Defined Benefit Plan
A defined benefit plan is an employee benefit plan in which the employer commits to pay its employees a defined amount based on a benefit formula which depends on future demographic/financial variables.
IAS 19 Employee Benefits, the IFRS standard dealing with pension plans, defines a defined benefit plan simply as ‘an employee benefit plan other than a defined contribution plan.’ A defined contribution plan is a plan in which the employer is only obligated to pay a specified contribution to the fund for service rendered. While in a defined contribution plan the employees bear any shortfall risk, in a defined benefit plan any pension plan under-performance is borne by the employer.
Example: defined benefit plan vs defined contribution plan
EBP Ltd. has post-retirement benefits plan which entitles its employees to an amount equivalent to the product of their basic salary and years of service. DCP Ltd. too has a pension plan but its agreement with the employees requires DCP to contribute an amount equal to the sum of the employee’s current basic salaries at the end of each financial year.
EBP's plan is a defined benefit plan because it entitles employees to a defined amount in future (which is based on future salary). Any risk arising from fluctuations in salary, interest rates and/or investment performance, etc. are borne by the employer. DCP’s plan is a defined contribution plan because the employees only receive an amount equal to their salaries today. Any positive or negative movement in inflation rate, interest rate, etc. accrues to the employees.
Accounting for a defined benefit plan
The expected benefit payments under a defined benefit plan are subject to significant actuarial assumptions. Employers often need to develop models to predict future payout scenarios which depend on demographic factors, interest rates, inflation rates, etc. The payouts under different scenarios are probability-weighted and their present value is determined.
The present value of expected future pension payments for service rendered in current and prior periods is called the projected benefit obligation. Due to employees rendering services for one additional period and due to time value of money, the defined benefit obligation increases and the company recognizes service cost and interest cost. Similarly, the projected benefit obligation decreases when benefits are paid out to employees. PBO also changes due to changes in actuarial assumptions.
The fair value of plan assets increases when contributions are received from the employer and/or the funds generate positive return, and decreases when benefits are paid.
The net pension asset or liability is determined by comparing the fair value of plan assets with the projected benefit obligation. Any excess of PBO over plan assets is recognized as a net pension liability, and any excess of plan assets over the PBO is recognized as a net pension asset (subject to certain exceptions).
In the income statement, pension expense is recognized which comprises the current service cost, prior service costs, and net interest on pension liability or asset.
Actuaries have calculated that the projected benefit obligation of EBP's pension plan is $30 million and $36 million in 20X0 and 20X1 respectively. At the end of 20X0, EBP had plan assets valued at $32 million. During 20X1, EBP contributed an amount of $2 million to the fund and paid out benefits of $5 million. EBP will report a net pension liability of $2 million at the end of financial year 20X0 ($32 million plan assets minus $30 million obligation).
At the end of financial year 20X1, its obligation would be $36 million and its plan assets work out to $29 million ($32 million + 2 million (contribution) − 5 million (benefits paid out)), resulting in a net pension liability of $7 million.
by Obaidullah Jan, ACA, CFA and last modified on