How to Account for a Defined Benefit Plan

A defined benefit plan is a retirement arrangement where an employer promises a specified payment amount to employees in retirement. This differs from a defined contribution plan, such as a 401(k), where the employer contributes a specific amount but makes no promise regarding the final retirement benefit. The accounting is complex because it involves estimating a liability for promises that may not be settled for decades, requiring actuarial assumptions about future events.

The accounting standards, found in the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC) Topic 715, break down the process into several areas. These areas cover what appears on the balance sheet, what is recorded as an expense, and what must be disclosed to provide a clear picture of the plan’s financial health.

Core Balance Sheet Components

The balance sheet reports the net financial position of the plan, determined by two components: the company’s obligation and the assets set aside to meet that obligation. This presents a snapshot of whether the plan is overfunded or underfunded at a specific point in time.

A central element is the Projected Benefit Obligation (PBO), which is the present value of all future pension payments earned by employees to date. Calculating the PBO is an actuarial exercise that relies on assumptions about the future. One assumption is the discount rate, used to convert future benefit payments into today’s dollars, which is based on yields of high-quality corporate bonds.

Another assumption is the rate of future compensation increases. Since the pension benefit is often based on an employee’s final or average salary, actuaries must project how employee pay will grow. The PBO is therefore a forward-looking estimate that incorporates expected salary growth.

Counterbalancing the obligation are the plan assets, which consist of funds and investments the company has set aside in a trust to pay for future benefits. These assets, which can include stocks, bonds, and real estate, must be reported at their fair value as of the balance sheet date.

The net position reported on the company’s balance sheet is the funded status, calculated by subtracting the PBO from the fair value of plan assets. If assets exceed the PBO, the plan is overfunded, and the company records a net pension asset. If the PBO is greater than the assets, the plan is underfunded, and the company records a net pension liability.

Calculating Annual Pension Expense

The annual pension expense, or net periodic pension cost, reflects the cost of the plan recognized on the income statement for a period. This figure is composed of several distinct components that are calculated separately and then aggregated.

The first component is service cost, which represents the value of benefits earned by employees for their work during the current year. It is calculated as the present value of the retirement benefit portion attributable to that year of service. Service cost is the only component of pension expense reported with other employee compensation costs in operating income.

Interest cost is the increase in the Projected Benefit Obligation that occurs because the settlement of benefits is one year closer. It is calculated by multiplying the PBO at the beginning of the year by the discount rate. This element is presented outside of operating income, in a non-operating section of the income statement.

The expected return on plan assets works to reduce the overall pension expense. It is calculated by multiplying the fair value of plan assets at the beginning of the year by an estimated long-term rate of return. This use of an expected return is a smoothing mechanism designed to prevent the volatility of financial markets from causing large swings in annual pension expense.

Plan amendments that grant employees additional benefits for past service create prior service cost. This cost is not expensed immediately but is amortized, or spread, into the pension expense over the average remaining service period of the employees who benefit from the amendment.

Amortization of gains and losses addresses deviations between expectations and actual experience. These gains and losses arise when the actual return on plan assets differs from the expected return, or when actuarial assumptions change. To avoid immediate volatility, these gains and losses are accumulated, deferred, and then amortized into pension expense over the average remaining service life of plan participants.

Reporting in Other Comprehensive Income

Certain pension-related financial events are not immediately recognized in the income statement but are instead reported in a separate section of the financial statements called Other Comprehensive Income (OCI). OCI captures specific types of unrealized gains and losses. This mechanism allows for transparency without causing the volatility that would result from including them directly in net income. The amounts are accumulated on the balance sheet in Accumulated Other Comprehensive Income (AOCI).

The most significant items that flow through OCI are actuarial gains and losses. These occur when there are changes in the PBO due to modifications in actuarial assumptions or when the actual return on plan assets differs from the expected return. The full amount of these gains or losses in a given year is recognized in OCI to prevent market fluctuations from distorting the company’s net income.

Another item recognized in OCI is prior service cost. When a company amends its pension plan to grant employees increased benefits for their past service, the entire cost of this retroactive enhancement is recorded in OCI in the period the amendment is made. This avoids charging the entire cost to the income statement at once.

The items recorded in OCI do not remain there indefinitely. The amortization of prior service cost and actuarial gains and losses, which are components of net periodic pension cost, represent the systematic transfer of these amounts out of AOCI and into net income over time. This process ensures that these costs are eventually recognized in the income statement in a smooth manner.

Required Financial Statement Disclosures

To provide users with a clear understanding of a company’s defined benefit plan, ASC 715 mandates a comprehensive set of disclosures in the notes to the financial statements. These disclosures are designed to offer transparency into the plan’s financial status, the components of its annual cost, and the assumptions used in the calculations.

Key disclosures include:

• A detailed reconciliation of the beginning and ending balances for both the Projected Benefit Obligation and the plan assets, showing the effects of all major activities during the year.
• The funded status of the plans and the amounts recognized on the balance sheet. If a company has multiple plans, it must disclose the aggregated PBO and fair value of plan assets for all plans that are underfunded.
• A detailed breakdown of the components of the net periodic pension expense, separately showing service cost, interest cost, the expected return on plan assets, and any amortization amounts.
• The weighted-average discount rate, the expected long-term rate of return on plan assets, and the rate of future compensation increases.
• A description of the company’s investment strategy for its plan assets and the fair value of different asset categories, such as equities, debt securities, and real estate.
• An estimate of the benefit payments expected in each of the next five fiscal years, as well as a total for the five years that follow, to help gauge the plan’s future cash demands.