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1.5 Pension plans
Publication date: 31 Oct 2023
us Pensions guide
A pension plan is a retirement benefit plan that specifies a pension benefit based on the plan’s formula—typically some combination of salary and years of service. In the US, a pension plan must comply with ERISA. ERISA (1) requires plans to provide participants with plan information, including information about plan features and funding; (2) sets minimum standards for participation, vesting, benefit accrual, and funding; (3) provides fiduciary responsibilities for those who manage and control plan assets; (4) requires plans to establish a grievance and appeals process for participants to get benefits from their plans; (5) gives participants the right to sue for benefits and breaches of fiduciary duty; and (6) guarantees payment of certain benefits through a federally chartered corporation if a defined benefit plan is terminated.
In addition, many plans are tax-qualified defined benefit plans. To be tax-qualified, the employer must pre-fund benefits in a segregated and restricted trust so that the plan meets minimum funding requirements. The pool of funds is typically invested in a variety of assets at the discretion of the plan’s trustees who have a fiduciary obligation to the beneficiaries—the employees or eventual retirees—to steward the fund in order to provide sufficient assets to fund the benefits upon retirement.
In addition to an employer's contributions, some pension plans may allow a worker to contribute part of their current income from wages into the pension fund to provide enhanced benefits, or merely to share the cost of funding the defined plan benefits.
The basic cost recognition premise in ASC 715 is that the cost of benefits provided by these plans should be recognized systematically over the active service period of the employee. A distinguishing characteristic of defined benefit pension plan accounting is that the “cost of benefits” includes not only the actuarial present value of the future benefit payments but also the interest on the obligation reduced by the return on the invested plan assets. Put simply, the entire plan constitutes the unit of account, which also impacts the income statement (components of pension cost) and balance sheet (plan assets and obligations) presentation. Another key feature of defined benefit pension plan accounting is the concept of delayed recognition of certain changes in estimates, namely differences in actuarial experience or investment returns. Thus, another component of pension cost is the subsequent amortization of these initially deferred gains and losses. The components of pension costs and assets and obligations are illustrated in Figure PEB 1-1, and are described in PEB 2, PEB 3, and PEB 4.
Figure PEB 1-1
Components of pension plan reporting
Components of pension plan reporting
Component |
Balance sheet |
Comprehensive income |
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Plan assets |
Benefit obligation |
Net income |
Other comprehensive income |
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Service cost
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Interest cost
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Expected return on plan assets
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Employer contributions
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Benefit payments
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Plan amendments
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Amortization of prior service cost
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Gains/losses
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Amortization of gains/losses
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Curtailments
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Settlements
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Acquisitions/disposals
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1.5.1 Qualified and nonqualified plans
Qualified plans meet Internal Revenue Code Section 401(a) and ERISA requirements. That gives the plans a tax-advantaged status, meaning both employers and employees receive a tax deduction on the contributions they make to the plan. Funds placed in a qualified retirement account then grow on a tax-deferred basis such that no tax is due on the earnings as long as they remain in the account. Upon retirement, when the employee begins to receive funds from the plan, the employee will generally be subject to personal income taxes on the benefits paid by the plan.
To be a tax-qualified plan, a plan sponsor must ensure the plan meets several guidelines regarding participation, vesting, benefit accrual, funding, and availability of plan information. Specific requirements for tax-qualification include:
- Disclosure and reporting – Retirement plans must comply with the reporting requirements of the US Department of Labor and IRS. Participants must receive periodic statements of their account balance/benefits.
- Coverage – A specified portion of employees, but not necessarily all, must be covered.
- Participation – Employees who meet eligibility requirements must be permitted to participate.
- Vesting – After a specified duration of employment, a participant's rights to pension benefits are non-forfeitable.
- Nondiscrimination – Benefits must be proportionately equal in assignment to all participants to prevent excessive weighting in favor of higher paid employees.
- Funding – Plans must comply with certain minimum funding requirements.
Nonqualified plans are those that do not meet the tax requirements. As a result, these plans do not qualify for the favorable tax treatment that is afforded qualified plans. Specifically, contributions to a nonqualified plan are not deductible by the employer until the employee receives the benefits provided by the plan and is taxed on the income. As such, nonqualified plans are most commonly offered only to key executives or other select employees or groups of employees.
1.5.2 Supplemental plans
In order to maximize the available tax benefits and also maintain an attractive benefits package for more senior executives, some entities have two defined benefit pension plans covering the same employees—a qualified pension plan and a nonqualified pension plan that pays benefits in excess of the maximum allowed for the qualified pension plan by Section 415 of the Internal Revenue Code. Even though the employees covered by the nonqualified plan overlap with the employees covered by the qualified plan, each plan is its own unit of account under ASC 715. The accounting for the plans may not be combined.
1.5.2.1 Supplemental executive retirement plans
A supplemental executive retirement plan (SERP) is a nonqualified retirement plan for key employees, typically executives, that provides benefits above and beyond those provided by other retirement plans. These plans are typically offered selectively to highly compensated executives whose qualified plan contributions are limited by contribution rules. The reporting entity and the respective executive enters into a formal agreement that promises the executive a certain amount of supplemental retirement income based on vesting and other eligibility conditions the executive must meet. The plan may be funded out of current cash flows, investments held by the reporting entity or through a trust, or through reporting entity funding of a life insurance policy with a cash surrender value, and the deferred benefits are not currently taxable to the executive. However, the income received upon retirement will be taxed as ordinary income.
1.5.3 Nonqualifying excess 401(k) plans and other similar plans
A nonqualifying 401(k) plan provides employees with an opportunity to save beyond the limits of the entity's qualified 401(k) plan. Under such a plan, the employee contribution generally goes into the general assets of the entity (i.e., essentially deferred compensation) and a "phantom account" is established. However, this type of plan would not meet the definition of a defined contribution plan because it does not have individual accounts for participants. In this case, because the benefit is essentially an unfunded defined benefit plan (i.e., a promise to the employee to pay them the value of their “phantom account” in the future) and not a collection of individual deferred compensation contracts, we believe application of the defined benefit plan accounting model would be appropriate. However, consistent with the underlying nature of the obligation, and by analogy to the guidance in ASC 715-30-35-40 through ASC 715-30-35-41 for plans in which the vested benefit obligation at the measurement date may exceed the actuarial present value of the benefits, marking-to-market the account balance would also be acceptable. A full actuarial valuation would be required if regular defined benefit plan accounting is followed.
If a reporting entity follows the "mark-to-market approach," we believe there are two acceptable interpretations to account for the excess 401(k) plan liability. This interpretation should be considered as a policy election to be followed consistently:
- The excess 401(k) plan liability is subject to ASC 820, Fair Value Measurement.
- The excess 401(k) plan liability is not subject to ASC 820. The mark-to-market approach is acceptable based on analogy to ASC 715-30-35-40 and ASC 715-30-35-41. Under that guidance, an employer may account for the types of benefit obligations described in ASC 715-30-35-40 by using the "actuarial present value of vested benefits to which the employee is entitled if the employee separates immediately." Technically, even though this is a current “walk-away value,” it is not fair value.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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