Unsure
Corp. has recently decided to implement a pension plan for its employees;
however, it is unsure if it would like to structure the pension as a defined
contribution plan or a defined benefit plan. As requested by management,
prepare a short memo outlining the nature of both plans, along with the
accounting treatment of each plan.
A
Defined Contribution Plan (DC)
A defined contribution (DC) plan is a post-employment
benefit plan that specifies how the entity’s contributions or payments into the
plan are determined, rather than identifying what benefits will be received by
the employee or the method of determining those benefits.
For a DC pension plan, the amounts that are
contributed are usually turned over to an independent third party or trustee
who acts on behalf of the beneficiaries (the participating employees). The
trustee assumes ownership of the pension assets and is responsible for their
investment and distribution. The trust is separate and distinct from the
employer.
The ultimate risk and reward of the DC pension rests
with the employees as the employer’s involvement is essentially limited to
making the annual contribution each year.
Therefore, the accounting for a DC pension is
relatively straight-forward. The
employer’s obligation is dictated by the amounts to be contributed. Therefore, a liability is reported on the
employer’s balance sheet only if the required contributions have not been made
in full, and an asset is reported if more than the required amount has been contributed.
The annual benefit cost (i.e., the pension expense)
is simply the amount that the company is obligated to contribute to the plan.
A
Defined Benefit (DB) Plan
A defined benefit (DB) plan is any benefit plan that
is not a defined contribution plan. It is a plan that specifies either the
benefits to be received by an employee or the method of determining those
benefits.
Similar to a DC plan, for a DB pension plan, the
amounts that are contributed are usually turned over to an independent third
party or trustee who acts on behalf of the beneficiaries.
The ultimate risk and reward of the DB pension rests
with the employer since the employer must guarantee that a set retirement
benefit will be paid to the employees. The benefits typically are a function of
an employee’s years of service and compensation level in the years approaching
retirement.
To ensure that appropriate resources are available to
pay the benefits at retirement, there is usually a requirement that funds be
set aside during the service life of the employees.
Therefore, accounting for a DB is much more complex. The pension cost and accrued benefit obligation depends on many factors such as employee turnover, mortality, length of service, and compensation levels, as well as investment returns that are earned on pension assets, inflation, and other economic conditions over long periods of time.
Because the cost to the company is affected by a wide
range of uncertain future variables, it is not easy to measure the pension cost
and liability that have to be recognized each period as employees provide
services to earn their pension entitlement.
This is not intended to be a comprehensive discussion
of all issues associated with the DB, but rather, to highlight some of the key
differences between a DB and DC pension.
