How to Account for Defined Benefit Pensions & Other Postretirement Plans

Accounting for defined benefits and pension plans is one of the most challenging but critical areas of accounting. A company's pension liabilities and future funding needs are highly sensitive to assumptions, many of which are subjective. The financial position of a company's defined benefits plan will greatly affect the company's financial performance, since underfunded pensions must be funded, which reduces a company's profits. Understanding how to account for defined benefits plans and postretirement obligations is a powerful and critical tool for corporate managers and investors.

Difficulty: Moderately Challenging

Instructions

1. Subtract the amount of pension payments to retirees from the total amount contributed to the pension plan by employees and the employer. If this number is negative, it should be included in "other expenses" on an income statement (which reduces earnings). If the number is positive, it should be included in "other income" on the income statement (which increases earnings).

2. Select the appropriate discount rate for future pension obligations. If the company's pension plan is guaranteed (either explicitly or implicitly) by the federal government, you should use the yield on 10-year treasury bonds as the appropriate discount rate. Otherwise, you should use the average yield on AA corporate bonds. You can find the yield information on Bloomberg (see Resources).

3. Discount future annual pension payments by the rate selected in Step 2. Sum the discounted payments to determine the present value of all future pension liabilities. Enter the pension-liability figure in the liabilities section of the balance sheet.

4. Enter the market value of all pension assets in the assets section of the balance sheet. If some of the pension assets are held in nonliquid, hard-to-value investments (such as real estate), you should use the most recent quarterly appraisal value when determining the value of pension assets.

5. Divide the value of pension assets (calculated in Step 4) by the value of pension liabilities (calculated in Step 3). If the value of pension assets is less than 85 percent of the value of pension liabilities, the company will have to make increased contributions to adequately fund its pension.

6. Calculate the required annual contributions by subtracting pension assets from pension liabilities and dividing the result by 30. Current regulations allow companies to amortize (spread out) the amount of underfunded pension liability over a 30-year period, which gives companies 30 years to fully fund their pensions. For example, if a company's pension assets equal $70 and the value of its pension liabilities equals $100, the required annual contribution equals ($100 - $70) / 30 = $1. Include the resulting number in "other expenses" on the income statement (which reduces earnings).

Tips & Warnings

• Pension accounting is a controversial topic, and the rules change frequently. Make sure you stay on top of any rule changes, and consult an accountant if you have questions.

References

• American Academy of Actuaries---Fundamentals of Pension Accounting and Funding

Resources

• Bloomberg--Rates & Bonds