Page 37 - FINAL CFA II SLIDES JUNE 2019 DAY 5.2

LOS 15.a: Describe the types of post-employment READING 15: EMPLOYEE COMPENSATION: POST-EMPLOYMENT AND SHARE BASED
benefit plans and implications for financial reports.

MODULE 15.1: TYPES OF PLANS

Defined contribution plan: Firm contributes a certain sum each period to the employee’s retirement account, based on say:
• Years of service,
• Employee’s age, Firm makes no promise regarding the future value of the plan assets. Employee makes all
• Compensation, investment decisions and assumes the risks.
• Profitability, or
• Even a % of the employee’s contribution. Pension expense = the employer’s contribution. No future obligation reported on balance sheet.

Defined-benefit plan: Firm promises to make periodic payments to the employee after retirement; benefit based on the employee’s years of
service and the employee’s compensation at, or near, retirement.

For example, an employee might earn a retirement benefit of 2% of her final salary for each year of service. Consequently, an employee
with 20 years of service and a final salary of $100,000 would receive $40,000 ($100,000 final salary × 2% × 20 years of service) each year
upon retirement until death.

Since the employee’s future benefit is defined, the employer assumes the investment risk.

Financial reporting: Employer must estimate the value of the future obligation to its employees by forecasting variables like:
• Future compensation levels,
• employee turnover, Other post-employment benefits (e.g. post-employment
• retirement age, health care plan), similar to a defined-benefit pension plan: the
• mortality rates, and future benefit is defined today but is based on a number of
• an appropriate discount rate. unknown variables e.g. forecasts of health care costs that are
expected once the employee retires.
Plan funded by contributing assets to a separate legal entity (trust)
and managed to generate requisite income and principal growth to Unlike defined-benefit plans, these are typically unfunded; the
pay the pension benefits as they come due. employer recognizes expense in the income statement as the
benefits are earned; however, the employer’s cash flow is not
Plan assets less benefit obligation = funded status of the plan. If: affected until the benefits are actually paid to the employee.
• Plan assets > pension obligation (“overfunded.” )
• Plan assets < pension obligation (“underfunded.” )