What are defined benefit and defined contribution pension plans?
3. Accounting for defined-contribution plans
Accounting for definite-contribution plans is relatively easy and straightforward. The employer makes a contribution each year based on the formula defined by the plan. Thus, the employer's annual pension expense equals the employer's contribution to the plan.
When the employer pays less than the obligated amount to the plan (i.e. actual payments is less than expected (defined) contribution), then the employer records a pension liability (obligation). On the other hand, when the employer pays more than the obligated amount to the plan (i.e. actual payment is more than the expected payment), then the employer records a pension asset.
For example, FinHealth Services Inc. contributes to a defined-contribution plan. Based on a formula, the company must contribute $120,000 to the plan each year. Thus, the company should recognize an annual pension expense of $120,000. Assuming that the company makes the payment at the end of the year, on December 31, 20X9 FinHealth Services Inc. should make the following entry:
Account Titles |
Debit |
Credit |
Pension Expense |
120,000 |
|
Cash |
120,000 |
However, if FinHealth Services recognizes and records pension expense on a monthly basis (which is more likely), the monthly journal entry will be as follows:
Account Titles |
Debit |
Credit |
Pension Expense |
10,000 |
|
Cash (or Pension Payable) (*) |
10,000 |
* If the company recognizes Pension Payable and pays it at the end of the year, the company will debit Pension Payable (i.e. decrease liability) and credit Cash when it makes the payment.
4. Explanation of defined-benefit plans
Defined-benefit plans outline the benefits that employees will receive after their retirement. Important to note that opposite to defined-contribution plans, in a defined-benefit plan the "beneficiaries" are employers because they assume investment benefits and risks.
Even though the employer hires an independent third-party (pension trust) to manage the plan, to make investments, and to distribute the benefits (similar to defined-contribution plans), ultimately the employer is responsible for the payment of the benefits to employees. Regardless of the trust's performance (i.e. whether the trust has or hasn't enough funds to pay the benefits), the employer is obligated to make up any shortfalls in the pension trust assets.
On the other hand, if the trust performs well, the employer can receive the benefits: a) reduce future funding; or b) reverse funds. In any case, employers are at risk with defined-benefit plans. Therefore, employers have to determine their contribution pattern to the plan to make sure that there are going to be enough assets to distribute promised benefits to the retired employees, when needed.
The examples of defined-benefit plans in the United States are U.S. Defined Benefit Pension Plans (funded to pension trusts), Social Security and post-retirement benefits plans (unfunded).
online accounting course:
