7.1 Defined benefit and defined contribution plans
4 min read•august 16, 2024
Pension plans are a crucial part of employee benefits, with two main types: defined benefit and defined contribution. These plans differ in how they're funded, managed, and the risks they pose to employers and employees.
Understanding these pension plans is key for both companies and workers. They impact financial statements, retirement security, and long-term financial planning. Let's explore the ins and outs of these plans and their accounting implications.
Defined Benefit vs Defined Contribution Plans
Key Characteristics and Features
Top images from around the web for Key Characteristics and Features
Defined benefit plans – Free Creative Commons Images from Picserver View original
Is this image relevant?
Defined Benefit Plans - Free of Charge Creative Commons Suspension file image View original
Is this image relevant?
Defined Benefit Plan - Clipboard image View original
Is this image relevant?
Defined benefit plans – Free Creative Commons Images from Picserver View original
Is this image relevant?
Defined Benefit Plans - Free of Charge Creative Commons Suspension file image View original
Is this image relevant?
1 of 3
Top images from around the web for Key Characteristics and Features
Defined benefit plans – Free Creative Commons Images from Picserver View original
Is this image relevant?
Defined Benefit Plans - Free of Charge Creative Commons Suspension file image View original
Is this image relevant?
Defined Benefit Plan - Clipboard image View original
Is this image relevant?
Defined benefit plans – Free Creative Commons Images from Picserver View original
Is this image relevant?
Defined Benefit Plans - Free of Charge Creative Commons Suspension file image View original
Is this image relevant?
1 of 3
- Defined benefit plans guarantee specific retirement benefit amounts based on salary history and years of service
- Defined contribution plans specify employer and/or employee contribution amounts
- Employers bear investment risk in defined benefit plans responsible for funding promised benefits
- Employees assume investment risk in defined contribution plans with final benefit amounts depending on investment performance
- Defined benefit plans offer predictable retirement income streams often as monthly lifetime payments
- Defined contribution plans provide lump sums or withdrawal series based on account balances at retirement
- Professional managers appointed by employers typically manage investments
- Employees make investment decisions within provided options for defined contribution plans
- Defined benefit plans often have longer vesting periods (5-7 years)
- Defined contribution plans may offer immediate or shorter vesting periods (1-3 years)
- Higher portability in defined contribution plans allows account balance transfers when changing jobs
- Limited portability options for defined benefit plans when switching employers
Plan Management and Employee Involvement
- Employers take on most responsibilities for defined benefit plan management and funding
- Employees have greater involvement and decision-making in defined contribution plans
- Defined benefit plans require complex actuarial calculations and long-term financial projections
- Defined contribution plans involve simpler ongoing administration and record-keeping
- Employers must carefully monitor and adjust defined benefit plan funding levels
- Employees actively manage contribution levels and investment allocations in defined contribution plans
- Defined benefit plans often include provisions for early retirement or disability benefits
- Defined contribution plans may offer loan provisions or hardship withdrawals
Advantages and Disadvantages of Pension Plans
Employee Perspective
- Defined benefit plans provide income security and predictability in retirement
- Lack of flexibility and limited portability in defined benefit plans when changing jobs
- Defined contribution plans offer greater control over investments and improved portability
- Investment risk and responsibility for adequate savings shift to individuals in defined contribution plans
- Defined benefit plans may incentivize long-term employment with a single organization
- Defined contribution plans allow for more customized retirement planning based on individual needs
- Employees may find defined contribution plans easier to understand and value
- Defined benefit plans can provide protection against outliving retirement savings (longevity risk)
Employer Perspective
- Defined contribution plans offer more predictable costs and reduced long-term financial obligations
- Potential challenges in attracting and retaining employees seeking guaranteed benefits with defined contribution plans
- Defined benefit plans serve as powerful tools for employee retention and attraction particularly for long-term employees
- Significant financial risks and potential funding shortfalls associated with defined benefit plans
- Simpler administration and more stable annual costs for defined contribution plans
- Complex regulatory requirements and potential volatility in contribution requirements for defined benefit plans
- Defined contribution plans may lead to higher participation rates and employee appreciation of benefits
- Defined benefit plans can create substantial unfunded liabilities impacting company valuations and financial health
Accounting for Pension Plans
Defined Contribution Plan Accounting
- Straightforward accounting recognizing expenses equal to required contributions each period
- Journal entry: Debit , Credit Cash (for employer contributions)
- No recognition of future obligations or on the balance sheet
- Minimal disclosure requirements typically limited to contribution amounts and plan descriptions
- Consistent expense recognition aligns with the period employees provide services
- No actuarial calculations or long-term projections required
Defined Benefit Plan Accounting
- Complex accounting requiring actuarial calculations to estimate future benefit obligations
- Recognition of (PBO) on the balance sheet representing present value of expected future payments
- Journal entry: Debit Pension Expense, Credit Pension Liability (for service cost component)
- Actuarial gains/losses recognized in other comprehensive income (OCI) and amortized into earnings over time
- Disclosure of assumptions used in calculating obligations (discount rates, expected returns)
- Funding status (difference between plan assets and PBO) reported on the balance sheet
- Service cost expected return on plan assets and amortization of gains/losses comprise pension expense
Financial Statement Impact of Pension Plans
Balance Sheet Effects
- Defined benefit plans create significant long-term liabilities (PBO) potentially affecting key financial ratios
- Net pension liability/asset recognition based on of the plan
- Defined contribution plans have minimal balance sheet impact limited to unpaid contributions
- Actuarial gains/losses for defined benefit plans accumulate in accumulated other comprehensive income (AOCI)
- Pension plan assets reported at fair value for defined benefit plans
- Underfunded defined benefit plans may require additional minimum liability recognition
Income Statement and Cash Flow Impacts
- Defined benefit plans can create volatility due to changes in and market performance
- Pension expense components for defined benefit plans include service cost interest cost and expected return on assets
- Defined contribution expenses limited to employer contributions made during the period
- Cash flow effects more predictable for defined contribution plans with consistent contribution payments
- Defined benefit plans may require large unpredictable contributions to meet funding requirements
- Interest rate changes have pronounced effects on defined benefit plan obligations influencing discount rates
- Defined benefit plans expose organizations to longevity risk as increasing life expectancies lead to higher benefit payments
Key Terms to Review (18)
Actuarial assumptions: Actuarial assumptions are the estimates and judgments made by actuaries regarding future events that affect the financial obligations of pension plans and other similar arrangements. These assumptions include projections about mortality rates, retirement ages, salary growth, and investment returns, which are essential for determining the funding requirements and financial health of defined benefit and defined contribution plans.
ASC 715: ASC 715 is the Accounting Standards Codification section that governs the accounting for pensions and other post-employment benefits, outlining the recognition, measurement, and disclosure of these obligations in financial statements. This guidance is essential for understanding how defined benefit plans differ from defined contribution plans and emphasizes the importance of actuarial assumptions and valuations in calculating these benefits.
Cost-sharing: Cost-sharing refers to the practice where the costs of a benefit plan are divided between the employer and employees. This approach is essential in both defined benefit and defined contribution plans, as it allows for a balanced distribution of financial responsibility, ensuring that both parties contribute to retirement savings. The arrangement helps to manage the overall expenses associated with providing employee benefits while also promoting employee engagement in their retirement planning.
Current service cost: Current service cost refers to the actuarial present value of benefits attributed to employee service during a specific period, usually a financial year, in defined benefit pension plans. This cost reflects the increase in the pension obligation due to employees' current service and is essential for understanding how much an employer needs to allocate to meet future retirement benefits.
Defined Benefit Plan: A defined benefit plan is a type of retirement plan where an employer guarantees a specific retirement benefit amount for employees based on a formula that considers factors such as salary history and duration of employment. These plans provide predictable income during retirement, making them different from defined contribution plans, where the retirement benefit depends on investment performance.
Defined Contribution Plan: A defined contribution plan is a retirement savings plan where the employer, employee, or both make contributions on a regular basis, with the final benefits depending on the contributions made and the investment performance of those contributions. Unlike defined benefit plans that promise a specific payout at retirement, defined contribution plans focus on accumulating funds that are available to employees upon retirement. This type of plan places the investment risk on the employee, as they are responsible for managing their individual account and determining how to allocate their investments.
Discount rate: The discount rate is the interest rate used to determine the present value of future cash flows. It reflects the opportunity cost of capital, which means it accounts for the risk and time value of money when valuing investments or obligations. Understanding the discount rate is crucial in various financial contexts, including assessing lease liabilities, pension plans, and post-employment benefits, as it affects how future payments are valued today.
Employee contributions: Employee contributions refer to the amounts that employees contribute to their retirement plans, which can include both defined benefit and defined contribution plans. These contributions play a crucial role in the overall funding of retirement benefits, as they directly affect the amount of money available for employees upon retirement. In defined contribution plans, the contributions are often matched by employers, while in defined benefit plans, employee contributions can influence the pension benefits received in the future.
ERISA: ERISA, or the Employee Retirement Income Security Act, is a federal law enacted in 1974 that sets standards for private-sector employee benefit plans, including pension and health plans. It aims to protect the interests of employee plan participants and their beneficiaries by requiring plans to provide certain information, ensuring fiduciary responsibility, and establishing grievance and appeals processes. This law is crucial for understanding how defined benefit and defined contribution plans are regulated in the U.S.
Funded status: Funded status refers to the financial health of a pension plan, specifically measuring the difference between the plan's assets and its obligations to pay future benefits. A plan is considered fully funded when its assets are equal to or greater than its liabilities, while underfunded plans have assets that fall short of their projected obligations. Understanding funded status is crucial for evaluating defined benefit and defined contribution plans, as well as complying with necessary disclosures and reporting requirements.
Funding Ratio: The funding ratio is a financial metric that compares the assets of a pension plan to its liabilities, indicating the plan's ability to meet its future obligations. A funding ratio above 100% means that the plan has more assets than liabilities, suggesting it is financially healthy, while a ratio below 100% indicates potential underfunding and may raise concerns about the plan's sustainability.
IFRS 19: IFRS 19 is the International Financial Reporting Standard that provides guidelines for accounting for employee benefits, including pensions and other post-employment benefits. It distinguishes between defined benefit plans, which guarantee a specific payout upon retirement, and defined contribution plans, where the employer's obligation is limited to the contributions made. Understanding IFRS 19 is crucial for recognizing how companies report their obligations and expenses related to employee benefits.
Interest cost: Interest cost refers to the expense incurred by a company when it borrows funds or has outstanding pension obligations, specifically related to defined benefit plans. This cost represents the time value of money on the funds that are earmarked for future payments to employees. In the context of retirement benefits, understanding interest cost is crucial, as it affects how these obligations are recorded and managed on the balance sheet, impacting both financial statements and future cash flow projections.
PBGC: The Pension Benefit Guaranty Corporation (PBGC) is a U.S. government agency that protects the retirement incomes of workers in private-sector defined benefit pension plans. It ensures that retirees receive their pension benefits, even if their employer goes bankrupt or is unable to pay the promised benefits. This agency plays a crucial role in providing stability and security for individuals relying on these plans.
Pension expense: Pension expense refers to the total cost recognized by a company related to its pension plans during a specific accounting period. This cost includes components such as service cost, interest cost on the projected benefit obligation, expected return on plan assets, and amortization of prior service costs. Understanding pension expense is crucial as it influences a company's financial statements and reflects the long-term financial obligations associated with defined benefit and defined contribution plans.
Plan assets: Plan assets refer to the investments and resources held within a pension or retirement plan that are designated to pay future benefits to participants. These assets are crucial for defined benefit plans, where the employer promises a specific payout at retirement, and for defined contribution plans, where the employee's contributions and any employer match are invested. The management and performance of plan assets directly impact the funding status of the pension plan and the financial security of its beneficiaries.
Projected Benefit Obligation: Projected Benefit Obligation (PBO) refers to the present value of future pension benefits that a company expects to pay to its employees for their service earned up to a specific date, taking into account future salary increases. This term is crucial in understanding how companies account for their pension obligations, particularly in defined benefit plans, where the employer is responsible for providing a guaranteed retirement benefit. The PBO reflects not only the benefits accrued to date but also considers expected future changes, emphasizing the importance of accurate projections and assumptions in financial reporting.
Vesting schedule: A vesting schedule is a timeline that dictates when an employee earns full rights to the benefits of a retirement plan, such as a defined benefit or defined contribution plan. This schedule often outlines the specific periods of service required for employees to gain ownership of employer contributions made on their behalf. Understanding vesting schedules is crucial because they can impact an employee's financial security and influence decisions related to job tenure and retirement planning.