How to Account for Defined Contribution Pension Plans

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  • 0:03 Employment & Pension Plans
  • 0:29 What Is a Pension Plan?
  • 1:17 Defined Contribution Plans
  • 3:49 Defined Contribution…
  • 4:44 Lesson Summary
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Lesson Transcript
Instructor: Shelumiel Ryan Abapo

Shelu is a Certified Public Accountant, SAP Business One Consultant, University Professor handling Taxation, Financial Accounting, Cost Accounting and Basic Accounting

In this lesson, you'll explore the nature of retirement and pension plans, the differences between a defined contribution plan and a defined benefit plan, and the accounting methods used with defined contribution plans.

Employment & Pension Plans

Today, you go to college and get a good education in the hope that sometime in the future, you can start your own business or be employed. When you get a job, a pension plan may be part of the compensation package.

Firms typically offer pension plans to attract and retain quality employees. Not all employers offer pension plans, though. Government organizations offer pensions, as do certain large organizations.

What Is a Pension Plan?

A pension plan is an arrangement whereby an employer provides benefits/payments to employees after they retire as compensation for the services they provided the company when they were working. The US Congress has expressed a desire to encourage responsible retirement planning by granting favorable tax treatment to a wide variety of pension plans.

Say you work for Walmart. The company will make arrangements to ensure that you get some compensation upon your retirement by setting up either a retirement fund or a trust that will be the source of your retirement benefits. This retirement fund will be comprised of your contributions and the amount matched by Walmart. The retirement fund is then managed according to whichever type of pension plan the company adopts, which can either be a defined contribution plan or a defined benefit plan.

Defined Contribution Plans

A defined contribution plan is a company-sponsored plan with an individual account for each participant or employee. Under this plan, an individual account is established for each participant. This means that as an employee, you will have your own account which will be used to pay retirement benefits when the employee retires.

In a defined contribution plan, the amount of contribution (or the contribution rate) by the employer is usually determined at the discretion of the employer, by contractual agreement, or both. Upon retirement and when the participant withdraws from the plan, the amount allocated to the participant's account represents the participant's accumulated benefits. This may then be paid to the retiring employee or used to purchase retirement annuity, as defined by the plan agreement.

In a defined contribution plan, what is definite is the amount of contribution to the plan by the company. This contribution may be set at a certain fixed amount every year or a certain percentage of employee wages or the firm's net income.

Let's go back to your job at Walmart. They match employee retirement contributions 100% on the dollar, up to 6% of pay. In other words, the company's contribution rate is 6% of the employees' wages, provided that employees contribute the same amount.

Fund managers of pension plans typically invest the money in US government securities, investment-grade bonds, blue chip stocks, private equity, real estate, and infrastructure investments. In a defined contribution plan, the actuarial risk and investment risk is borne by the employees. As such, the amount of pension benefits that will be received by retiring employees in the future is dependent on the performance of the fund.

Actuarial risk pertains to that risk where benefits will be less than that expected. On the other hand, investment risk refers to the possibility that the assets invested in the fund will be insufficient to meet the expected retirement benefits. If the fund earns well, employees will receive a greater amount of benefits. However, if the retirement fund performs poorly, employees suffer the consequence of getting lower pension benefits.

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