Question

Question 26

Explain the difference between a defined benefit pension plan and a defined contribution pension plan. Also explain why the accounting for the two types of plans is so different. Hint: you do not need to explain the details of pension accounting.

Answer 1

Defined benefit pension plan : A defined benefit pension plan is a retirement plan in which the entire money is pooled in by the company itself for it's employees. Once the employee retires, they reap the benefits of the plan as pensions that are given out every month. Under these plans you just show up for work and, assuming you meet basic eligibility rules, you’re automatically enrolled in the plan. You also need to stick around on the job for several years typically five to be fully vested in the plan. Since the contribution pattern is different from defined contribution plan there is a difference in accounting treatment for both plans. The accounting treatment under this plan is completely the responsibility of the company as there is no contribution from the emplyee. Hence each time annual contibution is the made an expense entry is recorded. Also, the calculation of the annual amount is based on a formula that takes into account how long you were on the job and your average salary during your last few years of employment. The benefit pension plan credits your account with a set percentage of your salary each year.

Defined Contribution plan :  A defined contribution plan is a retirement plan in which the money is pooled in by the company and employees together. Under these plans the contribution ammount is divided into 2 parts namely, "Employers contribution" and "Employees contribution". You also need to register under the plan either through your employer or personally in agreement with the employer. Since the contribution pattern is different from defined pension plan there is a difference in accounting treatment for both plans. The accounting treatment under this plan is the responsibility of the company and the employee both. Hence each time annual contibution is the made an expense entry is recorded by the company in it's books and by the employee in his books. Also, the calculation of the annual amount is based on the formula under which every parameter is clearly defined.. The benefit contribution plan credits your account with the total amount at once, where, the total amount comprises of "Employer conrtibution" and "Employee contribution" both.