Question

Please answer the following questions about defined benefit pension plans:

a. Companies with defined benefit pension plans must recognize pension expenses each period. What are the five components of pension expense? Briefly describe each component.

b. How does each component of pension expense affect pension expense during the period (increase, decrease, or uncertain)?

c. What is the difference between the accumulated pension obligation and the projected pension obligation?

d. What determines whether a pension plan is underfunded or overfunded

Answer 1

a. Following are the five components of pension expenses:-

(i). Service Cost

The primary component of pension expenses is service cost. Employers incur a liability for each complete year of employee service.

The service cost represents the present value of projected retirement benefits earned by covered employees in the current year. In simpler terms, service cost refers to the required amount the employer must set aside each year to cover employees' pension benefits upon retirement.

(ii) Interest Cost

Interest cost represents the interest accumulated on the unpaid balance of the projected benefit obligation as an employee's service time increases.

Projected benefit obligation refers to the current value of all benefits employees earn during employment. With each year of complete service, employees are one year closer to receiving retirement benefits.

(iii) Return on Plan Assets

Pension plan assets normally consist of stocks, bonds and other investment instruments such as mutual funds and real estate.

The return on plan assets represents the current year's earnings on invested plan assets. An employer figures the rate of return by multiplying the assets' fair value at the start of the year by the estimated long-term assets' rate of return.

(iv) Amortization of Prior Service Cost

When an employer implements or modifies a pension plan, employees usually receive credit for service prior to the change.

Employers must cover this cost over the outstanding portion of the employee's service, according to Money-Zine.

(v) Gains and Losses

Market instability impacts pension expenses. The gains or losses components show the changes in the employer's projected benefit obligation and the market impact on plan assets.

For example prior service cost generally increases the employer's pension expense, but can decrease the expense if the employer does not provide retroactive pension benefits.

b. Following are the effects of five components of pension are as follows :-

(i) Service Cost

Service cost depends on factors such as job promotion, salary increases and early retirement as these affect the final benefit amount.

(ii) Interest Cost

Employers must record this cost at a discounted rate. Market interest rates on premium investments or rate of return on retirement annuities set the discount rate.

(iii) Return on plan assets

The employer must subtract gains and add losses when computing pension expense.

(iv) Amortization of prior service cost

The amortization of prior service represents the cost of providing retroactive benefits over the remaining service-years of the covered employees.

(v) Gains and losses

a pension expense worksheet on hand to remind your accounting staff of the details of pension expenses on the income statement.

c. Following are the different Between accumulated pension obligation and projected pension obligation :-

Meaning

Accumulated pension obligation is a approximate amount of company's pension plan liability at a single point of time.

Projected pension obligation an actuarial measurement of what a company will need at the present time to cover future pension liabilities.

Calculation

Accumulated pension obligation is equal to the present value of the future amount that a pension plan expects to pay an individual during their retirement.

If it is below the pension plan's assets, then the plan is overfunded.

Projected pension obligation is substracted from the pension plan's funded status from the fair value of the plan's assets to determine the projected benefit obligation.

d. when pension plans can become overfunded as a result of long periods of stock market increases.

Pension plan is under- funded when obligations to pay pensions, exceed the assets that have accumulated to fund those payments.

Pensions can be underfunded for a number of reasons. Interest rate changes and stock market losses can greatly reduce the fund's assets.