Pension Liabilities Explained for Beginners

A pension plan Contractual agreement between an employer and its employees for the employer to provide benefits to employees after they retire; expensed when incurred. is a contractual agreement between an employer and its employees for the employer to provide benefits (payments) to employees after they retire. Most employers pay the full cost of the pension, but sometimes employees pay part of the cost. An employer records its payment into a pension plan with a debit to Pension Expense and a credit to Cash. A plan administrator receives payments from the employer, invests them in pension assets, and makes benefit payments to pension recipients (retired employees). Insurance and trust companies often serve as pension plan administrators.

Point: Fringe benefits are often 40% or more of salaries and wages, and pension benefits make up nearly 15% of fringe benefits.

Many pensions are known as defined benefit plans that define future benefits; the employer’s contributions vary, depending on assumptions about future pension assets and liabilities. Several disclosures are necessary in this case. Specifically, a pension liability is reported when the accumulated benefit obligation is more than the plan assets, a so-called underfunded plan. The accumulated benefit obligation is the present value of promised future pension payments to retirees. Plan assets refer to the market value of assets the plan administrator holds. A pension asset is reported when the accumulated benefit obligation is less than the plan assets, a so-called overfunded plan. An employer reports pension expense when it receives the benefits from the employees’ services, which is sometimes decades before it pays pension benefits to employees. (Other Postretirement Benefits refer to nonpension benefits such as health care and life insurance benefits. Similar to a pension, costs of these benefits are estimated and liabilities accrued when the employees earn them.)

Point: Two types of pension plans are (1) defined benefit plan—the retirement benefit is defined and the employer estimates the contribution necessary to pay these benefits—and (2) defined contribution plan—the pension contribution is defined and the employer and/or employee contributes amounts specified in the pension agreement.