Introduction to Pension Accounting
The accounting for pensions can be quite complex, especially in regard to defined benefit plans. In this type of plan, the employer provides a predetermined periodic payment to employees after they retire. The amount of this future payment depends upon a number of future events, such as estimates of employee lifespan, how long current employees will continue to work for the company, and the pay level of employees just prior to their retirement.
In essence, the accounting for defined benefit plans revolves around the estimation of the future payments to be made, and recognizing the related expense in the periods in which employees are rendering the services that qualify them to receive payments in the future under the terms of the plan.
How a Pension Works
Pension plans are best summarized in a diagram. The following diagram shows three major players: the employer, the employee, and the pension trust.
A pension trust is a legal entity that holds the pension investments and disburses the funds later, when necessary.
Trusts are managed by trustees, who are independent of the company. We can examine several relationships below.
Relationship 1: Employees provide services to the employer and, in return, they receive wages.
Relationship 2: Employers make contributions to the pension trust.
Relationship 3: Funds are used from the pension trust to pay the employee in the future and, sometimes, employees can also make contributions to the trust.
Pension Accounting Example
XYZ Company has a defined benefit pension plan. At the end of 2015, the fair value of the assets and liabilities in the pension amounted to $6 million. In 2016, the pension expense was $10 million and the company contributed $5 million to the pension plan. At the end of 2016, the fair value of the pension assets and liabilities was $10 million. Let’s see how pension accounting works.
To record company contribution to the pension
DR Defined Benefit Pension Liability 5,000,000
CR Cash 5,000,000
To record pension expense
DR pension expense 10,000,000
CR Defined Benefit Pension Liability 10,000,000
To adjust pension liability to fair value
DR Other comprehensive income (OCI) 1,000,000
CR Net defined benefit liability 1,000,000
Determining Pension Expense in Pension Accounting
There are four important components that must be considered when determining pension expense:
- Current Service Cost: The increase in the present value of the pension obligation that results from the employees’ current services
- Past Service Cost: These costs arise from plan initiations, plan amendments, and reductions in the number of employees under pension plans
- Interest Cost: The increase in the overall pension obligation due to the passage of time
- Expected Income from Plan Assets: Income expected from assets in the pension plan, including investment income from interest, dividends, and capital gains