Defined Contribution Plan
A defined contribution plan is a post-retirement benefit plan in which the employer only makes pre-determined contributions and has no legal or constructive obligation to meet any shortfall that may arise due to poor fund return.
Unlike a defined benefit plan in which the employer guarantees a benefit payout to each employee after retirement, in a defined contribution plan, an employer is responsible only to the extent of his contributions. In such a plan, the employees bear the actuarial risk, the risk that benefits will be less than expected, and the investment risk, the risk that fund assets will under-perform.
However, a plan is not a defined contribution plan even if it is structured as such, if the employer guarantees a certain minimum return, the plan requires the employer to pay additional contributions in case of a short fall, and/or the employer has a history of increasing contributions when fund performance declined, etc.
Accounting for a defined contribution plan
Accounting for a defined contribution plan does not involve any actuarial assumptions.
In the period in which an employee provides services, the employer records an expense and a liability at an amount equal to the contributions which it is required to make to the plan. This is often based on a formula linked to current salary, years of service, etc. It does not involve any component related to future inflation, investment return, etc.
When contributions are made to the fund, the employer records it as a reduction in the pension contributions payable. When the contributions exceed total obligation, the company recognizes a net prepayment and if the obligation exceeds the contribution, it recognizes an accrued expense.
After an employer has made contributions, the pension plan has no further accounting implications for the employer because the contributions are managed by a trust representing the employees and the employer shares no gain or loss that may arise.
Example
Company DCP has a defined contribution plan. According to employment contracts it has entered into with its 100 employees, it is required to contribute one gross monthly salary per employee per year to the plan. The average gross monthly salary per employee during 20X2 was $6,000.
The yearly contribution which DCP should record as pension expense amounts to $600,000 ($6,000 multiplied by 100). This would be recorded using the following formula:
| Pension expense | $600,000 | |
| Pension liability | $600,000 |
The contributions are made to a trust which represents employees and manages the contributions received from DCP on their behalf. If the company actually pays an amount of $1,000,000 during 20X2, it would be recorded as follows:
| Pension liability | $1,000,000 | |
| Bank | $1,000,000 |
As contributions exceed obligation, it results in a prepayment of $400,000 to be reported on the statement of financial position.
In case of DCP plan, any future increase in salary level, decrease in mortality rate, increase in expected inflation and expected return and prevailing market return, etc. will have no impact on the company's expense and liability related to the plan even though these factors would ultimately impact the amount paid to the employees.
by Obaidullah Jan, ACA, CFA and last modified on