16.3 Defined Contribution Plans

With this type of plan, the amount the employer contributes is defined by the contract or relationship the employer has negotiated with its employees. This means that the employer has agreed to fund the plan at a specified amount, usually calculated as a fixed amount or as some percentage of the employee’s pay. However, the employer has not agreed to provide any specific amount of pension income to the employee once he or she retires. The amount of pension income available to the employee will depend on how the pension plan assets have performed over the years. The pension plan assets are usually delivered to an independent trustee who will be given the task, and legal right, to invest the assets on behalf of the employees, and this trust is legally separate from the employer. While the trustee will prudently invest the assets in order to provide pension payments to the employees when they retire, there is no guarantee of how much retirement income an individual employee will receive as these funds are subject to investment risk. With a defined contribution plan, the employee bears all of the investment risk, as the employer has only agreed to contribute a specified amount to the plan.

Because the employer bears no investment risk, and no obligation for future pension payments, the accounting for the employer is quite simple. The amount the employer has agreed to pay on behalf of the employees is simply recorded as an expense every year, usually described as a pension or post-employment benefit expense. A liability would only be recorded if the company had not remitted the required funds to the pension plan trustee by the end of the fiscal year. It is also possible that an asset could be recorded if the employer had remitted more funds to the trustee than were required by the agreement with the employees. If either a liability or asset exists at the end of the fiscal period, it would likely be classified as current, as it would normally be expected that the amount would be settled within one year. However, there can be situations where future contributions may be required for current service under a defined contribution plan, such as a deferred contribution required under the terms of a collective agreement negotiated with an employee union. In this case, the future contributions would need to be discounted using the same interest rate as would be applied to a defined benefit plan.

The accounting for this type of plan is very straightforward.  The expense is usually determined based on a percent of an employees salary or wage.  Pension Expense is usually debited (on the income statement) and Cash credited for the amount of payment.  If the payment is in arrears, a Pension Liability (on the Statement of Financial Position) can be used.  A liability is reported on the statement of financial position only if the required contributions have not been made in full.

As an example:

Suppose Aylmer Inc has 10 employees.  Aylmer contributed 5% towards the employees defined contribution pension plan on an annual basis.  For the year ended December 31, Y6, the employees earned $750,000.  The payment does not need to be made until January 15, Y7.  Aylmer would recognize and expense and a liability of ($750,000 x 5%) = $37,500 towards the defined contribution plan.  Notes that the expense and the amount contributed (cash) are the same.

The journal entry on December 31, Y6 (to record the expense and the liability):

Pension Plan Expense                                          $37,500

Pension Liability                                                               $37,500

The journal entry on January 15, Y7 (to record the payment towards the plan):

Pension Liability                                                     $37,500

Cash                                                                                    $37,500