Pension Accounting is the bane of most Accountants’ lives.
It was about the only subject I did not master during my accounting studies, and thankfully it is not something I need to get involved with in my career. To me it has been relegated to the back along with Account Theory.
So what is Pension Accounting? To answer that I need to first state that in Canada there are two types of pensions – defined contribution and defined benefit. So what are they?
Defined Contribution – just as it sounds, whatever you put into your pension pot is what you get out of it. It’s a savings account, in essence, which is tax deferred usually. If you live in Canada this would be your RRSP. Usually either the individual administers their own account or they use an advisor. If you have a company sponsored plan they usually use and administrator such as GWL or SunLife. You put money into the pot, and sometimes your employer will match your deposit. Depending on how they get invested, the funds, you will have a nice little pot of money when you retire. These deposits into the RRSP are tax-deductible, with the premise being that when you retire you will be in a lower tax bracket and you will pay income tax when you withdraw funds from your RRSP/RRIF. During your working life you get to claim up to a certain level (18% of taxable of income to a max of about $13,500) when you do your tax return. If it is company sponsored then your employer will adjust your payroll tax deductions to reflect this – so instead of getting a nice hefty tax return (which in essence is the government paying you back what you overpaid) you don’t pay the tax on those funds in the first place. Employers love the Defined Contribution Pension.
Defined Benefit – This is the one which drove me nuts during my accounting studies. This used to be the most prevalent form of pension plan for the vast majority of Canadians, but sadly the only ones who seem to still have this type of pension are governmental employees or in workplaces heavily unionized – like the car companies such as Ford, GM and Chrysler. Employees love this type of pension while employers hate it. Basically you are guaranteed a certain level of pension for the rest of your life once you retire. The calculations are rather complex but basically if you put in X-number of years and you are of a certain age when you retire and whatnot you will get about 40-70% of your pre-retirement income (depending on how many years you worked at your employer) as your pension. Employees love this as they can plan for their retirement because they know how much their pension will be. Employers hate and I shall explain.
How Do Employers Feel about these Pensions?
Employers love the Defined Contribution Pension as it is extremely easy to calculate for them. If the benefit is that the company will put in a max of 4% of your yearly taxable income and your income is $50,000 then their pension expense is $2000.00 as that is exactly what they pay into your pension pot. It’s a very simple transaction, very little calculation required, and there are no liabilities to maintain for several decades. Unfortunately for the employee they are subject to the vagarities of the market and depending on interest rates and how well their investments perform they could either do really well or not. The end result is that the employer has a very simple pension expense calculation but the employee does not know how much money they will have once they retire.
Employers hate the Defined Benefit Pension because it is extremely difficult to calculate and the calculations are rather arcane. Usually Actuaries have to be involved in the calculations. Several factors need to be determine when calculating the Defined Benefit Pension Plan:
• Gender of the employee – women tend to live longer, so the pot needs to be bigger to pay for their pension
• How long has the employee been with the employer – the longer with the employer the bigger the required pot
• Employer needs to estimate at what level will the employee’s taxable earnings reach just before retirement, taking into consideration inflation (this needs to be forecasted as who knows how much the inflation rate will be in 25 years, for example)
The employer needs to take guidance from their Pension Specialists (Actuaries) who will let the employer know how much to fund the Pension Liability.
For Defined Contribution Pensions the journal entry is usually:
DR Pension Expense
CR Cash (as they have to pay the funds to the administrator such as SunLife or GWL)
For Defined Benefit Pensions the journal entry is usually:
DR Pension Expense
CR Pension Liability
And when a pension starts getting paid out:
DR Pension Liability
The problem arises when the Actuaries indicate that an adjustment needs to be made to the Pension Fund – rarely is it ever to the employer’s benefit. Usually it’s a case of having to recognize a larger funding requirement. And this has caused problems for a number of very large American Corporations.
For year GM was able to post favourable financial results. Until it came to light that they had a huge funding hole for the Pension Fund and had to quickly top it up as many of their employees were retiring with expectations of receiving a certain defined pension.
I hate Pension Accounting because I could never wrap my head around all the calculations required to get to the point of recording the liability.
So that is Pension Accounting. But this is also an example as it why it is important to read and review the Income Statement. It is imperative that all the Financials be reviewed – Balance Sheet, Income Statement, Cash Flow Statement, Disclosure Notes and the Management & Discussion Notes.