Subject 10. Defined Contribution and Defined Benefit Pension Plans

A pension plan provides benefits to retirees for services provided during employment. A pension fund is often used as an intermediary to satisfy the employer's pension obligations. Pension fund assets need to be invested to meet the needs of the retirees.

There are two types of pension plans: defined-benefit plans and defined-contribution plans.

Defined Contribution Plans

In a defined contribution plan, the employer agrees to contribute a certain sum each period based on a formula. This formula may consider such factors as age, length of employee service, employer's profits, and compensation level. Only the employer's contribution is defined; no promise is made regarding the ultimate benefits paid out to the employees.

The accounting for a defined contribution plan is straightforward. The employer's responsibility is simply to make a contribution each year based on the formula established in the plan. If the contribution is less than the pension expense, the employer accrues a liability. If the contribution is more than then pension expense, the employer accrues an asset.

Defined Benefit Plans

A defined benefit plan defines the benefits that employees will receive at the time of retirement.

  • The employer is committed to specified retirement benefits.
  • The trust accumulates assets, and the employer is the trust-beneficiary. That is, the employer assumes the risk of the investment. As long as the plan continues, the employer is responsible for the payment of the defined benefits, regardless of what happens in the trust.
  • Retiree benefits are a fixed amount. Any shortfall in the accumulated assets held in the trust must be made up by the employer, and any excess accumulated in the trust can be recaptured by the employer.

The employer needs to determine what the contribution should be today to meet the pension benefit commitments that will arise at retirement. It is at risk because it must be sure to make enough contributions. The liability is often controversial because its measurement and recognition relate to unknown future variables.

The plan's return objective is to meet the actuarial rate of return, which is the discount rate used to find the present value of the plan's future obligations and therefore determines the size of the firm's annual contribution to the pension plan.

The principal elements of a defined benefit plan are (1) the obligation for benefits to be paid to retirees and (2) the plan assets that will be used to meet that obligation.

The determination of pension cost is a function of the following components:

  • Service cost

    Service cost is the actuarial present value of pension benefits attributed to employee service in a period, based on the pension benefit formula.

    Example

    Assume that the annual retirement benefit earned by one employee in the current period is $5,000. Determine the service cost for the current year assuming an 8% discount rate, 15 years until retirement, and 10 years of retirement payments.

    Annual retirement benefit: $5,000
    Present value of an annuity factor (PVA, 8%, 10 periods of payments): 6.71008
    Present value of $1 factor (PV1, 8%, 15 periods until retirement): 0.31524
    Service cost = $5,000 x 6.71008 x 0.31524 = $10,576

  • Interest cost

    Interest cost is the growth in Projected Benefit Obligation (PBO) during a reporting period. It is calculated as PBOBeginning x discount rate of the previous period.

    Example

    Assume that 1995 is the first year of a retirement plan. PBO is $650,000 on 12/31/1995 and $740,000 on 12/31/1996. If the discount rate is 8%, what is the interest cost for 1995 and 1996, respectively?

    Interest cost is calculated by multiplying the PBO at the beginning of the year by the discount rate.
    PBO 1/1/1995 = $0 x 8% = $0
    PBO 1/1/1996 = $650,000 x 8% = $52,000

  • Expected return on plan assets

  • Actuarial gains and losses

    These occur when changes in assumptions about future events, such as quit rates, retirement dates, mortality, and the discount and compensation increase rates, decrease or increase PBO.

  • Prior service costs

    Prior service costs (PSC) result from the granting of pension benefits for service rendered before the pension plan began or from plan amendments granting increased pension benefits for service rendered before the amendment. It is the present value of the retroactive benefits.

User Contributed Comments 4

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Emily1119: Can any one explain how to calculate pv annual factor=6.71008?
moneyguy: Emily -- PVannuity equation

PV $1 = [1-(1+i)^-n] / i
johntan1979: TI BA II Plus for service cost:

N=10, I/Y=8, PMT=5,000, CPT PV=-33,550

2ND FV (clear tvm)

Set -33,500 as FV, N=15, I/Y=8, CPT PV=10,576
MonuPanda: calculation of pension is not there in LOS so give all the calculation related problems a quick pass. just know the difference b/w the two kinds of pension plans