Pension expense definition
/What is Pension Expense?
Pension expense is the amount that a business charges to expense in relation to its liabilities for pensions payable to employees. The amount of this expense varies, depending upon whether the underlying pension is a defined benefit plan or a defined contribution plan. The characteristics of these plan types are noted below.
Defined Benefit Plan
Under the defined benefit plan, the employer provides a predetermined periodic payment to employees after they retire. The amount of this future payment depends upon a number of future events, such as estimates of employee lifespan, how long current employees will continue to work for the company, and the pay level of employees just prior to their retirement. In essence, the accounting for defined benefit plans revolves around the estimation of the future payments to be made, and recognizing the related expense in the periods in which employees are rendering the services that qualify them to receive payments in the future under the terms of the plan.
Defined Contribution Plan
Under the defined contribution plan, the employer’s entire obligation is complete once it has made a contribution payment into the plan, as long as no associated costs are being deferred for recognition in later periods. Thus, the employer commits to pay a specific amount of funds into a plan, but does not commit to the amount of benefits subsequently distributed by that plan. The accounting for a defined contribution plan is to charge its contributions to expense as incurred.
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Defined Benefit Plan Costs
Here is a summary of the relevant costs associated with a defined benefit pension plan, which sum to the net periodic pension cost that is recognized in each accounting period:
| Cost | Explanation |
|
+ Service cost |
This is the actuarial present value of benefits related to services rendered during the current reporting period. The cost includes an estimate of the future compensation levels of employees from which benefit payments will be derived. |
|
+ Interest cost |
This is the interest on the projected benefit obligation. It is a financial item, rather than a cost related to employee compensation. |
|
+ Actual return on plan assets |
This is the difference between the fair values of beginning and ending plan assets, adjusted for contributions and benefit payments. It is a financial item, rather than a cost related to employee compensation. |
|
+ Amortization of prior service costs |
When an employer issues a plan amendment, it may contain increases in benefits that are based on services rendered by employees in prior periods. If so, the cost of these additional benefits are amortized over the future periods in which those employees active on the amendment date are expected to receive benefits. |
|
+ Gain or loss |
This is the gain or loss resulting from a change in the value of a projected benefit obligation from changes in assumptions, or changes in the value of plan assets. |
| = Net periodic pension cost |
The pension expense associated with a defined benefit plan can vary considerably over time, depending upon changes in the estimated costs noted in the preceding table. This can result in highly variable income statement results. There can be especially large swings in the reported pension expense under the following circumstances:
When there are many employees covered by the plan, since the related pension expense can comprise a disproportionate percentage of total expenses.
When the market interest rate suddenly shifts substantially, since this impacts the assumptions on the returns generated from invested funds.