Defined contribution vs. defined benefit
- Defined contribution — the employer promises a contribution; expense equals the contribution owed. Employee bears investment risk. Simple.
- Defined benefit — the employer promises a future benefit; the employer bears investment and actuarial risk. Complex accounting follows.
Funded status: the balance sheet number
Funded status = Fair value of plan assets − Projected benefit obligation (PBO)
An overfunded plan (assets > PBO) is a noncurrent asset; an underfunded plan is a liability. This full funded status must be recognized on the balance sheet.
Net periodic pension cost — "SIRAGE"
| Component | Effect on cost |
|---|---|
| Service cost | Increase — the PV of benefits earned this period |
| Interest cost | Increase — beginning PBO × discount rate |
| Return on plan assets (expected) | Decrease |
| Amortization of prior service cost | Increase |
| Gains and losses (amortization) | Either — via the corridor approach |
| Existing net obligation/asset at transition | Either |
The obligation measures
- PBO — present value of benefits based on projected future salary levels; this is the balance sheet measure
- ABO — accumulated benefit obligation, based on current salary levels
- VBO — the vested portion of the ABO
PBO ≥ ABO ≥ VBO in a plan with expected salary growth.
The corridor approach
Actuarial gains and losses accumulate in OCI. Only the amount exceeding 10% of the greater of beginning PBO or beginning plan assets must be amortized into pension expense, over the average remaining service period. This smooths volatility.
EXAM TIP: Prior service cost arises from a plan amendment granting credit for past service. It is recognized in OCI when it arises and amortized into expense over employees' remaining service periods — never expensed all at once.