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Chapter17: Pensions and Other Postretirement Benefits

What Is a Postretirement Benefit Plan?

Before addressing the accounting ramifications, let's look at a typical retiree health care plan.31 First, it's important to distinguish retiree health care benefits from health care benefits provided during an employee's working years. The annual cost of providing preretirement benefits is simply part of the annual compensation expense. However, many companies offer coverage that continues into retirement. It is the deferred aspect of these postretirement benefits that creates an accounting issue.

   Usually a plan promises benefits in exchange for services performed over a designated number of years, or reaching a particular age, or both. For instance, a plan might specify that employees are eligible for postretirement benefits after both working 20 years and reaching age 62 while in service. Eligibility requirements and the nature of benefits usually are specified by a written plan, or sometimes only by company practice.

Eligibility usually is based on age and/or years of service.

Postretirement Health Benefits and Pension Benefits Compared

Keep in mind that retiree health benefits differ fundamentally from pension benefits in some important respects:




The amount of pension benefits generally is based on the number of years an employee works for the company so that the longer the employee works, the higher are the benefits. On the other hand, the amount of postretirement health care benefits typically is unrelated to service. It's usually an all-or-nothing plan in which a certain level of coverage is promised upon retirement, independent of the length of service beyond that necessary for eligibility.




Although coverage might be identical, the cost of providing the coverage might vary significantly from retiree to retiree and from year to year because of differing medical needs.




Postretirement health care plans often require the retiree to share in the cost of coverage through monthly contribution payments. For instance, a company might pay 80% of insurance premiums, with the retiree paying 20%. The net cost of providing coverage is reduced by these contributions as well as by any portion of the cost paid by Medicare or other insurance.




Coverage often is provided to spouses and eligible dependents.

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Determining the Net Cost of Benefits

To determine the postretirement benefit obligation and the postretirement benefit expense, the company's actuary first must make estimates of what the postretirement benefit costs will be for current employees. Then, as illustrated in Graphic 17-14, contributions to those costs by employees are deducted, as well as Medicare's share of the costs (for retirement years when the retiree will be 65 or older), to determine the estimated net cost of benefits to the employer:

Estimating the Net Cost of Benefits

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   Remember, postretirement health care benefits are anticipated actual costs of providing the promised health care, rather than an amount estimated by a defined benefit formula. This makes these estimates inherently more intricate, particularly because health care costs in general are notoriously difficult to forecast. And, since postretirement health care benefits are partially paid by the retiree and by Medicare, these cost-sharing amounts must be estimated as well.

   On the other hand, estimating postretirement benefits costs is similar in many ways to estimating pension costs. Both estimates entail a variety of assumptions to be made by the company's actuary. Many of these assumptions are the same; for instance, both require estimates of:




A discount rate.




Expected return on plan assets (if the plan is funded).




Employee turnover.




Expected retirement age.




Expected compensation increases (if the plan is pay-related).




Expected age of death.




Number and ages of beneficiaries and dependents.

Many of the assumptions needed to estimate postretirement health care benefits are the same as those needed to estimate pension benefits.

   Of course, the relative importance of some estimates is different from that for pension plans. Dependency status, turnover, and retirement age, for example, take on much greater significance. Also, additional assumptions become necessary as a result of differences between pension plans and other postretirement benefit plans. Specifically, it's necessary to estimate:




The current cost of providing health care benefits at each age that participants might receive benefits.




Demographic characteristics of plan participants that might affect the amount and timing of benefits.




Benefit coverage provided by Medicare, other insurance, or other sources that will reduce the net cost of employer-provided benefits.




The expected health care cost trend rate.32

   Taking these assumptions into account, the company's actuary estimates what the net cost of postretirement benefits will be for current employees in each year of their expected retirement. The discounted present value of those costs is the expected postretirement benefit obligation.

Some additional assumptions are needed to estimate postretirement health care benefits besides those needed to estimate pension benefits.

The postretirement benefit obligation is the discounted present value of the benefits during retirement.

31For convenience, our discussion focuses on health care benefits because these are by far the most common type of postretirement benefits other than pensions. But the concepts we discuss apply equally to other forms of postretirement benefits.

32Health care cost trend rates recently reported have ranged from 5.5% to 12.5%, with 9–9.5% being the most commonly assumed rate. Accounting Trends and Techniques—2009 (New York: AICPA, 2009), p. 354.

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