7.1 Defined benefit and defined contribution plans

Pension plans are a crucial part of employee benefits, with two main types: defined benefit and defined contribution. These plans differ in how they're funded, managed, and the risks they pose to employers and employees.

Understanding these pension plans is key for both companies and workers. They impact financial statements, retirement security, and long-term financial planning. Let's explore the ins and outs of these plans and their accounting implications.

Defined Benefit vs Defined Contribution Plans

Key Characteristics and Features

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• Defined benefit plans guarantee specific retirement benefit amounts based on salary history and years of service
• Defined contribution plans specify employer and/or employee contribution amounts
• Employers bear investment risk in defined benefit plans responsible for funding promised benefits
• Employees assume investment risk in defined contribution plans with final benefit amounts depending on investment performance
• Defined benefit plans offer predictable retirement income streams often as monthly lifetime payments
• Defined contribution plans provide lump sums or withdrawal series based on account balances at retirement
• Professional managers appointed by employers typically manage defined benefit plan investments
• Employees make investment decisions within provided options for defined contribution plans
• Defined benefit plans often have longer vesting periods (5-7 years)
• Defined contribution plans may offer immediate or shorter vesting periods (1-3 years)
• Higher portability in defined contribution plans allows account balance transfers when changing jobs
• Limited portability options for defined benefit plans when switching employers

Plan Management and Employee Involvement

• Employers take on most responsibilities for defined benefit plan management and funding
• Employees have greater involvement and decision-making in defined contribution plans
• Defined benefit plans require complex actuarial calculations and long-term financial projections
• Defined contribution plans involve simpler ongoing administration and record-keeping
• Employers must carefully monitor and adjust defined benefit plan funding levels
• Employees actively manage contribution levels and investment allocations in defined contribution plans
• Defined benefit plans often include provisions for early retirement or disability benefits
• Defined contribution plans may offer loan provisions or hardship withdrawals

Advantages and Disadvantages of Pension Plans

Employee Perspective

• Defined benefit plans provide income security and predictability in retirement
• Lack of flexibility and limited portability in defined benefit plans when changing jobs
• Defined contribution plans offer greater control over investments and improved portability
• Investment risk and responsibility for adequate savings shift to individuals in defined contribution plans
• Defined benefit plans may incentivize long-term employment with a single organization
• Defined contribution plans allow for more customized retirement planning based on individual needs
• Employees may find defined contribution plans easier to understand and value
• Defined benefit plans can provide protection against outliving retirement savings (longevity risk)

Employer Perspective

• Defined contribution plans offer more predictable costs and reduced long-term financial obligations
• Potential challenges in attracting and retaining employees seeking guaranteed benefits with defined contribution plans
• Defined benefit plans serve as powerful tools for employee retention and attraction particularly for long-term employees
• Significant financial risks and potential funding shortfalls associated with defined benefit plans
• Simpler administration and more stable annual costs for defined contribution plans
• Complex regulatory requirements and potential volatility in contribution requirements for defined benefit plans
• Defined contribution plans may lead to higher participation rates and employee appreciation of benefits
• Defined benefit plans can create substantial unfunded liabilities impacting company valuations and financial health

Accounting for Pension Plans

Defined Contribution Plan Accounting

• Straightforward accounting recognizing expenses equal to required contributions each period
• Journal entry: Debit Pension Expense, Credit Cash (for employer contributions)
• No recognition of future obligations or plan assets on the balance sheet
• Minimal disclosure requirements typically limited to contribution amounts and plan descriptions
• Consistent expense recognition aligns with the period employees provide services
• No actuarial calculations or long-term projections required

Defined Benefit Plan Accounting

• Complex accounting requiring actuarial calculations to estimate future benefit obligations
• Recognition of projected benefit obligation (PBO) on the balance sheet representing present value of expected future payments
• Journal entry: Debit Pension Expense, Credit Pension Liability (for service cost component)
• Actuarial gains/losses recognized in other comprehensive income (OCI) and amortized into earnings over time
• Disclosure of assumptions used in calculating obligations (discount rates, expected returns)
• Funding status (difference between plan assets and PBO) reported on the balance sheet
• Service cost interest cost expected return on plan assets and amortization of gains/losses comprise pension expense

Financial Statement Impact of Pension Plans

Balance Sheet Effects

• Defined benefit plans create significant long-term liabilities (PBO) potentially affecting key financial ratios
• Net pension liability/asset recognition based on funded status of the plan
• Defined contribution plans have minimal balance sheet impact limited to unpaid contributions
• Actuarial gains/losses for defined benefit plans accumulate in accumulated other comprehensive income (AOCI)
• Pension plan assets reported at fair value for defined benefit plans
• Underfunded defined benefit plans may require additional minimum liability recognition

Income Statement and Cash Flow Impacts

• Defined benefit plans can create volatility due to changes in actuarial assumptions and market performance
• Pension expense components for defined benefit plans include service cost interest cost and expected return on assets
• Defined contribution expenses limited to employer contributions made during the period
• Cash flow effects more predictable for defined contribution plans with consistent contribution payments
• Defined benefit plans may require large unpredictable contributions to meet funding requirements
• Interest rate changes have pronounced effects on defined benefit plan obligations influencing discount rates
• Defined benefit plans expose organizations to longevity risk as increasing life expectancies lead to higher benefit payments