Some notes about pension accounting:
- Periodic pension cost recorded in the income statement (pension expense) = Service cost + Interest cost + Amortization of prior service cost – Expected return on plan assets – actuarial gains/(losses)
- Service cost is the present value of projected benefits earned by employees in the current accounting period, i.e. the increase in pension benefits payable to employees because of services performed during the current year. This takes into account future salary levels, turnover, early retirement, salary increases, promotion, etc..
- Interest cost is the interest on the projected benefit obligation (i.e., the increase in the amount of the projected benefit obligation due to the passage of time). The projected benefit obligation (PBO) is a liability recorded on a discounted basis. Each year, the plan’s obligation increases by the amount of interest that accrues based upon the selected discount rate.
- Amortization of prior service cost – When pension plans are adopted or amended, credit (for the new plans) is often given to employees for service performed prior to adoption or amendment. The cost of this service is called prior service cost (PSC). PSC is allocated/expensed over the remaining service lives of the covered employees. The amount of the PSC is measured by the increase in the PBO due to the adoption or amendment of the plan.
- Expected return on plan assets is the anticipated increase in the plan assets due to investment activities. It is calculated by multiplying the fair value of the plan assets at the beginning of the period by the expected long-term rate of return on plan assets.
- Actuarial gains/(losses) = asset gains/(losses) – liability gains/(losses) where
- Asset gains is when the actual returns of the plan assets exceed expected returns, and vice versa for asset losses.
- Liability gains and losses is the change in the PBO liability due to either actual PBO change that is different from what was projected earlier, or changes in the actuarial assumptions (e.g. mortality rates, future salary levels, employee turnover).
- The pension liability recorded on the balance sheet = Projected benefit obligation (PBO) – fair value of plan assets
- Projected benefit obligation (PBO) is the total amount due to employees in the pension fund for all of the past service completed up to that date. It is recorded on a present value discounted basis. The discount rate chosen is determined by market interest rates on high-quality investments or the implicit rate of return on retirement annuities.
- Note that the full amount of actuarial gains/losses may not be recognized in the period in which it occured. Unrecognized actuarial gains and losses are recognized over future periods and included in periodic pension cost (e.g. over the average remaining service lives of active employees, and over the estimated remaining lifetime of retired employees).