Chapter 14: Employee compensation: postemployment and share - Based

Chapter 14Employee Compensation: Postemployment and Share-BasedPresenter’s namePresenter’s titledd Month yyyytypes of postemployment benefits: pension plans Copyright © 2013 CFA Institute2Amount ofFuture benefit to EmployeeContribution from EmployerDefined contribution (DC) pension planDefined benefit (DB) pension planDepends on investment performance of plan assetsAmount (if any) is defined in each periodDepends on current period estimate and investment performance of plan assetsDefined based on plan’s formulatypes of postemployment benefits: pension plans & Employer’s obligationType of BenefitAmount ofFuture benefit to EmployeeContribution from EmployerEmployer’s Prefunding of Its Future Obligation Defined contributionDependsDefinedN/ADefined benefitDefinedDependsTypically prefunded;regulatory requirements.Copyright © 2013 CFA Institute3types of postemployment benefits: other Type of BenefitAmount ofFuture benefit to EmployeeContribution from EmployerEmployer’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.Copyright © 2013 CFA Institute4measuring 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.Copyright © 2013 CFA Institute5measuring 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 statusCopyright © 2013 CFA Institute6net pension liability (or asset)UnderfundedPension obligation exceeds pension plan assets.Liability equal to the net pension obligation is reported. OverfundedPension plan assets exceed the pension obligation.Asset equal to the overfunded pension obligation is reported, subject to limitations.Copyright © 2013 CFA Institute7components of a company’s defined benefit pension expenseCopyright © 2013 CFA Institute8Current Service CostInterestPast Service CostActuarial LossesReturn on Plan Assets$defined benefit plan assumptions Estimated future benefits, which depend onFuture 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.Copyright © 2013 CFA Institute9defined benefit plan assumptions: exampleAssume 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.Copyright © 2013 CFA Institute10defined benefit plan assumptions: exampleCopyright © 2013 CFA Institute11TodayRetirement DateRetirement Period EndAnnual benefit = (Estimated final salary × Benefit formula) × Years service Value at retirement date of estimated future benefits = Present value of annual benefit during retirement periodAnnual unit credit = Value at retirement date/Years of servicedefined benefit plan assumptions: exampleCopyright © 2013 CFA Institute12TodayRetirement DateRetirement Period EndAnnual benefit = (Estimated final salary × Benefit formula) × Years service = €60,198.56 × 1.5% × 5 = €4,514.89Value at retirement date of estimated future benefits = Present value of annual benefit during retirement periodAnnual unit credit = Value at retirement date/Years of servicedefined benefit plan assumptions: exampleCopyright © 2013 CFA Institute13TodayRetirement DateRetirement Period EndAnnual benefit = €4,514.89Value 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% = €51,785.46Annual unit credit = Value at retirement date/Years of servicedefined benefit plan assumptions: exampleCopyright © 2013 CFA Institute14TodayRetirement DateRetirement Period EndAnnual benefit = €4,514.89Value at retirement date of estimated future benefits = €51,785.46Annual unit credit = Value at retirement date/Years of service = €51,785.46/5 years = €10,357.09 per yearPension obligation increases by an amount equal to the present value of the annual credit earned in the yeardefined benefit plan assumptions: impact of changesChanges 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).Copyright © 2013 CFA Institute15pension 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.Copyright © 2013 CFA Institute16pension and other postemployment benefits: Using Disclosures 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 obligationsare 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 ofdifferences 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?). Copyright © 2013 CFA Institute17pension and other postemployment benefits: Using Disclosures  20092008200720062005Fiat S.p.A. 5.505.105.805.805.50The Volvo Group4.00−5.755.75−6.255.75−6.255.505.75General Motors 5.526.276.355.905.70Ford Motor Company6.506.256.255.865.61Copyright © 2013 CFA Institute18Assumed discount rates used to estimate pension obligations for U.S. plans (percent).Source: Companies’ annual reports.pension and other postemployment benefits: Using Disclosures 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.Copyright © 2013 CFA Institute19Effect of 1% increase (decrease) in assumed health care cost trend rates on 2009 total accumulated postemployment benefit obligations and periodic expense. 1% Increase1% 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)– $20 million (Expense)Source: Companies’ annual reports.pension and other postemployment benefits: Using Disclosures Example: Adjust items as reported to examine sensitivities.Copyright © 2013 CFA Institute20Caterpillar Inc.($ millions)ReportedAdjustment for 1% Increase in Health Care Cost Trend RateAdjustedTotal liabilities$50,738+ $220$50,958Total equity$8,823– $220$8,603Ratio of debt to equity5.75 5.92pension plan note disclosures: excerpts on funded status Copyright © 2013 CFA Institute21Source: L’oréal, Registration Document (2011).pension plan note disclosures: excerpts on funded status Copyright © 2013 CFA Institute22Source: L’oréal, Registration Document (2011).pension plan note disclosures: excerpts on funded status Copyright © 2013 CFA Institute23Source: Colgate-Palmolive Company, Annual Report (2011).cash flow information on defined benefit plansThe 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.Copyright © 2013 CFA Institute24cash flow information: exampleAssume a company reported (₤ millions):Total pension cost for period: ₤437Contribution to pension for period: ₤504Cash inflow from operating activities: ₤6,161 Cash outflow from financing activities: ₤1,741Using 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.Copyright © 2013 CFA Institute25cash flow information: exampleAssume a company reported (₤ millions):Total pension cost for period: ₤437Contribution to pension for period: ₤504Cash inflow from operating activities: ₤6,161 Cash outflow from financing activities: ₤1,741Using 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 ₤1,789Increase company’s cash inflow from operations from ₤6,161 to ₤6,209Copyright © 2013 CFA Institute26share-based compensationEmployee 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), andTypically dilutes existing shareholders’ ownership Copyright © 2013 CFA Institute27share-based compensation: stock grantsStock Grants: Stock granted to employees by their employer.Types of stock grants includesOutright, 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.Copyright © 2013 CFA Institute28share-based compensation: stock optionsCompensation 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.Copyright © 2013 CFA Institute29share-based compensation: stock optionsCopyright © 2013 CFA Institute30Grant DateVesting DateExercise DateExpiration DateDay 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.Copyright © 2013 CFA Institute31