Pension Plans Explained | CFA Level I FSA
Welcome back! In this guide, we’ll dive into pension plans, focusing on defined contribution plans and defined benefit plans. We’ll explore their differences and the financial reporting requirements for each. So let’s get started!
Understanding Pension Plans
A pension is a form of deferred compensation earned over time through employee service. Employees are promised some form of monetary benefit after they retire. The most common pension arrangements are:
Defined Contribution Plans
In a defined contribution plan, the firm contributes a sum each period to the employee’s retirement account. This contribution can be based on factors such as the employee’s age, years of service, compensation level, or the firm’s profitability. The firm doesn’t promise any specific future payout to the employee.
The employee makes the investment decisions, choosing from a set of portfolio options. All of the investment risk lies with the employee. If the investment decision turns out to be bad, the employee must accept the outcome at retirement.
Defined Benefit Plans
Conversely, in a defined benefit plan, the firm promises to make periodic payments to employees after retirement. The promised benefit is usually based on the employee’s years of service, their compensation at retirement, and the benefit factor.
An employee who has worked for 30 years, with a final salary of $100,000, and a benefit factor of 1%, will be expecting a retirement benefit of $30,000 per year, payable until death.
With a defined benefit plan, employees don’t need to worry about investment decisions. The employer assumes all the investment risk and is responsible for making appropriate contributions and investment decisions.
Trusts and Financial Reporting
In practice, most firms set up a trust to manage pension assets. The trust is responsible for generating the income and principal growth necessary to pay pension obligations as they become due. The employer is responsible for making regular contributions to the trust fund.
Defined Contribution Plan Reporting
Financial reporting for defined contribution plans is straightforward. Pension expense equals the employer’s contribution, and there is no future obligation to report as a liability on the balance sheet.
Defined Benefit Plan Reporting
Financial reporting for defined benefit plans is more complex, as the employer must estimate the value of future obligations to its employees. This involves estimating metrics such as employee turnover, average retirement age, mortality rates, and an appropriate discount rate to determine the present value of future benefits.
- If the fair value is greater, the plan is overfunded, and the firm records a net pension asset on its balance sheet.
- If the fair value is less, the plan is underfunded, and the firm records a net pension liability.
Elements Affecting Net Pension Asset or Liability
- Service cost: The present value of additional benefits earned by an employee over the year. As the obligation to an employee is determined by the number of years in service, an additional year of service will increase the liability.
- Past service cost: Retroactive benefits awarded when a plan is initiated or changed. For instance, an increase in the benefit factor will cause the obligation to increase, as all past service rendered must be recalculated.
- Actuarial gains or losses: Resulting from changes in assumptions, such as a downward adjustment in employee turnover rate estimates, which increases the pension obligation estimate and pension liabilities.
- Actual return on plan assets: Calculated based on both realized and unrealized gains and losses of the plan assets. Changes in value over the year will affect the plan assets.
Interest Income, Interest Expense, and Net Interest Expense or Income
Interest income is the beginning value of plan assets multiplied by the discount rate. Interest expense is the beginning value of plan liabilities multiplied by the discount rate. The net interest expense or income is the net plan liability or asset multiplied by the discount rate. This discount rate should reflect the yield of a highly rated corporate bond.
IFRS vs. US GAAP Reporting
Under IFRS, elements are grouped into three main components:
- Service costs (including past service costs): recorded on the income statement as pension expense.
- Net interest expense or income: also recorded on the income statement under pension expense.
- Re-measurements (including actuarial gains or losses and the difference between actual and expected returns): taken directly to stockholders’ equity as other comprehensive income and not amortized to the income statement over time.
US GAAP Reporting
Under US GAAP, elements are grouped into five main components:
- Service costs: recognized on the income statement as pension expense.
- Interest expense: reported separately on the income statement under pension expense.
- Interest income (expected return on plan assets): also reported separately on the income statement under pension expense.
- Past service costs: taken directly to stockholders’ equity as other comprehensive income.
- Actuarial gains or losses (including the difference between actual and expected returns on plan assets): taken as other comprehensive income and amortized to pension expense, allowing firms to smooth their effects on pension expenses over time.
And that wraps up our introduction to pension plans! You should now be able to distinguish between defined contribution plans and defined benefit plans, as well as identify the financial statement reporting for a defined benefit plan.
Next up, we’ll discuss solvency ratios. See you there!