8.1 Defined Benefit and Defined Contribution Plans
6 min read•july 30, 2024
Pension plans are a crucial part of employee benefits, offering financial security in retirement. This section dives into two main types: defined benefit and defined contribution plans. Each has unique features, impacting both employers and employees differently.
Understanding these plans is key for grasping how companies manage retirement benefits. We'll explore the roles, risks, and responsibilities of both employers and employees in each type of plan, as well as their advantages and disadvantages.
Defined Benefit vs Defined Contribution Plans
Defined Benefit Plans
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- Promise a specific benefit at retirement typically based on years of service and salary level
- Example: An employee with 30 years of service and a final salary of 60,000 (60% of final salary)
- Employer bears the investment risk and is responsible for funding the plan to meet the promised benefits
- If investment returns are lower than expected, the employer must make additional contributions to ensure the plan remains adequately funded
- Employer is responsible for ensuring sufficient funds are available to pay the promised benefits
- This requires ongoing monitoring and adjustments to contribution levels based on actuarial valuations
Defined Contribution Plans
- Specify the amount of contributions to be made by the employer and/or employee but do not promise a specific benefit at retirement
- Example: An employer may contribute 5% of an employee's salary to a , with the employee having the option to contribute additional funds
- Employee bears the investment risk and the ultimate benefit depends on the performance of the invested funds
- If investment returns are lower than expected, the employee's account balance and future retirement income will be reduced
- Employer's responsibility ends once the specified contributions are made
- The employer has no obligation to ensure a certain level of benefits or to make additional contributions if investment performance is poor
Employer & Employee Roles in Pension Plans
Employer Responsibilities
- In defined benefit plans, employers are responsible for:
- Making contributions to the plan
- Managing investments to ensure the plan remains adequately funded
- Ensuring the plan is adequately funded to meet future obligations
- In defined contribution plans, employers are responsible for:
- Making the specified contributions to employee accounts
- Offering a range of investment options for employees to choose from
- Employers sponsoring defined benefit plans bear the longevity risk (risk of retirees living longer than expected) and investment risk
- If retirees live longer than expected or investment returns are lower than anticipated, the employer must make additional contributions to cover the shortfall
Employee Responsibilities
- In defined benefit plans, employees are typically not required to contribute
- The employer bears the full responsibility for funding the plan and managing investments
- In defined contribution plans, employees are responsible for:
- Selecting investments from the options provided by the employer
- Monitoring their account balances and making adjustments to their investment allocations as needed
- Making additional contributions to their accounts if desired (e.g., through salary deferrals)
- In defined contribution plans, employees bear the investment risk and the risk of outliving their retirement savings (longevity risk)
- If investments perform poorly or the employee lives longer than expected, they may have insufficient funds to maintain their desired standard of living in retirement
Advantages and Disadvantages of Pension Plans
Advantages of Defined Benefit Plans
- Predictable retirement benefits for employees
- Employees can plan for retirement knowing they will receive a specific benefit based on their years of service and salary
- Employer-funded contributions
- Employees are not required to contribute to the plan, reducing their out-of-pocket costs during their working years
- Ability to provide a stable income stream in retirement
- The guaranteed benefit provides a reliable source of income for retirees, helping to mitigate the risk of outliving their savings
Disadvantages of Defined Benefit Plans
- Higher costs for employers
- Employers must make ongoing contributions and manage investments to ensure the plan remains adequately funded, which can be costly
- Less portability for employees
- Employees may lose some or all of their benefits if they leave their employer before reaching retirement age
- Risk of underfunding
- If the plan's investments perform poorly or the employer fails to make sufficient contributions, the plan may become underfunded, putting employees' benefits at risk
Advantages of Defined Contribution Plans
- Greater portability for employees
- Employees can typically take their account balances with them if they change jobs, allowing them to continue saving for retirement without interruption
- Flexibility in contribution amounts
- Employees can often choose how much to contribute to their accounts, allowing them to adjust their savings rate based on their individual circumstances
- Potential for higher returns through employee-directed investments
- Employees have the opportunity to select investments that align with their risk tolerance and financial goals, potentially leading to higher returns over time
Disadvantages of Defined Contribution Plans
- Lack of guaranteed benefits
- The ultimate benefit received by the employee depends on the performance of their invested funds, which can be impacted by market fluctuations
- Increased investment risk for employees
- Employees bear the full risk of their investment decisions, which can lead to lower-than-expected account balances if investments perform poorly
- Need for employees to actively manage their accounts
- Employees must regularly monitor their accounts, make investment decisions, and adjust their contributions to ensure they are on track to meet their retirement goals
Pension Plan Assets and Obligations
Pension Plan Assets
- Include employer contributions, employee contributions (if applicable), and investment returns
- Employer contributions are made based on actuarial calculations to ensure the plan remains adequately funded
- Employee contributions, when required or allowed, are typically made through salary deferrals
- Investment returns are generated by the plan's portfolio, which may include stocks, bonds, real estate, and other assets
- Typically managed by the plan sponsor or a third-party investment manager
- The plan sponsor (employer) has a fiduciary responsibility to manage the plan's assets prudently and in the best interests of plan participants
- Third-party investment managers may be hired to provide specialized expertise and manage the plan's investment portfolio
Pension Plan Obligations
- Represent the present value of future benefits promised to employees and retirees
- The present value is calculated using actuarial assumptions, such as life expectancy, retirement age, and salary growth rates
- Example: If an employee is promised an annual pension of $50,000 for 20 years starting at age 65, the present value of that obligation would be calculated based on the employee's life expectancy and an assumed
- Determined using actuarial assumptions
- Life expectancy: The expected number of years an employee or retiree will live and receive benefits
- Retirement age: The age at which employees are expected to retire and begin receiving benefits
- Salary growth rates: The expected annual increase in employees' salaries, which can impact the final benefit amount in defined benefit plans
Funded Status and Pension Expense
- The of a pension plan is the difference between the plan's assets and its obligations
- A plan is considered fully funded when assets are sufficient to cover all future obligations
- If assets exceed obligations, the plan is considered overfunded; if obligations exceed assets, the plan is considered underfunded
- represents the cost recognized by the employer in a given period
- Includes the cost of benefits earned by employees during the period, interest on the pension obligation, and amortization of actuarial gains or losses
- Actuarial gains or losses occur when actual experience differs from the assumptions used to calculate pension obligations (e.g., if employees live longer than expected or investment returns are higher or lower than anticipated)
- Actuarial assumptions play a crucial role in determining pension obligations and expense
- The discount rate is used to calculate the present value of future obligations and is typically based on the yield of high-quality corporate bonds
- The expected return on is an assumption about the long-term investment performance of the plan's portfolio
- Changes in these assumptions can significantly impact the plan's funded status and the employer's financial statements
Key Terms to Review (18)
401(k) plan: A 401(k) plan is a type of defined contribution retirement savings plan offered by employers that allows employees to save and invest a portion of their paycheck before taxes are taken out. This plan encourages employees to save for retirement by providing tax benefits and often includes employer matching contributions, which can significantly boost an individual's retirement savings. Contributions to a 401(k) are made through payroll deductions, and the investment grows tax-deferred until withdrawal during retirement.
ASC 715: ASC 715 refers to the Accounting Standards Codification Topic 715, which provides guidance on accounting for pension and other post-retirement benefits. This standard outlines how companies should recognize, measure, and disclose the costs and obligations associated with defined benefit plans, ensuring that financial statements accurately reflect these liabilities and expenses.
Defined benefit plan: A defined benefit plan is a type of retirement plan where an employer guarantees a specific payout upon retirement, based on factors like salary history and duration of employment. This means employees know exactly what they will receive when they retire, providing financial security for the future. The employer is responsible for managing the investments and assumes the investment risk, making these plans distinct from other retirement plans.
Defined contribution plan: A defined contribution plan is a retirement savings plan where an employer, employee, or both make contributions on a regular basis, and the retirement benefits depend on the amount contributed and the performance of the investment options selected. This type of plan contrasts with defined benefit plans, which promise a specific payout at retirement based on a formula. In defined contribution plans, the investment risk is borne by the employee, as their retirement benefits are not guaranteed.
Discount rate: The discount rate is the interest rate used to determine the present value of future cash flows. It's crucial for valuing long-term liabilities like pension obligations and leases, as it impacts how much those future obligations are worth today. A higher discount rate results in a lower present value, which affects financial reporting and decision-making regarding employee benefits and lease agreements.
Employee contribution: Employee contribution refers to the portion of an employee's earnings that is set aside for retirement savings, typically through a pension plan or retirement account. This contribution can take the form of direct deductions from the employee's paycheck and is often matched to some extent by the employer, depending on the plan type. Understanding employee contributions is crucial in evaluating retirement benefits and the financial planning required for employees' future security.
Employer contribution: An employer contribution refers to the funds that an employer contributes to an employee's retirement plan, such as a pension or retirement savings account. This contribution is an essential aspect of both defined benefit and defined contribution plans, helping employees build their retirement savings. It can take various forms, including matching contributions or direct payments, and significantly impacts the overall value of the retirement benefits employees receive upon retirement.
ERISA: ERISA, or the Employee Retirement Income Security Act, is a federal law enacted in 1974 that sets standards for pension and health plans in private industry to protect individuals in these plans. It ensures that employee benefit plans are managed fairly and that participants receive their promised benefits. By regulating defined benefit and defined contribution plans, ERISA plays a critical role in shaping how these retirement plans are funded and administered.
Funded status: Funded status refers to the financial health of a pension plan, indicating whether the plan has sufficient assets to meet its future obligations to retirees. A plan is considered fully funded when its assets equal or exceed its liabilities; otherwise, it is underfunded. Understanding funded status is crucial as it impacts how companies report pension expenses, assess their long-term liabilities, and manage retirement benefits for employees.
IFRS 19: IFRS 19 is an international accounting standard that outlines the principles for recognizing, measuring, and disclosing employee benefits. It specifically addresses both short-term and post-employment benefits, including defined benefit plans and defined contribution plans, ensuring that entities account for their obligations in a consistent manner across different jurisdictions.
Mortality rate: The mortality rate is a statistical measure that represents the number of deaths in a given population over a specific period of time, typically expressed per 1,000 individuals. In the context of defined benefit and defined contribution plans, understanding mortality rates is crucial as it impacts the funding and management of these pension plans, influencing factors like contributions, benefits payout, and investment strategies.
Other Comprehensive Income: Other comprehensive income (OCI) refers to revenues, expenses, gains, and losses that are excluded from net income on an entity's income statement. Instead of affecting the net income directly, OCI is reported separately in the equity section of the balance sheet, which affects the overall financial health of a company. This concept connects to various accounting topics, including the treatment of unrealized gains and losses on certain investments, the impact of tax allocation on comprehensive income, and the recognition of pension-related adjustments in defined benefit plans.
Pension expense: Pension expense represents the total cost recognized by a company for providing pension benefits to its employees during a given period. This expense includes components such as service costs, interest costs, and any gains or losses from plan assets, and is critical for understanding the financial implications of employee retirement benefits.
Pension liability: A pension liability is an obligation that a company has to pay retirement benefits to its employees in the future. This liability arises primarily from defined benefit plans, where the employer promises specific retirement benefits based on factors like salary and years of service. Understanding pension liabilities is crucial because they affect a company's financial health and can have significant implications for financial reporting.
Plan assets: Plan assets refer to the resources set aside within a pension or other postretirement benefit plan to cover future obligations to employees. These assets are crucial for ensuring that the plan can meet its promised benefits, which may include retirement payouts, healthcare coverage, or other postemployment benefits. The effective management and investment of these assets directly impact the financial health of the benefit plan, influencing both the employer's balance sheet and the employees' financial security in retirement.
PPA: PPA, or Projected Benefit Obligation, refers to the present value of a pension plan's projected future benefit payments to employees, taking into account factors like salary increases and years of service. It is crucial for understanding a company's obligations under defined benefit plans and helps assess the financial health of these retirement plans.
Projected benefit obligation: Projected benefit obligation (PBO) is a measure used in accounting for defined benefit pension plans that estimates the present value of future retirement benefits owed to employees, based on their service and salary history. This estimate incorporates assumptions about factors like salary growth, employee turnover, and mortality rates, which helps companies determine how much they need to set aside to meet future pension liabilities.
Traditional pension: A traditional pension, also known as a defined benefit plan, is a retirement plan where an employer guarantees a specific monthly benefit to employees upon retirement, based on a formula that typically considers factors like salary history and length of employment. This type of plan provides financial security for retirees, as the employer bears the investment risk and is responsible for ensuring that sufficient funds are available to meet the promised benefits.