Summary
Highlights
A pension plan is an agreement where an employer provides benefits, typically cash payments or health insurance, to retired employees for their past services. The employer contributes money to a separate pension fund managed by a financial institution, which invests it. Upon retirement, the former employee receives benefits from this fund.
Contributory plans require employees to make payments to the fund, either to cover costs or increase benefits, often offering tax advantages. Non-contributory plans are fully funded by the employer, with no employee contributions. Traditionally, many pension plans were non-contributory, but they are becoming less common.
Defined contribution plans, like 401k or 403b, involve the employer contributing a fixed amount to an employee's account. The employee then chooses investments and bears the risk, meaning the final benefit depends on investment performance. In contrast, a defined benefit plan (traditional pension) promises a specific, predetermined benefit to the employee upon retirement. The employer's contribution varies to ensure these promised benefits are met, and the employer, not the employee, bears the investment risk.
Actuaries, specialized professionals, estimate the employer's pension obligations based on various factors. These include mortality rates, employee turnover, interest and earnings rates on investments, early retirement frequency, and future salary projections. These estimates influence how much the employer needs to contribute to the pension plan.
Accountants are responsible for reporting the pension obligation (a liability) and computing the pension expense. The pension obligation represents a deferred compensation liability to employees, measured by the Projected Benefit Obligation (PBO). The PBO considers vested and non-vested benefits and future salaries, representing the largest and most comprehensive measure of the pension liability.
Three ways to measure pension obligation are discussed: Vested Benefit Obligation (VBO), which covers vested employees at current salaries; Accumulated Benefit Obligation (ABO), which adds non-vested employees at current salaries; and Projected Benefit Obligation (PBO), which includes vested, non-vested, and future salaries, making it the most comprehensive and largest measure used for reporting pension liability.
A pension plan's funding status is determined by comparing the Projected Benefit Obligation (PBO) with the plan assets. If plan assets exceed the PBO, the plan is overfunded. If the PBO is greater than the plan assets, the plan is underfunded, meaning there aren't enough assets to cover future obligations. Most companies often have underfunded pension plans.