Understanding the Rules for Defined-Benefit Pension Plans

Several charges connected with defined benefit plans may look enigmatic at first. Yearly pension expenditure computation and financial statement disclosure of a pension plan’s assets and liabilities. Though for many current and future retirees, a pension is the cornerstone that supports retirement security, financial well-being, and peace of mind. In application, there are several other changes to the pension liability, with pension payments to the retirees being the most common. More ubiquitous in recent decades is the defined-contribution plan, such as a 401(k) plan. With these plans, employees are responsible for saving and investing for their retirement years.

While defined benefit plans can be structured similarly in the US and outside of the US, their accounting and presentation can significantly differ between IAS 19 and US GAAP. In addition, when the actuarial valuations are outsourced, management still is responsible for the overall accounting. Therefore, dual reporters need to understand their actuaries’ experience and background, making sure that they have adequate knowledge of these GAAP differences. The actuarial gains/losses, net of any experience adjustments to plan assets, are allocated immediately into other comprehensive income and subsequently amortized into the income statement/profit and loss account over time in the US. The applicable defined benefit plan costs are accounted for in the table of net periodic pension costs recognized in each accounting period (see table above).

How to Save for Retirement Outside of a Defined Benefit Plan

Although employees generally have little control over their benefits, there are still annual limits for defined benefit plans. In 2023, the annual benefit for an employee can’t exceed the lesser of 100% of their average compensation for their highest earning three consecutive calendar years or $265,000. You’re probably more familiar with qualified employer-sponsored options like a 401(k) plan. Unlike 401(k)s, defined benefit plans are usually funded entirely by employer contributions, although in rare cases employees may be required to make some contributions. DB plans were implemented by people who had the best intentions for helping employees experience a financially sound life during their retirement years.

• Traditional DB plans, commonly referred to as pensions, typically provide a guaranteed monthly income to employees when they retire and place the burden of funding and choosing investments on the employer.
• The final salary of this employee at the time of retirement is expected to 100.
• Notice that the employer’s liability in year 5 (667.1) matches the size of the pension pot.
• There are very specific requirements around pension accounting, which will be outlined in this article.
• The interest expense for the expected benefit obligation is recorded when incurred.
• However, the accounting treatment becomes more complicated when employees earn the rights to the benefits NOW but receive those benefits later, in the FUTURE.

The 120,000 service cost is recorded as an operational item, while the remaining things are included as a net interest expense of 39,500 (84,500 – 45,000). Although a thorough understanding of pension accounting is optional for a valuation professional, it is critical to understand the “what and where” of the primary pension figures in a set of financials. In the United States, the Financial Accounting Standards Board (FASB) oversees the application of generally accepted accounting principles (GAAP) to pension accounting. “A pension is the $400 per month I receive for my many years of service at Acme Widgets. My pension helps to supplement the $600 per month I receive from Social Security and my retirement savings.”

Defined-Benefit Plan: Rise, Fall, and Complexities

Because the ultimate payment from the plan is defined, the risks of the plan now fall upon the employer. If the plan fails to retain sufficient assets to pay out the defined pension benefits, the employer is required to make up the difference through additional contributions. Under the defined benefit pension plan, the employer commits to depositing enough money into a pension fund in order to cover the future benefits. Since there is uncertainty in the investment returns, the life expectancy of retirees, and other factors, the employer’s ongoing contributions, pensions expense, and net income are uncertain.

4.1. Accounting for Defined Benefit Plans

Under US GAAP, curtailment losses are recognized when they are probable while curtailment gains are recognized when they occur. From a measurement perspective, curtailment gains and losses under IAS 19 are based on changes in the benefit obligation. Under US GAAP, such gains and losses reflect the increase or decrease in the benefit liability that exceeds the net actuarial gains or losses, in addition to any unrecognized prior service costs no longer expected to be incurred. Any actuarial gains or losses or prior service cost not yet recognized in net income under US GAAP would therefore result in a measurement different from IAS 19. Under IAS 19, actuarial gains and losses are recognized in OCI and are never recycled to net income in subsequent periods but may be transferred within equity (e.g. from OCI into retained earnings).

Accounting and Reporting by Defined Benefit Pension Plans

About half of 401(k)s have some sort of vesting schedule for employer contributions. Frequently, as in Canadian government employees’ pensions, the average salary uses current dollars. This results in inflation in the averaging years decreasing the cost and purchasing power of the pension. This can be avoided by converting salaries to dollars of the first year of retirement and then averaging. If that is done, then inflation has no direct effect on the purchasing power and cost of the pension at the outset.

The benefit is calculated in advance using a formula based on age, earnings, and years of service. Aside from the DBO, the other major element of the pension plan is the assets the pension plan holds in trust for the employees. The assets are typically held in a separate entity from the company and are usually legally restricted in a way that prevents their conversion for use in settlement of other non-pension liabilities of the company. The plan assets will usually be held in low-risk investments such as high-quality debt and equity securities, stable real estate properties, cash and other cash equivalents. The goal of the plan is to earn a reasonable return without taking too much risk.

Defined-Benefit vs. Defined-Contribution Plans

To receive benefits from the plan, an employee usually must remain with the company for a certain number of years. The primary objective of a plan’s financial statements is to provide information that is useful in assessing adjusting entries always include the plan’s present and future ability to pay benefits when they are due. This objective requires the presentation of information about the plan’s economic resources and a measure of participants’ accumulated benefits.

Defined-Benefit Plan vs. Defined-Contribution Plan Example

The interest cost on the obligation is a basic concept that reflects the time value of money. Because the payments to retirees will be made in the future, the obligation must be discounted to its present value. As time passes, interest must be accrued on the obligation during each accounting period, increasing the obligation’s carrying value each period until it reaches the ultimate amount payable to the employee on the date of retirement. Although the correct accounting treatment requires calculation of the interest cost based on actual transactions in the plan during the year, a simplifying assumption we will make is that transactions occur at the end of the year.