Overview of Pension Accounting

A pension is a contract for a fixed sum to be paid regularly to a person, typically following retirement from service.

Learning Objective

Summarize how a company reports their pension plan on their financials statements

Key Points

The two most common are the defined benefit and the defined contribution plan.
The employer (sponsor) reports pension expense on the income statement, and a pension liability which is the sum of two accounts, accrued/prepaid pension cost and additional liability, and an intangible asset-deferred pension cost (if required).
In a defined contribution plan (such as a 401k), while the company makes contributions or matching contributions, it does not promise the future benefit to the employee.

Terms

pension
A regularly paid gratuity paid regularly as benefit due to a person in consideration of past services; notably to one retired from service, on account of retirement age, disability, or similar cause; especially, a regular stipend paid by a government to retired public officers, disabled soldiers; sometimes passed on to the heirs, or even specifically for them, as to the families of soldiers killed in service.
contribution
An amount of money given toward something.

Full Text

Components of a Pension Plan

A pension is a contract for a fixed sum to be paid regularly to a person, typically following retirement from service.

Types of Pension Plans

While there are various pension plans in use today, the two most common are the defined benefit and the defined contribution plan.

With a defined benefit plan, an employee knows the terms of the benefit to be received upon retirement. So, the company must invest in a fund in order to meet its obligations to the employee. In this type of plan the company bears the investment risk.

In a defined contribution plan (such as a 401k), while the company makes contributions or matching contributions, it does not promise the future benefit to the employee. In such a plan, the employee bears the investment risk.

A 401k is a defined contribution plan

In a defined contribution plan the employees bear all the risk.

Pension Plan Accounting

Due to the nature of pension plans, accounting for them is rather complicated. The first complication is that pension benefits are payable to retirees in the far future, so it is hard to estimate the amount of future payments.

The second complication comes from the application of accrual accounting. Since, the actual cash flows are not counted each year; this means the annual pension expense is based on rules that attempt to capture changing assumptions about the future.

The last complication comes from the rules that require companies to prevent over/under stating the pension funds. This smoothing out of the account disguises the true position of the plan.

The employer (sponsor) reports pension expense on the income statement, and a pension liability which is the sum of two accounts, accrued/prepaid pension cost and additional liability, and an intangible asset-deferred pension cost (if required).

The employer is also required to maintain memo accounts for unrecognized prior service costs and unrecognized gains and losses.

How a Pension Plan Is Presented in the Financials

In addition to reporting the pension expense on the income statement companies should disclose the following information about the pension plan:

Plan description (including benefit formula, employee groups covered, funding policy. and types of assets held)
The amounts for the components of pension expense for the period
A reconciliation schedule relating the funding status of the plan

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