A Primer On Defined-Benefit Pension Plans

By Investopedia Staff AAA

While most know what a pension plan is, few understand the difference between the types of pensions offered and the factors that determine the value of such plans - namely, defined-benefit pension plans. Even fewer understand the economics of pension plan accounting and how corporations must report for pension plans on the financial statements. In this article, we will examine exactly these topics in hopes of gaining an increased understanding of defined benefit pension plan accounting.
TUTORIAL: Financial Statements: Pension Plans

Two Types of Pension Plans
There are two basic types of employer-sponsored retirement plans: defined-contribution plans and defined-benefit plans. The key difference between the two is which party bears the responsibility for the performance of the plan's invested contributions.

Defined Contribution
In a defined-contribution plan the employer (or firm) will contribute a given amount per period (monthly, annually, etc) to the employee's retirement account. Once the funds are in the account, the employer no longer has any responsibility as to the future value of those funds. The employee, or account holder, will make the investment decisions with regards to the account, allocating the contributed retirement dollars in the manner of their choosing (often within pre-prescribed options). For instance, the employee may wish to invest the entirety of the retirement funds in a balanced growth-type fund, in hopes of both growing the account with capital gains while receiving dividend payments (into the account) at the same time. The important part to remember here is that once the employer/firm has made the agreed upon contribution to the employee's defined-contribution account, the investment risk lies entirely with the account holder (the employee). (Learn more about your investment options in our Mutual Funds Tutorial.)

Defined Benefit
A defined-benefit plan, on the other hand, is more complicated, especially for the firm. In this type of plan, an employer will pledge to make periodic payments to the employer during retirement. These payments can be based on a number of factors, including time spent with the company and salary received over a given period. Since the firm is responsible for delivering a set pension amount to its employees during their retirement, the entirety of the investment risk falls squarely with the firm. With several factors affecting both the expected and actual growth of a firm's defined-benefit retirement burden, it is important to understand what these factors are and how firms account for such post-employment compensation on the financial statements.

The Pension Obligation
Now that we've differentiated between defined-contribution and defined-benefit plans, we need to dig deeper into the pension obligations facing firms who employ defined-benefit plans. Under U.S. GAAP, there are three different measures of a pension obligation:

1. Projected Benefit Obligation (PBO)
The present value of the future retirement/pension benefits earned by an employee to date, based on expected future increases in earnings.

2. Accumulated Benefit Obligation (ABO)
The present value of the future retirement/pension benefits earned by an employee to date, ignoring any expected future increases in earnings.

3. Vested Benefit Obligation (VBO)
The present value of the future retirement/pension benefits earned by an employee to date, granted they have been fully vested. VBO also does not consider any future service by the employee.

As you probably have already realized, the projected benefit obligation (PBO) should create the largest obligation, while the vested benefit obligation (VBO) should create the smallest, all things held equal. The PBO is the most commonly used, since most firms are considered to be going concerns and employees are expected to continue to work for the firm in the future, thus earning more retirement benefits. The ABO, on the other hand, is best implemented in situations where a company is anticipating discontinuing its defined-benefit plan and paying off its pension obligation. Since there are no longer expected to be increased pension obligations based on years of service or salary increases, ABO is the appropriate method. For firms with vesting periods attached to their pension benefits, VBO will be the most often used measure. (Experts are making bleak predictions for your post-work years. Be prepared and plan for your future, see The Demise Of The Defined-Benefit Plan.)

The three pension obligation measures are affected in any given period by the following factors:

1. Benefits Paid: As benefits are paid out to pensioners, the benefit obligation is reduced.

2. Interest Cost: As interest accrues on the plan, the obligation increases with the passage of time.

3. Current Service: Once again, as time passes, in most cases the benefits earned by employees through years of service or salary increases will cause the pension obligation to grow.

4. Plan Amendments: Any pension benefits given to employees or pensioners retroactively. Such awards will result in an increase in the obligation.

5. Actuarial Adjustments: These are changes made to the underlying assumptions of the plan on a go-forward basis. Such assumptions may include the rate at which benefits are discounted, the average employee retirement age and mortality tables. These types of changes can both increase or reduce pension obligations, depending on the change. (Learn more about picking an appropriate discount rate in How To Calculate Required Rate Of Return.)

Along with these five factors affecting a company's pension obligation from one period to another, the three primary assumptions which have the most bearing on a firm's pension estimate are its discount rate, its expected return on the plan and its anticipated rate of salary growth. These three assumptions play the biggest role in calculating a firm's pension obligation, as even a small change in one of these aspects can cause a large change in a plan's funded status. For instance, if a company was to increase the discount rate at which the plan's disbursements are discounted, the present value of those disbursements would decrease, thus reducing the firm's pension obligation. Likewise, if the expected return of the plan's assets were marked up, the present value of the pension expense today would fall. It is important to understand how these assumptions affect a company's pension obligations, as well as the factors directly influencing the plan from period to period. (Find out more in Calculating The Present And Future Value Of Annuities.)

Conclusion
As we have seen, defined benefit plans are complicated retirement vehicles that require extensive work on the part of the fund sponsor to account for its pension obligation on its financial statements. We hope this introductory primer has benefited you in beginning to understand the factors and assumptions behind the pension benefit estimations and how a plan can be affected by changes in these items.

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