewhere?  I have studied entirely from the CFAI textbooks, and occasionally reverting to schweser.

I might be wrong, time will decide that.  But i find that my understand tends to improve a lot this way.  I have done some mocks, will do one or two more in this last week.

CFAI EOCs are good, especially the vignette ones.

This is amazing - i’m putting you on the board of BlueStar Airlines!

80’s style

Thank you op. This was an amazing and well timed summary of pensions for level ii.

I’m saving a copy of this to read on my tablet during the break (if pensions don’t get tested in AM)..  I hear this site’s going down on exam day.

I’m building a StumbleUpon Clone

It doesnt go down. It goes read-only

OMG, clear as a bell, thank you.  You’re right, some of the naming conventions are confusing, the one that gets me is Total Return, and why it’s even defined at all.  GL!

Why are you talking about cost and expense? 
The CFA books only talk about cost whether it is TOTAL or not.

Amazing!

¯\_(ツ)_/¯

Interesting, not to FRA yet, but bookmarked!

This is bl**dy good bloodline… I hope not many people know the whole curriculum as good as you do because it’ll be hard for me to pass…

BTW are you planning to be the next S2000magician???? haha well done!

"Someone's in the shade today because someone planted a tree a long time ago"

I love u

Incredibly helpful! Thanks for putting this together. 

This was huge for me. Thanks.

bloodline wrote:

Here, i explain how i have come to understand the Pension Expense.  If it helps you great, if it doesn’t, please ignore.

First assume you have a mini balance sheet, seperately for your pension accounting.  Whatever the net outcome of your mini balance sheet is, will be recorded in your MAIN balance sheet as either an Asset or a Liability under a fancy account called Funded Status of Pension Plan.

Next, in your mini balance sheet, you’ve got the asset and the liability. ( Your Liability is also called PBO)

Your Liability is only one figure - it’s simply the present value of payments to be made in the future.  In lay man terms, this is a debt you owe to your hardworking employees and will have to pay back at some point in the future.

We all hate liabilities - at least, most of us do - so you decide on a nice plan to have some assets in place, to fund your liability whenever it comes due in the future.  This is simply some amount of cash you’ve invested and expect to earn some income on at some point in the future.

So all good!  Assets and Liabilities, equation balanced!  When you net your assets against your liability, whatever you get is your funded status.

But there is a caveat though.

Your liability, like all debt, is not static, for two reasons.  

1) Like all debts, you pay interest on it. - we will call this your interest expense

2) Each year your hardworking employees sweat hard for you, you owe them more – whatever you owe them in that year is what we will call the Current Cost.

At the end of the year, your liability will have increased by Interest Expense + Current cost.

So your ending PBO = Begining PBO + Interest expense + Current Cost.

Just in case you are mumbling and cursing beaneth your breathe at “Those d**n pigs bleeding their poor employer to death” …you might want to take a chill pill and look at your Assets!

Your Assets would have made some returns as well.  The total returns on your assets, as usual is in two components

1) Income component

2) Capital Gains component

If you are American, the income return component of your assets will simply be = Expected return * Plan Assets. (If you are british, you use interest rates instead of expected return)

So, Total Return on your assets = Income return Component + Capital Gains Component

and therefore, by simple mathematics, Capital Gains component = Total Actual Return - Income return, 

which is the same as writing [Actual return -(expected return * plan assets)]  

The Net periodic Pension cost is simply a net measure of the amount by which your Liability and your assets must have increased by the end of the year, after also factoring in employer contributions.

The amount is =[ Increase in Liability - Increase in Assets.] - Employer Contributions.

This is the same as

[ Current service cost + Interest Expense] - [Income Component + Capital Gains Component] - Employer Contributi

Also, remember that Liability - Assets = Funded status.

So, we can also re-write 

[ Increase in Liability - Increase in Assets.] - Employer Contributions 

as  Change in Funded status - Employer Contributions.

This is your Net Periodic Pension cost.  This is also your Periodic Pension Cost.  This is also your total Periodic Pension cost.  All three are the same just poor naming conventions.

So let’s talk a bit about how US GAAP differs from IFRS.

The first difference:

Rememeber that our asset return in each period is said to be made up of two components

1) Interest component

2) Capital Gains Component

The main significant difference is how interest component is defined.  Americans use Expected return * Asset (Americans like dreams and expectations), the british use Interest rates * Assets.

The second difference:

Remember our final derivation?

[ Current service cost + Interest Expense] - [Income Component of Returns + Capital Gains Component] - Employer Contributions

Under US GAAP, the equation is fine as it is.  Under IFRS, those two middle components are netted together in a single figure called NET INTEREST EXPENSE.

The third difference:

There are times, when you make ammends to your company’s pension plan to take into account some guys who may have come way back with you when you first started the company.  You call this Past Service Cost.—think of this as Loyalty Points.

Now look at that long equation again. The difference here is that under IFRS, this Past Service Cost is simply added to the Current Service cost…..but guess what the Americans do?  They toss it in the bin!  Yes you heard me right, so much for Loyalty.  Under GAAP, all that Loyalty Points are tossed into a big bin called OCI and then slowly amortised into the Income statement by dividing Past Service Cost by expected number of employee years.

Speaking of the big bin…..

What are the contents?  Well just about any s***ty stuffs you can think of really, mostly coded as “Actuarial Stuff”

Actuarial Stuffs are the randomn stuffs you were not expecting.  For instance, let’s say you change the assumptions you’ve made about your discount rates, the rate of compensation increase, or how long your employees are likely to live, these changes will affect the value of your liabilites and the increase or decrease is coded as “Actuarial Stuff”, tossed away in the big bin called OCI.

Additionally, if you are American, and had filed your statements using Expected returns, then you must also record the Capital Gains portion of your returns in the OCI.  

Recall that we agreed earlier on, that:

Capital Gains Component = Total Actual Return Component - Income Component

and Income Component = Expected return * Asset.

If you have manged to stay this far without getting confused, well thank you.  and here’s the final and fifth difference between IFRS and GAAP

- Under IFRS, you never amortize your bin bag!  You should say this to yourself over and over again!

- Under GAAP, you amortize Past service cost by dividing by expected number of years and you amortize the rest of your bin bag using the corridor approach.

That’s it!!!!

bookmarked

I have a printed copy of this post for reference, a super useful summary.

This is the most epic and colorful explanation of pension cost. Even 5 years later I love it. 

Thanks 

The year is 2019 and this is still saving lives. Thank you bloodline!

This is beyond awesome! Thank you!