Chapter 14: Employee Compensation: Post-Employment and Share ...

CHAPTER 14EMPLOYEE COMPENSATION:

POSTEMPLOYMENT AND SHARE-BASED

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Copyright © 2013 CFA Institute 2

TYPES OF POSTEMPLOYMENT BENEFITS: PENSION PLANS

Amount ofFuture benefit to Employee

Contribution from Employer

Defined contribution (DC) pension plan

Defined benefit (DB) pension plan

Depends on investment performance of plan assets

Amount (if any) is defined in each period

Depends on current period estimate and investment performance of plan assets

Defined based on plan’s formula


TYPES OF POSTEMPLOYMENT BENEFITS: PENSION PLANS & EMPLOYER’S OBLIGATION

Type of Benefit

Amount ofFuture benefit to

EmployeeContribution

from Employer

Employer’s Prefunding of Its

Future Obligation

Defined contribution Depends Defined N/A

Defined benefit Defined Depends

Typically prefunded;regulatory requirements.


TYPES OF POSTEMPLOYMENT BENEFITS: OTHER

Type of Benefit

Amount ofFuture benefit to Employee

Contribution from Employer

Employer’s Prefunding of

its Future Obligation

Other postemployment benefits (e.g., retirees’ health care)

Depends on plan specifications and type of benefit.

Eventual benefits are specified. The amount of the future obligation must be estimated in the current period.

Typically not prefunded.


MEASURING A DEFINED BENEFIT PENSION OBLIGATION

• Pension obligation is measured as the present value of estimated future payments to employees for benefits earned to date.

• Measured without deducting any plan assets.• Requires company to make actuarial assumptions:

- Estimated future benefits.- The discount rate at which to discount future payments.


MEASURING NET PENSION LIABILITY (OR ASSET) FOR DB OBLIGATIONS

• Pension obligation is measured without deducting any plan assets.• The net pension deficit (or surplus) deducts fair value of plan assets.

Present value of the DB obligation – Fair value of the plan assets = Funded status


NET PENSION LIABILITY (OR ASSET)

• Underfunded- Pension obligation exceeds pension plan assets.- Liability equal to the net pension obligation is reported.

• Overfunded- Pension plan assets exceed the pension obligation.- Asset equal to the overfunded pension obligation is reported,

subject to limitations.


COMPONENTS OF A COMPANY’S DEFINED BENEFIT PENSION EXPENSE

Current Service

Cost

Interest

Past Service

Cost

Actuarial Losses

Return on Plan Assets

$


DEFINED BENEFIT PLAN ASSUMPTIONS

• Estimated future benefits, which depend on- Future compensation increases and levels,- Length of service,- Vesting rate and turnover, and - Life expectancy postretirement.

• Discount rate at which to discount future payments and for net interest calculations.


DEFINED BENEFIT PLAN ASSUMPTIONS: EXAMPLE

• Assume for a company establishing a DB pension plan, the discount rate is 6%.

• Assume for an employee covered by a DB pension plan: - Salary in the coming year of €50,000. - Expected to work 5 more years before retiring.- Annual compensation increase is 4.75%.- Will receive benefit for 20 years.- Benefit based on (Estimated final salary × 1.5%) × Years of service.

• Employee’s estimated final year salary = €50,000 × [(1 + 4.75%)4] = €60,198.56.



Today Retirement Date

Retirement Period End

• Annual benefit = (Estimated final salary × Benefit formula) × Years service • Value at retirement date of estimated future benefits = Present value of annual

benefit during retirement period• Annual unit credit = Value at retirement date/Years of service





• Annual benefit = (Estimated final salary × Benefit formula) × Years service = €60,198.56 × 1.5% × 5 = €4,514.89

• Value at retirement date of estimated future benefits = Present value of annual benefit during retirement period

• Annual unit credit = Value at retirement date/Years of service



TodayRetirement Date


• Annual benefit = €4,514.89• Value at retirement date of estimated future benefits = Present value of annual

benefit during retirement period = Present value of annuity of €4,514.89 for 20 years, discounted at 6% = €51,785.46

• Annual unit credit = Value at retirement date/Years of service





• Annual benefit = €4,514.89• Value at retirement date of estimated future benefits = €51,785.46• Annual unit credit = Value at retirement date/Years of service = €51,785.46/5

years = €10,357.09 per year• Pension obligation increases by an amount equal to the present value of the

annual credit earned in the year


DEFINED BENEFIT PLAN ASSUMPTIONS: IMPACT OF CHANGES

• Changes in assumptions change the estimated obligation.• Direction of change in assumption that would increase a DB pension

plan obligation:- Lower discount rate.- Longer estimated working period before retiring.- Higher assumed annual compensation increase. - Longer estimated retirement period (longer life expectancy).


PENSION AND OTHER POSTEMPLOYMENT BENEFITS: USING DISCLOSURES

• Differences in key assumptions used for pensions and other postemployment benefits can affect comparisons across companies.

• Companies disclose their assumptions about - discount rates, - expected compensation increases, and - expected return on plan assets.

• An analyst can compare these assumptions over time and across companies to assess any conservative or aggressive biases.

• In some cases, an analyst can adjust items as reported to create more comparable data.



• In assessing potential conservative or aggressive biases, other fundamental explanations for differences should be considered.

• For example, the assumed discount rates used to estimate pension obligations- are generally based on the market interest rates of high-quality corporate

fixed-income investments, and - the investments have a maturity profile similar to the timing of a company’s

future pension payments. • Discount rates may thus differ across companies because of

- differences in the regions/countries involved and/or - differences in the timing of obligations.

• An important consideration is whether the assumptions are internally consistent (e.g., do the company’s assumed discount rates and assumed compensation increases reflect a consistent view of inflation?).



2009 2008 2007 2006 2005Fiat S.p.A. 5.50 5.10 5.80 5.80 5.50The Volvo Group 4.00−5.75 5.75−6.25 5.75−6.25 5.50 5.75General Motors 5.52 6.27 6.35 5.90 5.70Ford Motor Company 6.50 6.25 6.25 5.86 5.61

Assumed discount rates used to estimate pension obligations for U.S. plans (percent).

Source: Companies’ annual reports.



• As noted, in some cases, an analyst can adjust items as reported to create more comparable data or to examine sensitivities.

• For example, postemployment health care plans, a type of defined benefit plan, disclose assumptions about increases in health care costs.

Effect of 1% increase (decrease) in assumed health care cost trend rates on 2009 total accumulated postemployment benefit obligations and periodic expense.

1% Increase 1% DecreaseCNH Global N.V. + $106 million (Obligation)

+ $8 million (Expense)– $90 million (Obligation)– $6 million (Expense)

Caterpillar Inc. + $220 million (Obligation)+ $23 million (Expense)

– $186 million (Obligation)– $20 million (Expense)

Source: Companies’ annual reports.



Example: Adjust items as reported to examine sensitivities.

Caterpillar Inc.($ millions) Reported

Adjustment for 1% Increase in Health Care

Cost Trend Rate Adjusted

Total liabilities $50,738 + $220 $50,958

Total equity $8,823 – $220 $8,603

Ratio of debt to equity 5.75 5.92


PENSION PLAN NOTE DISCLOSURES: EXCERPTS ON FUNDED STATUS

Source: L’oréal, Registration Document (2011).



Source: L’oréal, Registration Document (2011).



Source: Colgate-Palmolive Company, Annual Report (2011).


CASH FLOW INFORMATION ON DEFINED BENEFIT PLANS

• The difference between periodic contributions to a plan and total pension costs of the period can be viewed as financing activity.- If periodic contributions to a plan exceed the total pension costs of

the period, the excess is similar to paying loan principal ahead of scheduled amounts.

- If periodic contributions to a plan are less than the total pension costs of the period, it can be viewed as a source of financing.

• Where the amounts are material, an analyst may choose to adjust the reported cash flows.


CASH FLOW INFORMATION: EXAMPLE

• Assume a company reported (₤ millions):- Total pension cost for period: ₤437- Contribution to pension for period: ₤504- Cash inflow from operating activities: ₤6,161 - Cash outflow from financing activities: ₤1,741

• Using an effective tax rate of 28.7%, adjust cash flow from operations and financing to reflect excess contribution as similar to a repayment of borrowing.


CASH FLOW INFORMATION: EXAMPLE

• Assume a company reported (₤ millions):- Total pension cost for period: ₤437- Contribution to pension for period: ₤504- Cash inflow from operating activities: ₤6,161 - Cash outflow from financing activities: ₤1,741

• Using effective tax rate of 28.7%, adjust cash flow from operations and financing to reflect excess contribution as similar to a repayment of borrowing.- After-tax excess contribution: ₤48 - Increase company’s cash outflow from financing activities from ₤1,741

to ₤1,789- Increase company’s cash inflow from operations from ₤6,161 to

₤6,209


SHARE-BASED COMPENSATION

• Employee compensation packages are structured to fulfill varied objectives, including satisfying employees’ needs for liquidity, retaining employees, and providing incentives to employees.

• Common components of employee compensation packages are salary, bonuses, and share-based compensation.

• Share-based compensation (such as stock and stock options) - Aims to align employees’ interest with those of the shareholders, - Requires no current-period cash outlays,- Is treated as an expense and thus reduces earnings,- Potentially dilutes EPS (earnings per share), and- Typically dilutes existing shareholders’ ownership


SHARE-BASED COMPENSATION: STOCK GRANTS

• Stock Grants: Stock granted to employees by their employer.• Types of stock grants includes

- Outright, - Restricted stock grant, and - Contingent stock grant (also known as performance shares).

• Accounting for stock grants’ compensation expense:- Amount of expense is based on fair value of the stock on grant date.- Expense is allocated over the employee’s service period.


SHARE-BASED COMPENSATION: STOCK OPTIONS

• Compensation expense is reported at fair value.• The fair value of option grants must be estimated using a valuation model.• Key assumptions and input into option pricing models include

- exercise price, - stock price volatility, - estimated life of each award, - estimated number of options that will be forfeited, - dividend yield, and - the risk-free rate of interest.

• Some inputs, such as the exercise price, are known at the time of the grant.• Other inputs are highly subjective (e.g., stock price volatility or the expected life

of stock options) and can greatly change the estimated fair value and thus compensation expense.


SHARE-BASED COMPENSATION: STOCK OPTIONS

Grant Date

Vesting Date

Exercise Date

Expiration Date

Day options are granted (usually, the date that compensation expense is measured).

Date that options can first be exercised.

Date when employees actually exercise the options.

• Immediate vesting: Expense is recognized on grant date. • Otherwise, expense is recognized over the service period.


SUMMARY

• Defined contribution pension plans specify (define) only the amount of contribution to the plan; the eventual amount of the pension benefit to the employee will depend on the value of an employee’s plan assets at the time of retirement.

• Defined benefit pension plans specify (define) the amount of the pension benefit, often determined by a plan formula, under which the eventual amount of the benefit to the employee is a function of length of service and final salary.

• The reported obligation and periodic expense for defined benefit pension plans and other postemployment benefit plans are sensitive to assumptions.

• Share-based compensation expense is reported at fair value.• Stock option compensation expense is estimated using a pricing model.• Key inputs into option pricing models include exercise price, stock price volatility,

estimated life of each award, estimated number of options that will be forfeited, dividend yield, and the risk-free rate of interest. Certain assumptions (stock price volatility, expected life of stock options) are subjective and can greatly change the estimated fair value and thus compensation expense.

Chapter 14: Employee Compensation: Post-Employment and Share ...

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