Pension Expense

Pension expense is the amount reported in the income statement related to a company's pension plan.

Pension expense under defined contribution plan

Under the defined contribution plan, the periodic contribution which the company is required to pay is expensed out on accrual basis.

Example

CPE Ltd. has a defined contribution plan which required the company to contribute $20 million to the fund each year. In the financial year 2011, the company pay $25 million while in financial year 2012, it paid $15 million.

The company will recognize a pension expense of $20 million each in 2011 and 2012. The first year payment will result in $5 prepayment of contribution which will expire in 2012.

Pension expense under defined benefit plan

The pension expense under the defined benefit plan is made up as follows:

1. Service cost

2. Interest cost

3. Expected return on plan assets

4. Amortization of prior service cost

5. Amortization of actuarial gains and losses

Amortization of actuarial gain and a positive expected return on plan assets result in a decrease in pension expense.

Service cost represents the portion of projected benefit obligation (PBO) earned by the employees in the current year.

Interest cost represents the increase in projected benefit obligation (PBO) on account of unwinding of discount. It equals the product of opening defined benefit obligation (PBO) multiplied by the interest rate.

Expected return on plan assets is the return which is expected to be earned by the plan assets over the next period.

Amortization of prior service cost represents the additional service cost resulting from changes to plan structure, which is expensed in the current period.

Amortization of actuarial gains and losses represent the amount of actuarial gains or loss that are written off in the current period.

5) Funded Status

Funded status is the net liability or net asset related to a company's defined benefit plans. At any point of time it equals the fair value of total plan assets minus the projected defined benefit obligation. Plan assets are the investments of the pension fund. These may include investment in the company's stock, other stocks listed on any stock exchange, exchange-traded funds, bonds, real estate, etc.

Projected defined benefit obligations (also known as present value of defined benefit plan) is the present value of expected pension payments which the employees are entitled to receive based on the service they have accumulated to date.

Under US GAAP, when the fair value of plan assets exceeds the projected defined benefit obligation, a net pension asset equal to the excess of fair value of plan assets over the projected benefit obligation is reported on the balance sheet. On the other hand, if the projected defined benefit obligation exceeds the fair value of plan assets, a net liability equal to the excess of defined benefit obligation over the fair value of plan assets is reported on the balance sheet.

Example

FS Ltd. has a defined benefit plan. As at 31 December 2011, its plan assets had a book value of $140 million and fair value of $160 million. The PBO at the time was $150 million. During the year, the company contributed an amount of $20 million to the fund, the fund paid out $15 million while the return on plan assets was $10 million. Service costs were $30 million, interest cost amounted to $12 million while actuarial gains were $3 million.

Solution

The funded status = fair value of plan assets − projected defined benefit obligation

As at 31 December 2011, the funded status was $10 million (calculated as $160 of fair value of plan assets minus $150 million of projected defined benefit obligation) and it would be reported as an asset on the balance sheet.

After one year, i.e. as at 31 December 2012, new fair value of plan assets is:

Opening fair value of plan assets	160
Contributions received	20
Benefits paid	(15)
Actual return on plan assets	10
Closing fair value of plan assets	175

The projected defined benefit obligation as at 31 December 2012 will equal $180 million as calculated below:

Opening PBO	150
Service cost	35
Interest cost	12
Benefits paid	(15)
Actuarial gain	(2)
Closing PBO	180

Funded status as at 31 December 2012 would be -$5 million which represents a net pension liability of $5 million to be reported on the balance sheet.