Defined contribution vs defined benefit pension plans

What is the difference between a defined contribution and a defined benefit plan?

A pension plan is deferred pay: the employee earns it now and receives it in retirement. The question is who carries the risk until then.

In a defined contribution plan , the company pays an agreed amount into the plan, often a match of what the employee pays. Once it has paid, it owes nothing more. The size of the pension depends on how the assets perform, so the employee carries both the investment risk and the longevity risk.

In a defined benefit plan , the company promises a pension, for example 60% of final salary for life. The company carries the investment risk (assets may earn less than expected) and the actuarial risk (people may live longer or retire at different times than assumed).

Memorize

How is a defined contribution plan reported?

The contribution for the period is the pension expense, and it is an operating cash outflow. The only balance sheet effect is lower cash, or an accrued liability if some of the contribution is still unpaid at year-end. Disclosure is short: the amount expensed. That makes this the simplest case on the exam.

How is a defined benefit plan shown on the balance sheet?

The balance sheet shows one net figure, the funded status : the fair value of plan assets minus the defined benefit obligation (the present value of the promised pensions, discounted at a high-quality corporate bond yield). The plan assets sit in a separate trust, but the net amount is the company’s.

$$F = A - D$$

If assets are less than the obligation, the plan has a deficit and the company reports a net pension liability among non-current liabilities. If assets exceed the obligation, it reports a net pension asset. Both IFRS and US generally accepted accounting principles (GAAP) do this.

Post-employment benefits

• Defined contribution plan Memorize employer pays a set amount; employee bears the risk
  • Expense the contribution
  • Balance sheet only unpaid contributions
• Defined benefit plan Memorize employer promises the pension and bears the risk
  • IFRS cost Memorize
    • Profit: service costcurrent and past
    • Profit: net interestrate × net liability or asset
    • OCI: remeasurementsnever recycled
  • US GAAP cost Use it
    • Profitservice cost, interest cost, less expected return
    • OCI, amortizedpast service cost, actuarial gains and losses
• Other post-employment benefits Know the idea retiree health care: like DB, usually unfunded

How is the cost of a defined benefit plan reported under IFRS?

Each year the net pension liability changes. IFRS splits the change into three parts: two go to profit or loss and one to other comprehensive income.

Memorize

1. Service cost goes to profit. It is the present value of the extra pension the employees earned by working one more year (current service cost). It also includes past service cost , the cost of plan amendments that credit earlier service, which IFRS recognizes in profit immediately.
2. Net interest goes to profit. It is the passage of time on the opening net position: the discount rate times the opening net pension liability or asset. The net interest expense is income when the plan is in surplus.
3. Remeasurements go to OCI and are never recycled to profit. They are the actuarial gains and losses (changes in assumptions such as turnover, mortality, retirement age and salary growth) and the difference between the plan assets’ actual return and the part already in net interest. The remeasurements are the only part that can swing wildly from year to year without touching earnings.

$$NI = r \times (D_0 - A_0)$$

$$C = S + Q + NI$$

$$\text{Remeasurement} = \text{actual return} - r \times A_0$$

The exam can give you the cost and ask for a component, or the components and ask for the cost. Interest on the net figure is the step people miss.

Exam tip Net interest uses the NET figure. If the plan is in surplus, net interest is income and it lowers the cost.

How does US GAAP differ?

The funded status on the balance sheet is the same. The income statement differs: the cost is built from more pieces and part of it is smoothed.

Use it

In profit each period under US GAAP: service cost, interest cost on the opening obligation, and the expected return on plan assets , which is a reduction of cost. Past service cost goes to OCI first and is then amortized into expense over the future service period of the employees. Actuarial gains and losses also go to OCI and are amortized over time, although US GAAP permits immediate recognition.

$$C = S + r\,D_0 - ER + \text{amortization}$$

So with the same plan, IFRS and US GAAP report the same balance sheet but different earnings. The expected return is also a lever: a higher assumed return lowers reported cost under US GAAP without any cash being earned.

Which assumptions move the numbers, and what is disclosed?

Measuring the obligation needs assumptions about the future, and small changes are large in effect. The discount rate assumption is a present-value rate: raise it and the obligation falls. The compensation growth assumption works the other way: higher expected raises mean higher final-salary pensions and a larger obligation. Longer life expectancy also raises it.

Assumption change	Effect on the obligation	Effect on cost
Higher discount rate	lower	lower service cost
Higher salary growth	higher	higher
Longer life expectancy	higher	higher
Higher expected return on assets (US GAAP)	none	lower

The notes carry far more for a defined benefit plan than for a defined contribution plan. International Accounting Standard (IAS) 19 asks for the plan’s characteristics and risks; a reconciliation of the opening to closing net liability for both assets and obligation (service cost, interest, remeasurements, past service cost, contributions); a sensitivity analysis to the main assumptions; the composition of plan assets (equities, bonds, real estate); and the effect on future cash flows. Analysts use these to treat a deficit as debt-like and to judge how aggressive the assumptions are.

Retiree health care and similar other post-employment benefits are accounted for like defined benefit plans, but they are usually not funded in advance, so the obligation is mostly unfunded and payments are made as they fall due.

Go deeper Why a lower discount rate inflates the obligation, and what analysts do with deficits

The obligation is the present value of payments that might start decades away, so it behaves like a long-duration bond liability: a 1 percentage point fall in the discount rate can raise it by well over 10%. That is why falling interest rates have pushed pension deficits up even when the assets did fine. In credit analysis and enterprise value, analysts often treat the net pension deficit (sometimes after tax) as debt, which raises leverage and reduces equity value. Other short-term benefits, such as paid leave and bonuses, are expensed as employees earn them and are not part of this model.