Definition: A pension plan is a retirement plan where the employer is contractually obligated to provide benefits for its employees when they retire. True pension plans are less popular today than they were 40 years ago because of the overwhelming costs to fund them.
What Does Pension Plan Mean?
Still, there are many different types of pension plans, but the most common are completely funded by the employer. This means the employee just has to maintain his employment and the employer funds the retirement plan for the employee. Since this type of plan is extremely costly to the employer, many companies have moved to a jointly funded plan where the employees have to contribute a small percentage of the payments.
Employers can expense these payments when they are made by debiting the pension expense account and crediting the cash account. These payments are made to the plan administrator who takes the money and invests it in pension assets to pay out to the retired employees or pension recipients.
Example
One of the most popular pension plan types is the defined pension benefit plan. The plans set the benefits the employees with receive when they retire. It’s up to the company to fund the plan to make sure the benefit obligation can be met.
In order to do this, actuaries estimate how many people will retire at future dates and how much the benefits will cost. The company must accumulate enough plan assets to cover the future obligations. If it can’t, it must record a liability on the financial statements for the amount the pension plan is underfunded. Otherwise, no liability is recorded.
The idea behind this reporting process is that the company doesn’t actually owe the money until the employees retire, so a liability shouldn’t be recorded. Plus, the plan assets should be enough to cover the cash outlays. If the plan assets aren’t enough, a liability is recorded. The opposite is true if the plan is overfunded.
