The purpose of this paper is to provide an overview of how pension plans work and what types of pension plans are available. Included will be an explanation of the effect of pension plans on financial statements if the cash contribution amount is more or less than the anticipated pension expense, and a discussion of how pensions are accounted for on the company’s financial statements.
How Pension Plans Work
The purpose of a pension plan is to provide enough savings that individuals receive ample income during their retirement years. “This is accomplished by setting aside funds during the employee’s working years so that at retirement the accumulated funds plus earnings from investing those funds are available to replace wages” (Spiceland et al., p. 828). Qualified pension plans are plans which are created in accordance with rigid guidelines. Qualified plans provide the employer “an immediate tax deduction for amounts paid into the pension fund” (Spiceland et al., p. 829). It is important to note that there are specified limits to the amounts that employers may deduct. General requirements for meeting the guidelines of a qualified pension plan include: 1) It must cover at least 70% of employees; 2) It cannot discriminate in favor of highly compensated employees; 3) It must be funded in advance of retirement through contributions to an irrevocable trust fund; 4) Benefits must vest after a specified period of service, commonly five years; and 5) It complies with specific restrictions on the timing and amount of contributions and benefits (Spiceland et al., p. 829).
Generally, a pension plan is comprised of employer, employee, or both employer and employee contributions into an interest bearing account, such as mutual funds, stocks, bonds, certificates, etc. Earnings in a qualified pension plan accumulate tax free, which provides an additional tax benefit to the employee.
There are two categories of pension plan: defined contribution plan and defined benefit plan. The defined contribution plan and the defined benefit plan are both covered by the employee retirement income security act (ERISA). The defined contribution plan assures fixed contribution amounts to the pension fund, such as 3% of an employee’s annual salary. The defined benefit plan assures predetermined retirement benefits characterized by a pre-selected formula, such as a “specified monthly benefit at retirement” (U. S. Department of Labor). Within each category of pension plan are a variety of specific plan types. Some of these specific plans are discussed below.
Cash balance plan – defined benefit plan. A cash balance plan “defines the benefit in terms that are more characteristic of a defined contribution plan” (U. S. Department of Labor). When the individual participant in a cash balance plan retires, the benefits to be received are determined based on an account balance. “Increases and decreases in the value of the plan’s investments do not directly affect the benefit amounts promised to participants. Thus, the investment risks and rewards on plan assets are borne solely by the employer” (U. S. Department of Labor).
Profit sharing plan – is a defined contribution plan. A profit sharing plan is one in which contributions are discretionary and based upon company profits. This type of plan provides “a set formula for determining how the contributions are divided” (Internal Revenue Service) among each participant.
401(k) plan – a defined contribution plan. A 401(k) plan is a deferred plan in which “employees can elect to defer receiving a portion of their salary which is instead contributed on their behalf, before taxes” (U. S. Department of Labor) to the plan. Often, employers match the employee contribution up to a stated percentage of the employee’s annual salary.
Employee stock ownership plan (ESOP) – is a defined contribution plan. In an ESOP, “the investments are primarily in employer stock” (U. S. Department of Labor). Basically, the company contributes new shares of its own stock to a trust fund set up for that purpose. Then, “shares in the trust are allocated to individual employee accounts… Money purchase pension plan – is a defined contribution plan. A money purchase pension plan “requires fixed annual contributions from the employer to the employee’s individual account” (U. S. Department of Labor).
Another form of pension plan is the simplified employee pension plan (SEP). In this type of plan, employees set up ownership of an individual retirement account (IRA). Employees may make tax-favored contributions to these accounts. Employers may also contribute to the employee owned IRA (U. S. Department of Labor).
Amount of Cash Contribution in Relation to the Anticipated Pension Expense
“It is not unusual for the cash contribution to differ from that year’s pension expense” (Spiceland et al, p. 846). There will be an effect on the income statement if the cash contribution amount is more or less than the anticipated pension expense. When the cash contribution is more than the anticipated pension expense, the excess payment represents an asset: prepaid pension cost. When the cash contribution is less than the anticipated pension expense, the underpayment represents a liability: accrued pension cost.
For example, if the anticipated annual pension expense equals $50,000 and the actual cash contribution is $45,000, the journal entry would be to debit pension expense $50,000, credit cash $45,000, credit accrued pension cost $5,000.
If the anticipated annual pension expense equals $50,000 and the actual cash contribution is $53,000, the journal entry would be to debit pension expense $50,000, debit prepaid pension cost $3,000, debit cash $53,000.
Accounting for Pensions on Financial Statements
Accounting for pensions on financial statements includes the following: recording the future pension obligation on the balance sheet as a liability; recording the plan assets that the employer has set aside for payment of future retirement benefits on the balance sheet as an asset; and recording the periodic pension expense on the income statement as an expense
The National Center for Employee Ownership. “How an Employee Stock Ownership Plan (ESOP) Works.” NCEO website. URL: (http://www.nceo.org/library/esops.html).
Spiceland, J. D., Sepe, J. F., & Tomassini, L. A. (2007). Intermediate accounting. (4th ed.). Burr Ridge, IL: McGraw-Hill/Irwin.
U. S. Department of Labor. “Types of retirement plans.” U.S. Department of Labor in the 21st Century. URL: (http://www.dol.gov/dol/topic/retirement/typesofplans.htm).
