Pension plans generally fall into two types, a defined contribution pension plan or a defined benefit pension plan.
In a defined contribution pension plan the contributions are known (defined) and guaranteed and the benefits will vary depending on the investment performance of the plan. In a defined benefit pension plan, the benefits are known (defined) and guaranteed and the contributions will vary depending on the amount needed to fund the defined benefits.
Both employers and employees can pay into defined contribution plans. The monies paid in serve to build up a fund that can be used to provide an income on retirement, usually by means of an annuity.
Defined contribution pension plans are becoming more popular with employers due to the ever increasing cost of defined benefits plans. With defined contribution plans, the employee takes all the risk if the plan does not perform, the employers liability is limited to the fixed contributions.
Accounting for a Defined Contribution Pension Plan
In a defined contribution pension plan, the contributions are known and are recognized as an expense in the period in which they are incurred. If the business matches the timing and amount of their contributions to the obligations for each accounting period, it is not necessary for it to recognize any further liabilities.
This is in contrast to accounting for a defined benefits pension plan where the contributions are unknown and will vary depending on the performance of the pension fund, in these circumstances, the business may need to provide for the future uncertainty in funding requirements based on actuarial valuations, so the accounting treatment is much more complex.
Defined Contribution Pension Plan Bookkeeping Example
Suppose for example, a business is required to contribute 3% of all employees salaries to a defined contribution pension plan; the defined contribution is 3% of the salary. If the salaries for a month are 50,000, then the defined contribution for the month is 50,000 x 3% = 1,500.
The double entry bookkeeping journal entry to post the defined contribution pension plan expense would be as follows:
|Defined contribution pension plan expense||1,500|
The contributions are posted as an expense and will appear on the income statement of the business, reducing its net income for the year.
Providing the business pays the defined contribution of 1,500 it will have met its obligations for the accounting period and, under normal circumstances, the business has no further risk and bears no further liability in relation to the defined contribution plan.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.