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Pension Expense? What Pension Expense?

The large increases in most equity market measures over the past few years have helped the net income of many firms that would not necessarily be expected to benefit from the stock market. A large part of this benefit is due to the earnings of the pension fund assets. Those assets have recently produced rates of return that far exceed the long run rates of return estimated by the actuary. These unexpectedly large pension fund earnings may be used to decrease pension expenses in current and future years. In some cases, the pension expense is decreased to less than zero, resulting in "income" from having the pension plan! The recent market "adjustments" in which the Dow, NASDAQ, and S&P 500 all suffered large losses may moderate the impact of this effect, but its magnitude will still be substantial.

Accounting For Defined Benefit Pension Plans

The provisions of accounting for defined benefit pension plans are specified by the Statement of Financial Accounting Standards No. 87, Employer's Accounting for Pensions (SFAS No. 87) issued in December 1987. The calculation of periodic pension expense is defined in SFAS No. 87 as consisting of the following six components:

1. Service Cost for the Current period

2. + Interest Cost on the Projected Benefit Obligation

3. - Expected Return on Pension Plan Assets

4. [+ or -] Amortization of Actuarial Gains and Losses

5. + Amortization of Prior Service Cost

6. [+ or -] Amortization of Net Unrecognized Obligation or Net Asset Existing at the Date of Initial Application (also called Transition Amount)

=Periodic Pension Expense [1]

Description of the Components of Pension Expense

Service cost is the actuarial present value of additional pension benefits attributed to the current period by the pension benefit formula. The Projected Benefit Obligation (PBO) is the actuarial present value of all pension benefits attributed to prior employee service calculated using the plan's benefit formula. [2] The PBO includes assumptions about future compensation levels. [3] Since the PBO is the present value of future benefit payments, the interest on the PBO is the increase in the PBO liability due to the passage of time. The same discount rate is used for this calculation as was used in calculating the present value of the future benefits. [4]

The Expected Return on Plan Assets (ERPA) is determined by multiplying the amount of plan assets by an expected long-term rate of return on plan assets. Since the ERPA is a REDUCTION of pension expense, the larger the ERPA, the lower the pension expense. If the actual return on pension plan assets is greater than the expected return, there is an actuarial gain. If the actual return on the plan assets is less than the expected return, there is an actuarial loss. These actuarial gains and losses are amortized if they exceed 10 percent of the greater of the PBO or Plan Assets. [5] If a pension plan has actuarial gains to amortize, these will reduce pension expense, and increase net income, while the amortization of actuarial losses will increase pension expense and decrease net income.

The last component of periodic pension expense is the amortization of Prior Service Cost (PSC). Prior Service Cost usually results from an amendment of the pension plan or benefit formula which grants a retroactive increase in plan benefits for previous years of service. [6] The transition amount is the net of the Pension Benefit Obligation and the fair value of the pension fund assets at the date of the adoption of SFAS No. 87. If this net amount is an asset (the fair value of the Pension Fund Assets is greater than the Pension Benefit Obligation), the amortization reduces pension expense. If the opposite is true, then the amortization of the transition amount increases pension expense. [7] The sum of these components determines the amount of pension expense that is charged against net income for a period.

The Funding Decision

The PBO is determined based upon the number of employees, their length of service, their ages, income levels, and many other factors. This liability will grow due to additional years of service by covered employees, as well as interest on the liability. The amount and rate of funding for this liability will vary from firm to firm. If a firm's cumulative funding is less than the amount of the PBO, then the plan is under-funded and the ERPA may not be enough to cover the interest on the PBO. Conversely, if the cumulative funding is greater than the amount of the PBO, then the plan is over-funded and the ERPA may be greater than the interest on the PBO. Keep in mind that the settlement rate is used to calculate the interest on the PBO, while the expected LONG-TERM earnings rate is used to determine the ERPA. The settlement rate and the expected earnings rate on plan assets are not required to be the same.

When SEAS No. 87 was issued in 1987, it was expected that the ERPA would be relatively low (seldom larger than 10 percent, due to the conservative nature of the investments). The extended major increases in stock prices, and hence, in the investment portfolios of pension funds that have occurred in the last decade have caused more plans to be overfunded due to the larger than expected returns on pension plan assets. Table I presents the increase in the Dow Jones Industrial Average (DJIA) for the period 1990-1999. Note, that for the ten year period, the DJIA has a cumulative increase of 317.59 percent. This means that a firm which had $10 million in pension fund assets would have $41.759 million as of December 31, 1999. ($10 million original amount + $31.759 million increase).

Table II illustrates the growth of the pension fund assets and the PBO (Projected Benefit Obligation or Pension Liability). A firm which had pension plan assets of $10 million dollars at the beginning of 1990 and invested in securities that track the DJIA would have had $41.7 million in pension plan assets at the end of 1999 without making any additional contributions! If additional annual contributions were made, the impact would be even greater. If the same firm had a PBO (Projected Benefit Obligation or Pension Liability) at the beginning of 1990 of $10 million, that pension liability would have grown to $25.9 million by the end of 1999--assuming a settlement rate of 10 percent and no new employees entering the plan (future value of $1 for n=l0, i=10%). Thus, the pension plan for this hypothetical firm was fully funded at the beginning of 1990 (PBO = Plan Assets = $10 Million). By the end of 1999, thanks to large returns on plan assets, it would be over-funded by $15.8 million ($41.7-$25.9). If the expect ed return on plan assets was also 10 percent, the $15.8 million would be available as actuarial gains to offset current and future pension expense. In addition, in 2000, the rapid growth of the pension plan assets would result in the ERPA reducing pension expense by $4.17 million, while the interest on the PBO would increase pension expense by only $2.59 million--providing a net decrease of $1.58 million in pension expense.

A recent article in the Wall Street Journal interactive Edition [3] describes how pension funds have provided an increase in earnings for many firms. These firms are experiencing a situation similar to the one presented for the hypothetical firm in Table II. Due to spectacular earnings on the pension plan assets, they have a higher ERPA as well as remaining actuarial gains to amortize. The sum of these two effects is large enough to offset not only the interest on PBO, but also the total amount of service cost. These firms are not experiencing "Pension Expense," but "Income from Pension Plan". As an example, let us examine selected elements of one of the firms described in the Wall Street Journal Interactive Edition article. Information about the pension plan of General Electric is presented in Table III.

Notice that net income after taxes is $10.7 billion while total pension plan Income (emphasis added) is $1.4 billion, or almost 13% of net income after taxes.

The net actuarial gain recognized (of $467 million) is due to the actual earnings on pension assets being greater than the expected return on pension assets in prior years. The net actuarial gain of $16.85 billion presented as part of the computation of Prepaid Pension Asset is the unamortized amount of actuarial gains that remains to be amortized over the average future service period of the current employee group. This means that pension expense in future periods will be reduced by this amount with a corresponding increase in earnings before income taxes.

Will This Continue?

For pension plans that are overfunded, future earnings will be assisted by the return on pension plan assets for a long period of time. Even if the return on pension plan assets decreases to the point that it is equal to the ERPA, many firms will continue to have negative pension expense for the foresee-able future. In order to illustrate this, Table IV presents the Projected Pension Income for GE for the year 2000--assuming no recognition of actuarial gains.

In Table IV, the projected pension plan income of $2,071 is substantially greater than the $1,380 recognized in 1999. This is in spite of the fact that the projected pension income for 2000 includes NO amortization of actuarial gains. As long as the pension fund assets are expected to grow at least as rapidly as the pension obligation, overfunded pension plans will continue to generate negative pension expense for a long time.

The firms that are experiencing negative pension expense have overfunded plans which generate large amounts of ERPA to reduce net income. In addition, most of these firms have accumulated large amounts of actuarial gains to further reduce pension expense in the future. In order to negate the large ERPA amounts--due to overfunded plans--as well as deplete the accumulated actuarial gains, an extended period of stock market decline as large in magnitude as the increase of the 1990s would be required.


Large pension plans are usually considered an expense to the company which sponsors the plan. For companies who adequately funded their pension plans prior to and during the stock market runup of the 1990s, the pension plan assets are generating more than enough return to cover the cost of the pension plan. As illustrated in this article, many firms are even enhancing their income due to the overfunded status of their pension plans.

Firms that have experienced rapid increases in their pension plan assets will probably continue to have negative pension expense, and hence, increase net income for a long period of time. In many cases, the decision to adequately fund the pension plan a decade ago has resulted in the enhancement of net income for future decades. Who would have thought that financial reporting would reward planning?

Dr. Tom Oxner received his undergraduate degree from Campbell University and his MBA and Ph.D. from the University of Georgia. He is currently chair of the Department of Accounting at the University of Central Arkansas in Conway, AR. He has published numerous articles in professional journals.

Dr. Karen Oxner received her DBA from Southern Illinois University. She has worked in public accounting and as an internal auditor. She is currently an Assistant Professor of Economics and Business at Hendrix College in Conway, AR.


(1.) Financial Accounting Standards Board, "Statement of Financial Accounting Standards No. 87, Employer's Accounting of Pensions, Stamford, Conn. 1985, [GRAPHIC EXPRESSION NOT REPRODUCIBLE IN ASCII] 20-34.







(8.) "Stock Gains Swell Assets in Plans, Often Giving Earnings a Silent Lift," The Wall Street Journal Inreractive Edition, June 6, 2000.
 Dow Jones Industrial Average for
01/01/90 2753.20
12/31/90 2633.66 -4.34% -4.34%
12/31/91 3168.83 20.32% 15.10%
12/31/92 3301.11 4.17% 19.90%
12/31/93 3654.09 10.69% 32.72%
12/31/94 3834.44 4.94% 39.27%
12/31/95 5117.12 33.45% 85.86%
12/31/96 6448.27 26.01% 134.21%
12/31/97 7908.25 22.64% 187.24%
12/31/98 9181.43 16.10% 233.48%
12/31/99 11497.12 25.22% 317.59%
 Pension Plan Asset Growth and Projected
 Benefit Obligation Growth
01/01/90 $10,000,000 $10,000,000
12/31/90 9,565,814 $11,000,000 -$1,434,186
12/31/91 11,509,625 12,100,000 -$590,375
12/31/92 11,990,084 13,310,000 -$1,319,916
12/31/93 13,272,156 14,641,000 $1,368,844
12/31/94 13,927,212 16,105,100 -$2,177,888
12/31/95 18,586,082 17,715,610 $870,472
12/31/96 23,421,001 19,487,171 $3,933,830
12/31/97 28,723,849 21,435,888 $7,287,961
12/31/98 33,348,213 23,579,477 $9,768,736
12/31/99 41,759,117 25,937,425 $15,821,692
 Pension Disclosure for General Electric
(Amounts in Millions of Dollars) 1999 1998 1997
EARNINGS BEFORE INCOME TAXES $15,577 $13,477 $11,179
Provision for income taxes (note 7) (4,860) (4,181) (2,976)
NET EARNINGS $10,717 $9,296 $8,203
The effect on operations of principal
pension plans is as follows:
(In millions)
Expected return on plan assets $3,407 $3,024 $2,721
Service cost for benefits earned (a) (693) (625) (596)
Interest cost on benefit obligation (1,804) (1,749) (1,686)
Prior service cost (151) (153) (145)
SFAS No.87 -transition gain 154 154 154
Net actuarial gain recognized 467 365 295
Special early retirement cost -- -- (412)
Total pension plan income $1,380 $1,016 $331
(a) Net of participant contributions
December 31 (In millions)
Fair value of plan assets $50,243 $43,447
Add (deduct) unrecognized balances:
Prior service cost 699 850
SFAS No. 87 transition gain (154) (308)
Net actuarial gain (16,850) (9,462)
Projected benefit obligation (25,522) (27,572)
Pension liability 981 797
Prepaid pension asset $9,397 $7,752
Actuarial assumptions used to determine
costs and benefit obligations for
principal pension plans follow.
December 31
Discount rate 7.75% 6.75% 7.0%
Compensation increases 5.0 5.0 4.5
Return on assets for the year 9.5 9.5 9.5
Experience gains and losses, as well as
the effects of changes in actuarial
assumptions and plan provisions, are
amortized over the average future
service period of employees.
Source: GE 10-K Filing Dated 3-17-2000
 Projected Pension Income for GE for
 Year 2000
 Assuming No Actuarial Gains
Expected return on plan assets $ 4773 [*]
Service cost for benefits earned (728) [**]
Interest cost on benefit obligation (1,978) [***]
Prior service cost (150) [****]
SFAS No. 87 transition gain 154 [*****]
Net actuarial gain recognized $ 2,071
Total pension plan income

(*.)ERPA= (Fair Value of Plan Assets at 12-31-99) $50,243 X .095 (Expected Return on Assets) $4,773.

(**.)Service Coat for Benefits Earned = (Service Cost for Benefits Earned in 1999) $693 X .05 (Estimated Compensation increase) = $728.

(***.)Interest Cost on Benefit Obligation = (Benefit Obligation at 12-31-1999) $25,522 X .0775 (Estimated Discount Rate) = $1978.

(****.)Prior Service Cost = The Average of the past three years (1997-1999).

(*****.)SFAS No. 87 Transition Gain The amount recognized for the past three years.
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Article Details
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Author:Oxner, Tom; Oxner, Karen
Publication:The National Public Accountant
Article Type:Statistical Data Included
Geographic Code:1USA
Date:Dec 1, 2000

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