Question

Case 14-1 Pension Benefits

Pension accounting has become more closely associated with the method of determining pension benefits.

Required:

a. Discuss the following methods of determining pension benefits:

i. Defined contribution plan

ii. Defined benefit plan

b. Discuss the following actuarial funding methods:

i. Cost approach

ii. Benefit approach

Answer 1

Post-employment plans are classified as either defined contribution plans or defined benefit plans:

a. i. Defined Contribution plan - The entity's legal or constructive obligation is limited to the amount that it agrees to contribute to the fund. Thus, the amount of the post-employment benefits received by the employee is determined by the amount of contributions paid by the entity and also by by the employee to a post-employee benefit plan or to an insurance company together with the investment returns arising from the contributions.

In these plans actuarial risk ( risk that benefits will be less than expected) and investment risk ( the risk that assets invested will be insufficient to meet expected benefits) fall on the employee.

ii. Defined Benefit plan - In these plans it is entity's obligation to provide the agreed benefits to current and former employees and actuarial risk ( the risk that benefits will cost more than expected ) and investment risk fall in substance on the entity. Therefore if the actuarial or investment experience are worse than expected, the entity's obligation may be increased.

b.i. Cost approach - The cost approach estimates the total retirement benefits to be paid in future using assumptions like employees current salary , number of years upto retirement, the salary escalation rate, number of years employees will continue receiving those payments and then determines the equal annual payments that will be necessary to fund those benefits. This annual payment is adjusted for the amount of interest assumed to be earned by funds contributed by the plan.

ii. Benefits approach - Under the benefits approach the amount of pension benefits earned by employee service to date is determined. and then the present value of those benefits is calculated.. Two benefit approaches may be used: (1) the accumulated benefits approach and (2) the benefits/years of service approach. The major difference between these two methods is that under the accumulated benefits approach, the annual pension cost and liability are based on existing salary levels, whereas under the benefits/years of service approach (also called the projected unit credit method), the annual pension cost and liability are based on the estimated final pay at retirement.