So to make sure that pension expense isn’t all over the place, the expected return is used for pension expense (PE) which is based off of actuarial assumptions. Pension expense is based off an assumption that we’re going to earn some percentage on the return of the plan assets (PA), but due to market fluctuations, etc. the actual return may end up being more or less (gain/loss respectively) than the expected return on PA. Any actuarial gain (excess) or loss (deficiency) from the actual vs. expected has to go somewhere, so we defer it in Other Comprehensive Income (OCI) (not recognized in this year’s PE).
For example, assume we expect to have $100 in expected return on plan assets; however, this year we have $120 in actual return on PA. We will recognize the expected return ($100) as a subtraction to PE because we use the expected to arrive at PE. But, the extra $20 has to go somewhere too, so this extra $20 will go to OCI.
Now, the problem becomes when our OCI account becomes too big (either credit or debit) because we keep deferring all of these gain or loss, respectively. Usually this happens because the company didn’t use a good estimated rate of return to start with or the market is performing way differently than expected in essence the actuarial assumption is wrong. This is where the corridor approach is necessary to lower the amount in OCI.
So, to reduce or OCI account, some of this excess will be brought back (amortized) into our PE in future years. Here enters the corridor approach. We will compare our beginning deferred amount in our account in OCI to 10% of the GREATER of the beginning projected benefits obligation or beginning PA. If our deferred amount is less than the 10% of the greater of PBO or PA then we don’t amortize, and we’re done. However, if the deferred amount is greater than that 10%, we will amortize the excess of the (beg deferred amount – [greater of 10% of PA or PBO]) over the average remaining service life.
Now lets also assume a few years later we keep adding extra gains to our OCI account and at the beginning of the year we now have $80 in deferred gains in OCI. (meaning that our actual return on PA has been greater than our expected return on PA by $80) Our beginning PA is $600 and our PBO is $700. We now have to do the corridor approach to check and see if our OCI account is too big. So because our PBO > PA ($700 > $600) we will use the PBO * 10% which is $70 ($700 * 10%). Our beginning deferred gain account is $80; we now compare our 10% of PBO to our deferral, and we see that we have to amortize $10 of our gain. Why? Because $80 (our beginning deferral) is greater than $70 (our PBO) [deferral > PBO]; thus, we do $80 – $70 (beginning deferral – 10% of PBO) = $10. So we will amortize our $10 excess over the average service life. Let’s say our average service life is 10 years, so we will SUBTRACT $1 from PE each year beginning now because it is a gain and gains lower PE. If this was a loss, we would do the same exact calculation but we would add the $1 to PE to increase it.
I hope this makes some sense… Pensions are way confusing unless you work out quite a bit of problems.
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Licensed in Massachusetts (1/2016)
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