Difficulty: Intermediate | Prerequisites: Introductory financial accounting, time value of money concepts (present value, annuities).
Pension plans sit at the intersection of compensation, tax law, and long-term financial reporting. This chapter covers how employers account for the two major types of retirement plans and how each one affects the balance sheet and income statement differently. You should already be comfortable with present value calculations and basic journal entries. If you are not, review Chapter 6 (time value of money) first, as PBO calculations rely heavily on discounting future cash flows.
Employers offer pension plans to help employees save for retirement. In a defined contribution plan, the employer puts money in and walks away; the employee bears the investment risk. In a defined benefit plan, the employer promises a specific retirement payout based on a formula, bears the investment risk, and must account for a complex liability (the projected benefit obligation) on the balance sheet.
Pension plan
An employer-established investment arrangement that helps employees save for retirement, typically with tax-deferred ("qualified") status.
In simple terms, it is a pot of money your employer helps you build so you have income after you stop working.
Defined contribution plan
A pension arrangement where the employer (and often the employee) contributes a set amount to an individual retirement account; retirement income depends entirely on investment performance.
Think of it as: "The employer puts money in. What you get out depends on how the market does."
Defined benefit plan
A pension arrangement where the employer promises a specific retirement payment, usually calculated by a formula involving years of service and salary.
Think of it as: "The employer guarantees your retirement cheque, regardless of what the investments do."
Contribution
The amount that goes into the pension plan during the year.
Distribution
The amount taken out of a pension plan, typically during retirement.
Benefits
The payments a retiree receives from the plan after retirement.
401(k) / 403(b)
Common defined contribution plan types named after sections of the U.S. tax code. In a 401(k), the employee contributes a portion of salary, and the employer often matches up to a percentage.
Money purchase plan
A type of defined contribution plan where the employer contributes a fixed percentage of each employee's salary.
Profit sharing plan
A type of defined contribution plan where the employer's contribution is based on a formula tied to company profits, or made at the employer's discretion.
Pension plans are generally tax-deferred ("qualified") arrangements with three core tax benefits:
Contributions are not currently taxable for the employee
Contributions are tax-deductible for the employer
Investment earnings grow tax-free until the employee takes distributions in retirement
The tax deferral is the main incentive. The employee pays no income tax on contributions or earnings until retirement, when their tax bracket is typically lower.
In a defined contribution plan, each employee has their own individual retirement account. The employee selects investments from the options available (stocks, bonds, etc.), and retirement income depends on how well those investments perform over time.
The employee bears the investment risk. If the portfolio performs poorly, the employee's retirement income shrinks. If it performs well, they benefit directly.
Types of defined contribution plans:
Money purchase plan - the employer contributes a fixed percentage of each employee's salary to the retirement account every year, regardless of profits
Profit sharing plan - the employer contributes based on a formula tied to company profits, or at the employer's discretion
401(k), 403(b), or similar - the employee contributes a portion of their own salary; the employer often matches contributions up to a certain percentage of salary
The power of starting early:
The source material illustrates this with an example worth remembering. At a $50,000 salary, saving 3% ($2,100 per year) for 10 years at 5% interest:
Start at age 25: $26,414 by age 35, growing to $114,158 by age 65 (with no further contributions)
Start at age 35: $26,414 by age 45, growing to only $70,084 by age 65
Starting 10 years earlier, with the same contributions for the same period, yields over $44,000 more at retirement, purely from the extra compounding time.
In a defined benefit plan, the employer pays into a single pension fund for all employees. The money is invested in a professionally managed portfolio.
The employer promises a specific retirement payment to each employee, calculated by a formula. The formula is typically based on years of service and salary (often the final year's salary or an average of the last few years).
Example formula: 1.5% x years of service x final year's salary
An employee with 30 years of service and a final salary of $100,000 would receive: 0.015 x 30 x $100,000 = $45,000 per year in retirement.
Who bears the risk?
The employer bears the investment risk. The employer must pay the promised amount to retirees regardless of how well the investments have performed. If the portfolio loses value in a recession, the company absorbs the loss, not the retiree.
Why accounting is more complex:
Defined benefit plans raise several questions that defined contribution plans do not:
Is the employer contributing enough to meet its future promises?
Should the employer show a liability on the balance sheet, and how is it calculated?
Should the employer show an asset based on the investment portfolio?
How is pension expense calculated when the cash outflows occur decades later?
Accounting for defined contribution plans is straightforward. Pension expense is recognised in the income statement when the employer makes its cash payment to the trustee of the account, based on the plan's provisions.
Example journal entry: If the employer contributes 3% of each employee's salary, and total salaries are $500,000:
Account | Debit | Credit |
|---|---|---|
Pension Expense | 15,000 | |
Cash | 15,000 |
Once the contribution is made, the employer has no further obligation. The employee's future retirement income depends on the amount contributed and how well the investments perform over time.
The key point: the employer's only accounting entry is recording the contribution as an expense. There is no ongoing liability to track.
Most private-sector employers in the U.S. now offer defined contribution plans (such as 401(k)s) rather than defined benefit plans, largely because they shift investment risk to the employee and are far simpler to account for. Defined benefit plans remain common in the public sector (government, education) and in some large legacy corporations. Understanding the accounting difference matters because it directly affects how a company's financial statements look: a company with a large underfunded defined benefit plan carries a significant long-term liability, which affects leverage ratios, credit ratings, and investor perception.
Students often confuse who bears the investment risk in each plan type. In a defined contribution plan, the employee bears the risk. In a defined benefit plan, the employer bears the risk. The trick to remembering: whoever promises the payout bears the risk of delivering it.
Students sometimes think a retiree collecting from a defined benefit plan should worry about recessions. They should not: the employer is obligated to pay the promised amount regardless of market performance.
A common error is thinking that 401(k) plans are defined benefit plans because the employer "matches" contributions. The match is a contribution, not a promised benefit. It is still a defined contribution plan.
Students sometimes assume that pension expense for a defined contribution plan involves complex calculations. It does not. The expense equals the contribution made. Full stop.
⚠️ Be able to identify whether a scenario describes a defined contribution or a defined benefit plan. Key giveaway: if the employer promises a specific payout formula (e.g. 1.5% x years x salary), it is defined benefit. If the employer contributes a set amount and the employee picks investments, it is defined contribution.
⚠️ Know the journal entry for a defined contribution plan. It is a single debit to Pension Expense and credit to Cash. That simplicity is the point.
⚠️ Understand that in a defined benefit plan, the employer bears the investment risk, and the accounting involves tracking a liability (PBO), plan assets, and pension expense with multiple components. Part 2 of these notes covers this in depth.
⚠️ The three major components to account for in a defined benefit plan are: the pension obligation (liability), the pension plan assets (investments), and the periodic pension expense.
True or false: In a defined contribution plan, the employer guarantees a specific retirement payment to the employee. (False: the employer only guarantees the contribution, not the payout.)
True or false: A 401(k) plan is a type of defined contribution plan. (True.)
Fill in the blank: In a defined benefit plan, the ______ bears the risk of return on the investments. (Employer.)
True or false: Pension expense for a defined contribution plan equals the amount the employer contributes to the plan. (True.)
Fill in the blank: The three major components to account for in a defined benefit plan are the pension ______, the pension plan ______, and the periodic pension ______. (Obligation, assets, expense.)
Q: Salina Corp offers a retirement plan that allows employees to contribute a percentage of their salary to their choice of investment accounts. The company matches each employee's contribution up to 3% of their salary. What type of pension plan is this?
A: Defined contribution plan. The employee chooses the investments and the employer matches contributions. There is no promised benefit formula.
Q: Harry is a retiree collecting monthly pension payments from Electric Co's defined benefit plan. He is worried his pension income will decrease if there is another recession. Should he be worried?
A: No. Electric Co is obligated to pay Harry's pension at the amount stated in the plan. The company absorbs investment losses, not the retiree.
Q: An employer contributes 3% of total salaries ($500,000) to employees' retirement accounts. What journal entry does the employer record?
A: Debit Pension Expense $15,000, Credit Cash $15,000. The employer has no further obligation after making the contribution.
Q: What is the key difference between who bears risk in a defined contribution plan versus a defined benefit plan?
A: In a defined contribution plan, the employee bears the investment risk because their retirement income depends on portfolio performance. In a defined benefit plan, the employer bears the risk because they must pay the promised amount regardless of investment returns.
This material connects directly to time value of money concepts from earlier in the course (present value of annuities), which are essential for calculating the projected benefit obligation in defined benefit plans. It also ties into the broader theme of matching expenses to the periods in which related revenue is earned, a core GAAP principle covered in revenue recognition and accrual accounting chapters. The pension liability discussion connects to long-term liabilities and the balance sheet presentation topics.
Pension plans, defined contribution plan, defined benefit plan, 401(k), 403(b), money purchase plan, profit sharing plan, retirement benefits, employer matching, pension expense, tax-deferred plan, qualified plan, employee compensation, investment risk, pension accounting, ACCTG 472, intermediate accounting, Chapter 17