What are defined benefit and defined contribution pension plans?

5. Accounting for defined-benefit plans

Accounting for defined-benefit plans is fairly complex due to the following reasons:

  • Pension expense recognized each period does not necessary equal to the employer's cash contribution to the plan.
  • Pension asset or liability recognition is controversial because it is measured using unknown future variables (e.g. future salary levels, future interest rates, employees' years of service).
  • The amount of pension expense recognized depends on many factors such as:
    • Service costs
    • Interest expense (on the pension liability)
    • Actual return on plan assets
    • Prior service cost
    • Unexpected gains or losses on plan assets

Because the computation of the pension expense and pension asset/liability is mathematically complex, employers hire actuaries to make sure that the pension plan is adequately funded for the employee groups covered by the plan. Actuaries assign probabilities to future events and calculate their financial effects on pension plans; hence, they help to develop and implement pension plan funding.

Actuaries, for example, make predictions (actuarial assumptions) about:

  • Employees' turnover rate
  • Employees' mortality rate
  • Length of employees' service
  • Early retirement frequency
  • Future interest and earnings rates
  • Future salary and compensation levels
  • Many other factors affecting the operations of pension plans

Actuaries also measure factors that affect financial statements: for example, pension liability, annual cost of serving the pension plan, costs of amendments (changes) to the plan, etc. Thus, actuaries play an important role in accounting for defined-benefit plans.

Finally, in addition to pension expense and pension asset/liability recognition, employers have to report pension plan funding status on their balance sheet. There are two pension plan funding statutes: overfunded and underfunded. The funding status is measured as the difference between the projected benefit obligation (PBO) and the fair value (i.e. market value) of plan assets.

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