Pension Expense

Pension expense is the cost an employer recognizes in its income statement for the retirement benefits its employees earn during a period. How it is measured depends on the type of plan. For a defined contribution pension plan, such as a 401(k) with an employer match, the expense is simply the amount the employer is required to contribute for the period. For a defined benefit pension plan, which promises employees a specified retirement income, the expense is calculated by actuaries from several components and may differ sharply from the cash the employer actually pays into the plan.

In the United States, pension accounting is covered by ASC 715, issued by the FASB; under IFRS it is covered by IAS 19. Pension expense can be a large figure for older industrial companies, airlines, utilities and governments, which often have substantial defined benefit obligations.

• Service cost: the present value of benefits earned by employees for their work during the period.
• Interest cost: the increase in the projected benefit obligation (PBO) because the payment date is one year closer, calculated as the obligation times the discount rate.
• Expected return on plan assets: a reduction in expense based on the long-term rate of return the employer expects the plan's investments to earn.
• Amortization of prior service cost: the cost of plan amendments that granted extra benefits for past service, spread over future years.
• Amortization of net actuarial gains and losses: when cumulative gains or losses exceed a corridor of 10 percent of the larger of the PBO or plan assets, the excess is amortized into expense.

Since ASU 2017-07, only service cost is presented with other employee compensation in operating income; the other components are reported outside operating income.

A company's defined benefit plan has a projected benefit obligation of $100,000,000 at the start of the year and plan assets of $90,000,000. The discount rate is 5 percent and the expected return on assets is 6.5 percent. Actuaries calculate service cost of $4,000,000. Prior service cost amortization is $300,000 and loss amortization is $200,000. Pension expense is:

Here $SC$ is service cost, $IC$ is interest cost, $ER$ is the expected return on plan assets, $PSC$ is amortization of prior service cost and $AL$ is amortization of net actuarial loss. Interest cost is $100,000,000 times 5 percent, or $5,000,000, and expected return is $90,000,000 times 6.5 percent, or $5,850,000. Pension expense is $4,000,000 plus $5,000,000 minus $5,850,000 plus $300,000 plus $200,000, which is $3,650,000. If the company contributes $5,000,000 in cash, the net pension liability falls, because cash paid exceeds the expense.

The funded status of a defined benefit plan, plan assets minus the obligation, appears on the balance sheet as an asset or liability. In the example, the plan is $10,000,000 underfunded at the start of the year. Actual gains and losses on assets and changes in actuarial assumptions are first recorded in other comprehensive income and held in accumulated other comprehensive income, then amortized into expense under US GAAP. IAS 19 takes a different approach: pension cost in profit or loss is service cost plus net interest on the net liability or asset, using the same discount rate for both obligation and assets, and remeasurements stay in other comprehensive income permanently.

Pension expense depends heavily on assumptions about discount rates, salary growth, life expectancy and expected returns. A higher assumed return lowers expense, which is why regulators and analysts scrutinize these rates. Falling interest rates in the 2010s raised obligations and pushed many companies to close their defined benefit plans and move to defined contribution plans, where the employer's cost is predictable and the investment risk rests with employees. Analysts often adjust reported earnings to strip out the nonoperating pension components and treat any underfunding as a form of debt, since the shortfall must eventually be met in cash by the sponsor of the pension fund.