What are defined benefit and defined contribution pension plans?

5.1. Project benefit obligation in defined-benefit pension plans

Project benefit obligation (PBO) is a pension liability that equals a present value of vested (i.e. fixed, absolute, definite) and nonvested benefits measured at future employees' salary levels. Vested benefits are the benefits that employees have a right to receive even if they do not render services to the employer. In other words, the employees will receive their vested benefits even if they stop working for the employer. Thus, nonvested benefits are the benefits an employee can receive in the future if he or she continues providing services to the employer. To receive a vested benefit status, employees usually have to work for a certain minimum number of years (e.g. 3-5 years).

To calculate the funding status of a plan, an employer has to take a difference between PBO and market value of plan assets. For example, assume that FinHealth Services has a PBO of $500,000, and the market value of plan assets is $450,000. Because the company's liability is greater than the market value of plan assets (i.e. $500,000 > $450,000), the pension plan is underfunded. In this case, the company has to report a pension liability of $50,000 (i.e. 450,000 500,000). Instead, if the market value of plan assets was $600,000, then the pension plan would be overfunded by $100,000 (i.e. $600,000 500,000), and the company would report pension asset of $100,000.

Pension assets are recorded in the noncurrent section in the balance sheet. For example, FinHeath Services would report the pension asset of $100,000 (see the example above) in the noncurrent assets section. The rationale for such a classification is the idea that pension plan assets are restricted assets used to fund pension plan benefits in the future. However, pension liability can be recorded in both current and noncurrent section in the balance sheet. If a company cannot pay employees benefits from existing plan assets, the portion of a pension liability that is expected to be paid in the next 12 months (or operating cycle) will be reported in the current liabilities section in the balance sheet.

Lastly, if a company has multiple pension plans, it can combine underfunded plans together and overfunded plans together. However, the company cannot combine all plans together and report a single amount as a net pension asset or liability (GAAP). For example, assume FinHealth Services has four (4) pension plans with the following funding statuses:

  1. $50,000 underfunded (pension liability)
  2. $100,000 overfunded pension asset)
  3. $25,000 overfunded (pension asset)
  4. $20,000 underfunded (pension liability)

FinHealth Services will report a pension plan asset of $125,000 (i.e. (2) $100,000 + (3) $25,000) and a pension plan liability of $70,000 (i.e. (1) $50,000 + (4) $20,000). But the company cannot report a net pension plan asset of $55,000 (i.e. $125,000 - $70,000).

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