Financial Statement - Pension Plans
Under pension plans, an employee contributes a part of his/her income in a fund during his service years, to avail its benefits in future, during his/her post-retirement period. The employee's fund is then invested by the company on his/her behalf, permitting him/her to enjoy pension benefits after retirement.
In fact, pension plans are a means by which the employees transfer a part of their income as savings, to enjoy it during the post-retirement days. Pension Fund is a kind of Long Term Liability.
Categories of Pension Plans:
Pension Plans are categorized into two main types, as:
- Defined-contribution Plans: They enable an employer to make pre-settled contributions on behalf of the employee. However, the final benefit amount received by the employee is based upon the performance of the investment.
- Defined-benefit Plans: Here, the employers assure the employee that he/she will derive a definite amount of the benefit at the time of his/her retirement, irrespective of the underlying investment performance.
Elements of Pension Plans:
A pension plan is made up of two principal elements:
- The pension fund or plan assets, used for the payment of the retirement benefits.
- The future liabilities or benefit obligations, created during the service tenure of the employee concerned.
How does Pension Plans work?
At the basic level, a pension plan is simple and uncomplicated in nature. The company (known as the Plan Sponsor in this respect) makes contribution to its pension fund, which subsequently gets invested in equities, bonds and other forms of assets. Such investments are required by the company to meet its long-term obligations.
The employees of the company after their retirements receive the benefits from their individual pension funds. 3 elements contribute in complicating the accounting of these pension funds. They are as follows:
- Use of accrual accounting: Applying accrual accounting within pension fund indicates that the actual flow of cash remains uncounted annually. In fact, computation of the expenses regarding payment of annual pensions depends on the rules which try to trace the changing future suppositions.
- Benefit obligations: They involve a series of mandatory payments made to employees in their post-retirement periods. At the time of assessing the total number of retirees, the salary increases along with other factors, for discounting the future series of estimated payments into a single present value. This makes the process complicated.
- Rules guiding the pension plan: The rules guiding the pension plans and funds demand that the companies must smooth the annual fluctuations occurring on the investment returns and actuarial suppositions. This, in turn, will enable the pension fund accounts not to attain over-stated or under-stated conditions, even if their investments produce above or below-average performance in a particular year.