Question

What is a pension plan? According to U.S. GAAP, how should pension plans be accounted for? What are the components of a current year's pension plan expense? Discuss each of these components. Why are pension plans problematic to account for?

Answer 1

A pension plan is a retirement plan that requires an employer to make contributions to a pool of funds set aside for a worker's future benefit. The pool of funds is invested on the employee's behalf, and the earnings on the investments generate income to the worker upon retirement.

Pension accounting principles require pension costs to be recognized in a specific pattern to attribute the value of the benefits over a work life and require clear and consistent disclosure of pension costs, along with the plan’s assets and obligations in a company’s financial statements. Statement of Financial
Accounting Standard No. 87 prescribes the single method that a U.S.-based company following GAAP must use to reflect the cost of pension plans in its income statement and on its balance sheet.

As noted earlier, each company selects a measurement date, generally equal to the last date of the fiscal year.
As of that date, the company sets assumptions and gathers the participant data used to measure its obligations and determines the fair value of assets in the pension trust. It uses these amounts to calculate the cost of the plan in the future year. It also determines if additional amounts must be recorded on its balance sheet.

To calculate a pension expense, the employer must report the service and interest cost, expected return on plan assets, amortization of prior service cost and effects of gains and losses.

*Service Cost

The primary component of pension expenses is service cost. Employers incur a liability for each complete year of employee service. The service cost represents the present value of projected retirement benefits earned by covered employees in the current year. In simpler terms, service cost refers to the required amount the employer must set aside each year to cover employees' pension benefits upon retirement. Service cost depends on factors such as job promotion, salary increases and early retirement as these affect the final benefit amount.

*Interest Cost

Interest cost represents the interest accumulated on the unpaid balance of the projected benefit obligation as an employee's service time increases. Projected benefit obligation refers to the current value of all benefits employees earn during employment. With each year of complete service, employees are one year closer to receiving retirement benefits. Since pensions are a deferred compensation agreement, the employer incurs a liability until the employees retire. Employers must record this cost at a discounted rate. Market interest rates on premium investments or rate of return on retirement annuities set the discount rate.

*Return on Plan Assets

Pension plan assets normally consist of stocks, bonds and other investment instruments such as mutual funds and real estate. The return on plan assets represents the current year's earnings on invested plan assets. An employer figures the rate of return by multiplying the assets' fair value at the start of the year by the estimated long-term assets' rate of return. Fair value refers to the current purchase or sale price of an asset in the present market. The employer must subtract gains and add losses when computing pension expense.

*Amortization of Prior Service Cost

When an employer implements or modifies a pension plan, employees usually receive credit for service prior to the change. Employers must cover this cost over the outstanding portion of the employee's service. The amortization of prior service represents the cost of providing retroactive benefits over the remaining service-years of the covered employees.

*Gains and Losses

Market instability impacts pension expenses. The gains or losses components show the changes in the employer's projected benefit obligation and the market impact on plan assets. For example, prior service cost generally increases the employer's pension expense, but can decrease the expense if the employer does not provide retroactive pension benefits. Service and interest costs always increase pension expenses. The rate of return normally decreases pension expense, but can increase it if the assets incur a loss.

PROBLEMATIC

The most notable disadvantage of pension funds is the lack of flexibility in when you can access your money. In most cases, you won't be permitted to withdraw funds from your pension until you're 55, and even then you're subject to taxation.