The Methods Of Financing Pensions Accounting Essay

Published: Last Edited:

This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.


The development of the society led to the appearance of the concept of pension. The pension is the financial compensation, which is paid to the worker after he or she looses the possibility to get the regular income from the employment. The compensation can be paid by the lump sum, but usually the people and organizations use the plan of monthly payment. Usually the issue of pension plans is in the charge of special governmental financial institutions, large businesses or private financial organizations. The objective of this research is to describe the most popular pension plan, the differences between them, and the methods of their financing.

What is a pension plan as used in a firm and related to employee compensation?

The pension plan as used in a firm and related to employee compensation is known as the defined benefit plan. In the USA any pension plan that is not a defined contribution plan can be specified as a defined benefit plan (26 U.S.C. § 414(j). The differences between the defined benefit plan and defined contribution plan will be described in details below. Traditionally the amount of pension depends on the employee's salary at retirement or, for example, the average salary of the highest five years of earnings, the number of the years worked, and multiplied on the accrual rate. (Accrual rate is a "The rate of interest that is added to the principal of a financial instrument between cash payments of that interest" (Investopedia, 2010). The final amount of pension can be paid as a lump sum, but monthly payment is more common.

Due to many factors of influence determining the benefit in a defined benefit pension plan it is very popular among the unionized workers. This category of workers usually prefers working for the same company for many years. The simplest scheme offering monthly payment in the amount of $100 per every year of working in the company (or sometimes industry) provides $3000 per month for the worker with the thirty years of working experience. The common type of pension plan in the USA is a Final Average Plan, or FAP. The main factor determining the benefit in FAP plans is the average salary of employee over the latest years of his career. Usually the pension plan suggests special terms for early retirements, before the attainment of normal retirement age of 65 years.

What is the difference between a defined contribution plan and a defined benefit plan?

To discuss the differences between a defined benefit pension plan and defined contribution pension plan it is necessary to say a few words about the methods of plan funding. According the funding all the DB pension plans are divided onto funded and unfunded. The social security system in the USA uses the unfunded pension plan; this method of financing is also popular in many European countries. Under this plans all the pension are paid with the pension sponsor, the private employee, the large business or the state institutions. These payments are funded of social security contributions and current taxes. The funded plan suggests the existence of special investment fund founded with the contributions from the employer and other plan members. The benefits are dependent of the future returns on investment and can't be known in advance. However in many countries including the USA the government provides tax incentives to funded plans, so many private benefits plans in the USA are funded.

According to United States Code, "the term "defined contribution plan" means a plan which provides for an individual account for each participant and for benefits based solely on the amount contributed to the participant's account, and any income, expenses, gains and losses, and any forfeitures of accounts of other participants which may be allocated to such participant's account. (26 U.S.C. § 414(i)."

There are some principal difference between a defined benefit plan (DB) and a defined contribution plan (DC). It would be necessary to mention that Dc plans suggest the usage of personal accounts unlike the DB plans.

First difference is the method of benefits determination. Under DB plan benefits are determined by a special formula, which is based on the years of service and earning history. As a rule the employee doesn't contribute to the fund. Under the DC plan benefits are contributed by the amount the employee and employer contribution as well as the performance of the market.

Second difference is the issue of guarantees. In the case of DB the employer usually guarantees a settled benefit level after the retirement. In the case of DC there are no guarantees as for benefit level at retirement.

Third difference is the absorption the risk. Under the first pension plan (DB) all the risk is absorbed by the employer, under the second plan (DC) all the risk is absorbed by the employee.

Forth difference is the issue of liability. In DB plans the employer is liable for paying the pension benefits, in DC plans the liability of the employer ends with the money contribution into the fund.

Fifth difference is the plan portability. DB plans are usually partly portable, DC plans are portable.

At last, DB and DC pension plans differ with the typical arrangement. For the DB pension plan the formula includes the working experience with the company, the average salary in the highest years of earning, multiplied on the accrual rate. The typical arrangement for DC plan is the following: the employee contributes 5% of the salary into the plan, the employee (or) the company contributes 10%.

The United States Department of Labor warns that the DC plans don't promise a proper amount of benefit. The reason is that most of the defined contribution plans are funded. The balance on account depends on the changed in the value of investments.

What is accumulated benefit obligation and how is such associated with a projected benefit obligation?

The Forbes financial glossary explains the accumulated benefit obligation as the following:

"An approximate measure of the liability of a pension plan in the event of a termination at the date the calculation is performed. (Glossary, 2010)"

The ABO is basically the value of the future plan benefits that's based on accrued service and salary history to the date of the actuarial evaluation. It's based on a concept that the plan in ongoing, it's not assuming that we're terminating the plan. It looks at the service and salary history to the date of the valuation. The accumulated benefit obligation tends to be closer to the actuarial accrued liability for those two groups, because a lot of the liability is retiree and the retiree liability is the same under both the ABO column and the actuarial accrued liability column. Again, the ABO gives you a concept of what people have earned to the date of the valuation based on their salary history to that date. The actuarial accrued liability is more akin to what they've earned to the date of valuation with future salary increases reflected in them; the market value assets an idea of where we are relative to those two liability measurements.

The ABO can be the important material for analysis, especially for investors. The analysis of ABO helps measuring better the aggression of the company in many ways. For example, future investor can evaluate the discount rate used for future pension obligations as the characteristics of the company policy. That is why ABO should be disclosed at the financial statement of the company or in the footnote to it.

Defining the projected benefit obligation, Investopedia writes: "Actuarial present value as of a date of all benefits attributed by the pension benefit formula to employee service performed before that date. It is measured using assumptions as to future compensation levels if the pension benefit formula is based on those future salary levels (e.g., pay-related, final-pay (Investopedia, 2010)" "

Unlike the ABO, the projected benefit obligation "assumes that the pension plan is ongoing, and thus accounts for future salary increases. (Investopedia, 2010)" Different cost methods calculate the PBO differently, but it always reflects only past service. Sometimes the PBO reflects expected future pay increases because many pension plans are designed so that the retirement benefit is based on the pay at retirement. To allow the plan sponsor to recognize the cost of the plan gradually over the participant's lifetime, the actuary considers the portion of the future benefit due to past service to already include expected future pay increases.

What is the funded status and where is it reported? How does a firm report post-retirement benefits in accounting statements?

The difference between funded and unfunded methods of pension plan financing was described in the second paragraph. Shortly speaking, the unfunded pension pal uses the current actives like security system contributions or tax revenue. The funded pension plans are based on the special investment funds. The unfunded plans are known as PAYG, or pay-as-you-go plans. They don't involve different assets and the benefits at retirements are usually paid directly from employer contributions. Unlike the unfunded plans, the funded plans can accumulate the assets that have been set aside. As was stated above, the most popular type of such asset is the investment fund. As all the other investment funds, the fund in pension plan depends on the market volatility and the professionalism of investment manager. The information about the post-retirement benefits should appear at the footnotes to the company financial statement. Though is shouldn't be considered as a primary financial indicator of company performance, it could be useful material for the analysis. The policy of post-retirement benefits within the company can reflect the level of aggression within the company. In 2006 the article entitled "Pension Reporting SparksDebate" described the situation when the companies had to include the report based on the projected obligation into the regular financial statements. At the same time FASB (The Financial Accounting Standards Board, private non-profit organization) at the same time proposed the companies to include the surplus or deficit of pension program to the balance sheet instead the footnotes. "Moving the "funded" status of pension plans - as well as other retirement benefit obligations like health-care plans - onto the balance sheet could force many companies to recognize a big liability, which could cut their net worths and possibly hinder dividend payments or jeopardize lending agreements. (Investopedia, 2010)"

After the implementation of this recommendation the funded status became one of the influential financial indices. Thus, recently BNY Mellon, a global financial services company, reported about the "lowest-funded status for the typical U.S. corporate pension plan since February 2009 (BNY Melon, 2010)" , due to the lower interest rates in June and the U.S. stock market decline. As was stated in the financial statement, "plan liabilities are calculated using the yields of long-term investment grade corporate bonds. (BNY Melon, 2010)" Thus, funded status turned from the inner financial information to the external instrument of investment attraction.

What is an actuary and what is the actuary's duty in this process? Provide a discussion of all potential scenarios and the relevant accounting requirements.

Actuary is the business professional, whose work is close to accountant and business-risk manager, but it is no the first, neither the second. The actuary is the professional who ca evaluate the financial impact of the risks and uncertainty. Focusing on the mechanisms of financial systems, their mathematics and complexity, the actuary makes the expert assessments for the financial security in the company. The main tools of every actuary is mathematics, the actuary evaluates the possibility of different event and their potential impact to minimize company's risks. The evaluation of different possible perspective should include even the deaths because it can be avoided. Besides, the actuary should evaluate the possible impact of future event on the both sides of company's balance sheet. The programs of risk control also include the understanding of human behavior and the vagaries of information systems.


The system of pension benefits is rather sophisticated,. Many different institutions were created to distribute the special ponds from the social security system. However the pension systems in the USA is rather poor; because the opponents of pension system are always unavailable for the encounters Besides, it is necessary to the actuary to have some qualification in business knowledge, analytical skill and so on. The actuary, who evaluate the financial risks for the company, should have the sufficient knowledge about the methods of funding, Besides, he or she should know about two different sides of bad play. Analytical mind and the status of housewife create the miracles.