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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. +/-Amortization of Actuarial Gains and Losses
5. + Amortization of Prior Service Cost
6. +/-Amortization of Net Unrecognized Obligation or Net Asset Existing at the Date of Initial Application (also called Transition Amount) =Periodic Pension Expense'
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.' 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...