Pension Plan Types

Why This Matters

Pension accounting represents one of the most complex areas you'll encounter in intermediate accounting, and it all starts with understanding the fundamental differences between plan types. The way a company structures its pension plan determines everything from how obligations appear on the balance sheet to how pension expense flows through the income statement. You're being tested on your ability to distinguish who bears the investment risk, how that risk allocation affects financial reporting, and why certain plans require actuarial assumptions while others don't.

The core concepts here—risk allocation, measurement of obligations, expense recognition, and funding requirements—show up repeatedly in both multiple-choice questions and computational problems. Don't just memorize that a 401(k) is a defined contribution plan; understand why the employer's accounting is simpler (hint: no projected benefit obligation to estimate). When you can connect plan structure to its accounting treatment, you'll navigate even the trickiest exam scenarios with confidence.

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Plans Where the Employer Bears Investment Risk

These plans create the most complex accounting challenges because the employer promises a specific future benefit regardless of how investments perform. This means companies must estimate obligations using actuarial assumptions about discount rates, mortality, salary growth, and turnover—and any changes in those assumptions hit the financial statements.

Defined Benefit Plans

• Employer guarantees a specific retirement benefit—typically calculated as a formula incorporating years of service, final average salary, and an accrual rate (e.g., 1.5% × years × final salary)
• Projected Benefit Obligation (PBO) represents the actuarial present value of all benefits earned to date, assuming future salary increases—this is the liability measure used under U.S. GAAP
• Pension expense includes multiple components—service cost, interest cost, expected return on plan assets, and amortization of prior service cost and actuarial gains/losses

Cash Balance Plans

• Legally a defined benefit plan despite appearing like a defined contribution plan—the employer still bears investment risk and must fund any shortfall
• Hypothetical account balance grows through annual pay credits (percentage of salary) plus interest credits at a stated rate, making benefits easier for employees to understand
• Portability advantage comes from the lump-sum format—employees can roll balances into IRAs, but the accounting treatment follows full defined benefit rules including PBO calculations

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Plans Where the Employee Bears Investment Risk

These plans dramatically simplify employer accounting because the company's obligation ends once contributions are made. There's no need to estimate future benefits, calculate projected obligations, or recognize actuarial gains and losses—the employee assumes all investment performance risk.

Defined Contribution Plans

• Employer expense equals contributions made—no complex pension liability appears on the balance sheet, and expense recognition is straightforward
• Common structures include 401(k), 403(b), and profit-sharing plans—employees typically direct their own investments and bear the consequences of market fluctuations
• Vesting schedules determine when employer contributions become the employee's property—cliff vesting (all at once) or graded vesting (incrementally over time)

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Hybrid Structures

Hybrid plans attempt to balance employer cost predictability with employee benefit security. From an accounting perspective, classification depends on which party ultimately bears the investment risk—the label matters less than the economic substance.

Hybrid Plans

• Combine defined benefit and defined contribution features—may guarantee a minimum benefit floor while allowing upside from investment returns
• Pension equity plans credit employees with a percentage of final pay at retirement rather than building hypothetical balances annually—still classified as defined benefit for accounting purposes
• Accounting treatment follows the dominant characteristic—if the employer guarantees any benefit level, full defined benefit accounting typically applies

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Multi-Employer and Alternative Arrangements

These structures introduce additional complexity through shared obligations or regulatory flexibility. Understanding their unique characteristics helps you recognize when standard pension accounting rules apply—and when they don't.

Multi-Employer Plans

• Multiple unrelated employers contribute to a single plan—common in unionized industries like construction, trucking, and entertainment where workers move between employers
• Accounting typically follows defined contribution treatment even if the underlying plan is defined benefit—employers recognize contributions as expense because individual employer obligations are difficult to isolate
• Withdrawal liability creates significant risk—if an employer exits the plan, they may owe a proportionate share of any underfunding, which must be recognized as a liability

Non-Qualified Deferred Compensation Plans

• Not subject to ERISA funding and vesting requirements—allows flexibility in plan design but means benefits represent unsecured promises backed only by employer creditworthiness
• Rabbi trusts are commonly used to informally fund these obligations—assets remain subject to employer creditors, so the liability stays on the employer's books
• Accounting requires liability recognition as compensation is earned—the obligation grows over the deferral period and is reduced as payments are made

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Quick Reference Table

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Self-Check Questions

1. A company sponsors a plan where employees receive retirement benefits equal to 2% of final average salary multiplied by years of service. The employer guarantees this amount regardless of investment returns. What type of plan is this, and which party bears the investment risk?

2. Compare and contrast the balance sheet presentation for a defined benefit plan versus a defined contribution plan. Why does one create a net pension liability (or asset) while the other does not?

3. An employer participates in a multi-employer pension plan and is considering withdrawal. What potential liability should the company evaluate, and when would it be recognized?

4. Both cash balance plans and 401(k) plans show employees an "account balance." Why is the accounting treatment fundamentally different for employers sponsoring these two plan types?

5. A non-qualified deferred compensation plan allows executives to defer salary until retirement. Why can't the employer use a trust to remove this obligation from its balance sheet, and what type of trust is commonly used for these arrangements?