Level 1 CFA® Exam:
Post-Employment Benefits
Companies offer various benefits to their employees after retirement. These are called post-employment benefits and may be based either on current obligations or future promises to pay.
Pension plans constitute a good example of post-employment benefits and they are an important pillar of the pension system. Pension plans can be divided into 2 basic categories, namely:
- defined contribution pension plans (aka. DC plans), and
- defined benefit pension plans (aka. DB plans).
Defined contribution pension plans are all about defined periodic contributions made by the employer to an employee’s retirement pension plan.
Defined benefit pension plans are based on periodic payments made by the employer after the employee retires from work.
In the case of a defined contribution pension plan, in its financial statements, the company reports only the expense equal to the amount of the contribution in a given period. Reporting a defined benefit pension plan in the company’s financial statements is a bit more complicated.
Defined contribution pension plans are all about defined periodic contributions made by the employer to an employee’s retirement pension plan. The amount of the contribution usually depends on certain factors, such as the employee’s age, years of service, or his or her performance. The employer has no future obligation to pay and all he has to do is to contribute specific amounts to the employee’s pension plan. The investment risk is borne by the employee.
In the case of a defined contribution pension plan, in its financial statements, the company reports only the expense equal to the amount of the contribution in a given period.
Defined benefit pension plans are based on periodic payments made by the employer after the employee retires from work. The amount of the benefit is dependent on the employee’s years of service, compensation, and so on. To exemplify how defined benefit pension plans work, we could hypothesize that for each year of service the retiree receives a benefit in the amount of 1% of the compensation that he or she received in the final year before the retirement.
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Reporting Defined Benefit Pension Plans in Company’s Financial Statements
star content check off when doneBefore we elaborate on this issue in more detail, we need to say a few words about actuarial assumptions used to measure the employer’s pension obligation under a DB plan.
The present value of the defined benefit obligation under IFRS or the projected benefit obligation under U.S. GAAP is the actuarial present value of future benefits due to the employee on a given day. The amount of the pension obligation varies in time and is estimated using different actuarial assumptions, such as:
- future levels of compensation and expected increases,
- discount rates, or
- vesting.
The value of the employer’s pension obligation depends on average employee compensation, as well as on expected compensation increases. For its calculation, it is assumed that the employer continues to operate and that the employee is employed by the employer until retirement.
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According to IFRS, the periodic pension cost (related to changes in net pension asset or liability) consists of 3 components, two of which are reported in the income statement and one is reported in equity through other comprehensive income. These components include:
- service costs,
- net interest expense or income, and
- remeasurement.
Current service costs determine the value by which the pension obligation of an employer increases as the employee provides the service over a given period of time. The amount by which the pension obligation increased as a result of the amendments in the pension plan or its curtailment is called past service cost. Service costs are reported in the income statement.
To compute the net interest expense or income we multiply the net pension liability or net pension asset respectively by the discount rate that we used to compute the present value of the pension obligation. Net interest expense constitutes a financial cost of deferring pension payments, and net interest income is a financial income resulting from the pre-payment of the pension obligation. Net interest expense or income is reported in the income statement.
The remeasurement of net pension asset or liability involves actuarial gains and losses and differences between the actual return on plan assets and the return calculated as plan assets times the interest rate used for calculating the present value of the pension obligation. The values from remeasurement are reported as other comprehensive income.
According to U.S. GAAP, the periodic pension cost (related to changes in net pension asset or liability) consists of 5 components, three of which are reported in the income statement, and two are reported in equity through other comprehensive income. These components include:
- current service costs,
- past service costs,
- interest expense,
- return on plan assets,
- actuarial gains and losses.
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- Pension plans can be divided into 2 basic categories: defined contribution pension plans (aka. DC plans) and defined benefit pension plans (aka. DB plans).
- Defined contribution pension plans are all about defined periodic contributions made by the employer to an employee’s retirement pension plan.
- Defined benefit pension plans are based on periodic payments made by the employer after the employee retires from work.
- In the case of a defined contribution pension plan, in its financial statements the company reports only the expense equal to the amount of the contribution in a given period. Reporting a defined benefit pension plan in the company’s financial statements is a bit more complicated.
- Under IFRS the periodic pension cost (related to the DB plan) reported in the income statement includes both past and current service costs, as well as net interest expense or income. The periodic pension cost reported in equity covers remeasurement, that is net return on plan assets and actuarial gains and losses.
- Under U.S. GAAP, the periodic pension cost (related to DB plan) involves current service cost, interest expense, expected return on plan assets, past service cost amortization, actuarial gains and losses amortization that are reported in the income statement plus actuarial gains and losses and past service cost reported in other comprehensive income.
- Different methods of reporting the periodic pension cost in financial statements under different accounting standards lead to problems with comparing companies that report under different standards.