8.1 Defined Benefit and Defined Contribution Plans

Defined Benefit and Defined Contribution Plans

Pension plans are how companies provide retirement income to employees, and the accounting treatment differs dramatically depending on the plan type. The distinction between defined benefit and defined contribution plans determines who bears the financial risk, how obligations appear on the balance sheet, and how pension expense flows through the income statement.

Defined Benefit vs Defined Contribution Plans

Defined Benefit Plans

A defined benefit (DB) plan promises employees a specific retirement benefit, usually calculated from years of service and salary. The employer bears the investment risk and must fund the plan to meet those promises.

• The benefit formula typically multiplies a percentage by years of service and a salary measure. For example, an employee with 30 years of service and a final salary of $100,000 might receive $0.02 \times 30 \times \$100{,}000 = \$60{,}000$ per year in retirement.
• If investment returns fall short of expectations, the employer must increase contributions to keep the plan adequately funded.
• Ongoing actuarial valuations determine whether contribution levels need adjustment, making DB plans complex and costly to administer.

Defined Contribution Plans

A defined contribution (DC) plan specifies the contributions made by the employer (and sometimes the employee), but does not promise any particular benefit at retirement. The employee bears the investment risk.

• A common example: an employer contributes 5% of an employee's salary to a 401(k) plan, and the employee may contribute additional funds through salary deferrals.
• If investment returns disappoint, the employee's account balance shrinks and their retirement income decreases accordingly.
• The employer's obligation ends once the specified contributions are made. There is no requirement to make up for poor investment performance.

Employer & Employee Roles in Pension Plans

Employer Responsibilities

In defined benefit plans, the employer takes on substantial ongoing obligations:

• Making contributions to the plan based on actuarial calculations
• Managing or overseeing investments to keep the plan adequately funded
• Bearing both investment risk (returns may fall short) and longevity risk (retirees may live longer than expected)

If retirees live longer than projected or returns underperform, the employer must contribute additional funds to cover the shortfall.

In defined contribution plans, the employer's role is more limited:

• Making the specified contributions to employee accounts on schedule
• Offering a reasonable range of investment options for employees to choose from

Once those contributions are made, the employer has no further financial obligation related to the plan's performance.

Employee Responsibilities

In defined benefit plans, employees typically do not contribute. The employer funds the plan and manages investments entirely.

In defined contribution plans, employees play an active role:

• Selecting investments from the options the employer provides
• Monitoring account balances and adjusting investment allocations over time
• Deciding whether to make additional voluntary contributions (e.g., through salary deferrals)

DC plan participants bear both investment risk and longevity risk. If investments perform poorly or the employee lives longer than expected, they may not have enough savings to sustain their desired standard of living in retirement.

Advantages and Disadvantages of Pension Plans

Advantages of Defined Benefit Plans

• Predictable retirement income. Employees know in advance what they'll receive, making retirement planning straightforward.
• No employee contributions required. The employer funds the plan, reducing out-of-pocket costs for workers during their careers.
• Stable income stream. The guaranteed benefit provides reliable income that helps protect retirees from outliving their savings.

Disadvantages of Defined Benefit Plans

• Higher and less predictable costs for employers. Ongoing contributions, investment management, and actuarial monitoring make DB plans expensive to maintain.
• Limited portability. Employees who leave before retirement age may forfeit some or all of their accrued benefits, depending on vesting schedules.
• Underfunding risk. Poor investment returns or insufficient employer contributions can leave the plan underfunded, potentially threatening employees' promised benefits.

Advantages of Defined Contribution Plans

• Portability. Employees can generally roll over their account balances when changing jobs, preserving their retirement savings.
• Flexible contributions. Employees can adjust how much they contribute based on their personal financial situation.
• Investment choice. Employees select investments matching their own risk tolerance and goals, with the potential for higher returns if they invest wisely.

Disadvantages of Defined Contribution Plans

• No guaranteed benefit. The retirement payout depends entirely on investment performance, which is subject to market fluctuations.
• Investment risk falls on the employee. Poor investment decisions or prolonged market downturns directly reduce the employee's retirement funds.
• Requires active management. Employees must monitor their accounts, rebalance allocations, and make informed decisions throughout their careers. Many employees lack the financial literacy to do this effectively.

Pension Plan Assets and Obligations

Pension Plan Assets

Plan assets represent the resources set aside to pay future benefits. They come from three sources:

• Employer contributions, determined by actuarial calculations in DB plans or by the plan formula in DC plans
• Employee contributions (when applicable), typically made through salary deferrals
• Investment returns generated by the plan's portfolio, which may include stocks, bonds, real estate, and other asset classes

These assets are typically managed by the plan sponsor (employer) or a third-party investment manager. The plan sponsor has a fiduciary responsibility to manage assets prudently and in the best interests of participants.

Pension Plan Obligations

The pension obligation represents the present value of future benefits promised to employees and retirees. Calculating this present value requires several actuarial assumptions:

• Life expectancy: How long retirees are expected to live and collect benefits
• Retirement age: When employees are expected to begin drawing benefits
• Salary growth rates: The projected annual increase in salaries, which affects the final benefit amount in DB plans
• Discount rate: Used to convert future benefit payments into a present value

For example, if an employee is promised $\$50{,}000$ per year for an estimated 20 years starting at age 65, the present value of that stream of payments depends on the assumed discount rate and the employee's projected life expectancy.

Funded Status and Pension Expense

Funded status is the difference between plan assets and the pension obligation:

• Overfunded: Plan assets exceed the obligation (reported as a net asset on the balance sheet)
• Underfunded: The obligation exceeds plan assets (reported as a net liability)
• Fully funded: Assets are sufficient to cover all projected future obligations

Pension expense is the cost the employer recognizes each period. Its main components include:

1. Service cost — the cost of benefits employees earned during the current period
2. Interest cost — interest accruing on the beginning pension obligation (obligation × discount rate)
3. Expected return on plan assets — reduces pension expense, reflecting anticipated investment earnings
4. Amortization of actuarial gains/losses — smooths the impact when actual experience differs from assumptions (e.g., employees living longer than projected, or returns deviating from expectations)

Two assumptions deserve special attention because changes to either one can significantly shift the funded status and pension expense:

• The discount rate, typically based on yields of high-quality corporate bonds, determines the present value of the obligation. A lower discount rate increases the obligation; a higher rate decreases it.
• The expected return on plan assets affects how much investment income offsets pension expense. An overly optimistic assumption understates the true cost of the plan.