Components of a company’s pension liability

A company’s defined-benefit pension plans have three basic components:

Setting aside unamortized actuarial gains and losses, when plan assets are less than the accrued benefit obligation, a net pension liability is recorded on the statement of financial position. A net pension liability is the estimate of the amount needed to pay for pension benefits that have been earned by current and past employees, less the pool of assets set aside in a separate legal entity to eventually pay for the benefits.

A net pension asset arises when plan assets are greater than the accrued benefit obligation. This comes about when total contributions to the plan, plus investment returns, are greater than the pension expense recognized since the start of the plan.

The following sections discuss the components that make up a pension liability reported in IFRS financial statements.

Accrued Benefit Obligation

The accrued benefit obligation of a pension plan is measured as the estimated present value of all of the payments to be made to members when they retire, based on the service they have already rendered over their working lives under the plan and members already retired, through certain actuarial models based on each individual’s life expectancy.

The accrued benefit obligation of a pension plan changes each reporting period is disclosed as follows:

Accrued benefit obligation

31/12×1

31/12×0

Opening balanceob obob ob
Increase for current employee service (in short ‘Service costs’)

++++

++++

Benefit payments to retired plan members

– – – –

– – – –

Actuarial gains and losses

+ – + –

+ – + –

Closing balance= = = == = = =

Fair Value of Plan Assets

Plan assets are the amounts contributed by the plan sponsor (the company) and the plan members (employees) to the pension fund. The pension plan entity invests contributions in accordance with the plan’s investment policies, with the aim of earning returns. However, they can also incur losses, for example, in market downturns.

The pension plan assets change each period is disclosed as follows:

Plan assets

31/12×1

31/12×0

Opening balanceob obob ob
Expected interest income on plan assets

++++

++++

Excess (shortfall) of actual returns on plan assets over (under) expected interest income

+ – + –

+ – + –

Contributions received from all sponsor(s)

++++

++++

Benefit payments to retired plan members

– – – –

– – – –

Closing balance= = = == = = =

Unamortized Actuarial Gains and Losses

A pension plan has actuarial gains (and losses) each year resulting from actuarial assumptions that have changed, and actual events during the year that do not exactly match previous long-term assumptions (referred to as “experience gains and losses”). Actuarial gains and losses are generated by both plan assets and the accrued benefit obligation separately.

Actuarial assumptions are updated for new information about the economic environment—the discount rate, for example, or plan-member demographics. These updates can create actuarial gains and losses from the benefit obligation or the plan assets, depending on how the changes affect actuarial calculations.

Experience gains or losses on plan assets occur because the actual investment returns were higher or lower than the expected returns. Experience gains or losses on the accrued benefit obligation occur because long-term assumptions—the discount rate, for example, or salary increases—were not met. In other words, despite best estimates, experience can render assumptions incorrect.

Actuarial gains and losses impact the net value of the pension liability measured by an actuary each period. For accounting purposes, all actuarial gains and losses are accumulated in an account called “unamortized actuarial gains/losses.” Unamortized actuarial gains/losses are deferred through an accounting adjustment that removes them from the pension liability or asset balance. Because most changes in the pension liability flow through pension expense, the purpose of this adjustment is to “smooth” the sponsor’s annual pension expense to account for year-over-year fluctuations between the sponsor’s expectations and actual results. Without this adjustment, annual pension expense could vary significantly year over year, creating fluctuations in a sponsor’s annual accounting deficit or surplus.

Read more: Determining annual pension expense

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