Johnson & Johnson - Retirement Obligations

Cases in Financial Reporting 8e

a. ii. Under a defined contribution plan, the employer contributes a certain sum to a pension
plan each period. This amount is determined by a formula that considers multiple factors
including age, employee service length, employer profits, and compensation level. One of the
key components of this plan is that it only defines the employer’s contributions. It does not
promise a specified amount in benefits to be paid out in the future. A defined benefit plan differs
from a contribution plan in that benefits are determined based on what the employee will receive
when they retire. The benefit amount is based on the employee’s years of service and
compensation levels in the years before retirement. Since the benefit amount is a future payment
amount, a time value of money computation is needed to determine what the company must
contribute today in order to properly fund the future payout. At employee retirement, if the fund
is short, the employer is responsible for paying the remaining amount. Johnson & Johnson has
both types of plans.

a. ii. Retirement plans are liabilities because they are represent a future economic sacrifice the
company must make to pay a certain amount to current employees in the future during their
retirement. As stated above, the employer must calculate the future payout using the time value
of money computation in order to set aside the appropriate amount of money today for the
retirement plan.

a. iii. The expected number of years of an employee’s service, age at retirement, mortality rate,
wage increases, and the discount rate for the present value of the retirement plan (time value
calculations).

b.
 Service cost represents the additional amount added to a pension obligation based on an
employee’s service during the year for the employer. It is one of the two largest costs of a
retirement plan.
 The second largest cost of a pension plan is interest cost. Interest cost is the amount of
interest accrued to the plan for the year.
 Actuarial gains and losses occur when there is a difference between the actual return on a
plan’s assets and the expected return on the plan’s assets.
 The retirement obligation will decrease when benefits are paid out to the beneficiaries.
The payments satisfy the obligation performance.

c.
 Actual return on pension investments will increase the value of the assets and vice versa
when there is a loss or decrease in value. Returns can include interest, dividends, and
capital gains.
 When a company makes a contribution to the plan its assets will increase in value.
 The pension plan’s assets are reduced when benefits are paid out to retired employees.

d. Pension expense is determined using the expected return on plan assets. This is calculated by
multiplying the fair value of the plan assets at the beginning of the year by the estimated rate of
return for the year. The expected return reduces pension expense because the higher the return,
the less the employer has to contribute. However, the plan assets are increased by the actual
 return and not the estimated return. The pension plan is reported on the balance sheet at their fair
market value. The rationale behind this, in my opinion, has to do with the short-term effect vs.
long term effect of market fluctuations on the pension plan’s performance. While the market can
be volatile in the short run, up one period and down in the next, in the long run the plan assets
should be able to earn around the estimated return on assets.

e. The difference between the retirement plan and other benefits to retirees is that the retirement
plans have a legal obligation to be funded by the employer and are funded in advance, whereas,
the other benefits do not have a legal obligation to be funded. According Note 13 “The Company
does not fund retiree health care benefits in advance and has the right to modify these plans in
the future.”

f. i. Johnson & Johnson reported $646 million in pension expense for 2007.

f. ii. Net periodic benefit cost – service cost 597

Net periodic benefit csot – interest cost 656
Retirement obligation 1253

g. i.
 $12,002 million is the retirement plan obligation at December 31, 2007.
 This amount represents the present value of future benefits owed to current and retired
employees. The value is based on assumption of life expectancy, compensation, years of
service, age at retirement, discount rates, etc.
 However, this number is fairly reliable since it is calculated by an actuary and audited.

g. ii. The pension related interest cost is $656 million.

Beginning of year $ 11,660.00

End of year $ 12,002.00
Total $ 23,662.00
Average Pension Obligation $ 11,831.00

Interest Cost $ 656.00

Average Pension Obligation $ 11,831.00
Average Interest Rate 5.54%

2007 2006 Total Average

U.S. Discount Rate 6.50% 6.00% 12.50% 6.25%
Intgernational Discount Rate 5.50% 5.00% 10.50% 5.25%

 Based on the average U.S. Discount Rate and the average International Discount Rate,
the average interest rate of 5.54% is within the range and reasonable.

g. iii.
 $481 million was paid to retirees during 2007.
 The pension plan trust made the payments to the retirees not Johnson & Johnson.
  Since the payment to the retirees is made from the pension asset funds for part of the
obligation due, said obligation and assets are thus reduced by the amount paid out.

h. i. $10,469 is the fair value of the retirement plan assets at December 31, 2007.

h. ii.
 Expected return on assets in 2006 was $701 million and actual was $966 million. The
expected return on assets in 2007 was $809 million and actual was $743 million.

Expected Actual Difference As a %

2006 Return on assets 701 966 265 27.43%
2007 Return on assets 809 743 -66 -8.88%

 Based on the final %’s, the difference between expected and actual returns is significant.

 I believe the estimated return on assets is a better reflection of what the assets will earn in
the current year and beyond. Whereas, the actual represents the return on assets during
based on that year’s market alone and would unnecessarily introduce market volatility to
the income statement.

h. iii.
 $317 million was contributed by Johnson & Johnson, and $62 million was contributed by
employees.
 This is significantly more than what was contributed in 2006. $259 million contributed by
Johnson & Johnson, and $47 million contributed by employees.

h. iv. Types of investments in Johnson & Johnson’s retirement plan assets

U.S. Retirement Plans

Equity securities 79%
Debt Securities 21%
International Retirement Plans
Equity securities 67%
Debt securities 32%
Real estate & other 1%

i. Funding status of retirement plan:

2007 2006
Non-current assets $ 481.00 $ 259.00
Current liabilities $ (43.00) $ (26.00)
Non-current liabilities $ (1,971.00) $ (2,355.00)
Total recognized on the balance sheet $ (1,533.00) $ (2,122.00)

 In both years the retirement plan is underfunded. The pension plan assets are netted
against the pension plan liabilities. Because of this, the balance sheet only includes the
underfunded amounts in the balance sheet accounts listed above for 2007 and 2006.
j. i. The total obligation of the other benefits plan at December 31, 2017 is $2,721 million and
has plan assets of $29 million, which means it has a very large and significant underfunding
status of $2,692 million.

j. ii. By law the pension plan must funded by the employer and is funded in advance, whereas,
the other benefits do not have a legal obligation to be funded. According Note 13 “The Company
does not fund retiree health care benefits in advance and has the right to modify these plans in
the future.”

k. i. Estimated actual rate of return for 2007:

Beginning plan assets $ 9,538.00

Ending plan assets $ 10,469.00
Total plan assets $ 20,007.00
Average plan assets for the yar $ 10,003.50
Actual return $ 743.00
Actual return as a % of average 7.43%

 The footnote on page 61 of the financial statement states that the “expected long-term
rate of return on plan assets is 9% for U.S. Benefit Plans, and 8.25% “expected long-term
rate of return on plans assets” for International Benefit Plans. The actual rate of return is
lower than the estimated rate of return. While the estimated rate of return may fluctuate
with the actual in the short-run, over the long-run the estimated rate of return should
approximate the actual rate. This helps smooth market volatility.

k. ii. The higher discount rate of 6.5% decreases the projected pension benefit obligation and
the present value of future obligations payed out. Because of this, the pension liability recorded
on the balance sheet will be lower than if Johnson & Johnson had used the 6% discount rate.

k. iii. The rate of increase in compensation levels for 2005 and 2006 was 3.75%. 2007 recorded
a 4% rate of increase in compensation producing a difference of 0.25%. The present value of
future payments affects the projected benefit obligation. Increasing the future payments
increases both the projected benefit obligation and the pension expense.

l. i. Combined retirement and other benefit expenses over 3 years:

2007 2006 2005

Pension expense $ 646.00 $ 685.00 $ 602.00
Other benefit expense $ 346.00 $ 322.00 $ 158.00
Total $ 992.00 $ 1,007.00 $ 760.00
 Overall, the expenses are increasing. However, there is no distinguishable pattern that
would indicate whether or not this increase will continue. Most likely, the pattern will
continue to fluctuate from year to year as indicated above.
l. ii. Operating & Non-operating Components for each year:

2007 2006 2005

Operating component:
Service cost (pension & other benefits) $ 737.00 $ 674.00 $ 518.00
Non-operating component $ 255.00 $ 333.00 $ 242.00
Total $ 992.00 $ 1,007.00 $ 760.00

 The operating component, service cost, is increasing over time. Whereas, the non-
operating component fluctuated from year to year. This is most likely attributed to
interest rates associated with assets in the market place and the volatility that comes with
it.
 So long as the company continues to grow, the increasing trend for the operating segment
should remain persistent through the coming years. However, that cannot be said for the
non-operating segment.

m. i. Effect of gross assets on respective gross obligations:

Gross amount that Net amount Net amount that

would be added currently included would be added
Retirement and other benefit plan assets $ 10,498.00 $ 481.00 $ 10,017.00
Retirement and other benefit plan liabilities $ 14,723.00 $ 4,706.00 $ 10,017.00

m. ii. Amounts and ratios per reported financial statements vs pro forma with above additions:

As Reported Pro Forma

Total Assets $ 80,954.00 $ 90,971.00
Total liabilities $ 37,635.00 $ 47,652.00
Liabilities to equity ratio 0.87 1.10
Return on assets 13.9% 12.4%
Return on equity 24.4% 24.4%

m. iii. Since the obligation is covered mostly by pension plan assets that are held in a trust by a
third party (with legal restrictions on use and funding), I believe the currently reported numbers
better reflect the economic reality of Johnson & Johnson since they are only liable for
contributions to the net amount.