What are Defined Contribution Plans?
Pensions and OPEBs (other post-employment benefits) are arrangements between employers and employees which aim to provide benefits to retired employees as a reward for their service during their working career. There are many types of pension schemes, but all fall into two categories: defined contribution and defined benefit.
In a defined contribution scheme, the contributions paid into the pension scheme by the employer are pre-determined, often as a percentage of salary. These are by far the most common plans offered by a sponsoring employer to its employees.
Key Learning Points
- The costs of a defined contribution plan are expensed in the income statement as they are incurred, and the investment risk is borne by the plan participant
- A defined contribution scheme includes guaranteed contributions into a pension scheme. The set amount is typically a percentage of the employee’s salary
- The pension received by the employee depends on the investment performance of the pension fund. The employee bears the investment risk
- In terms of the accounting treatment, the only liability facing the company is the annual contributions into the pension scheme. The contribution expense is treated as an operating expense
- In contrast to a defined contribution plan, in a defined benefit plan, the amount of the eventual pension amount is set by the sponsoring employer. The employer takes on the investment risk
Features of Defined Contribution Plans
A defined contribution involves set contributions into a pension plan. The set amount is typically a percentage of the employee’s salary (5%, for example). The contributions pre-determined and fixed, meaning both the employer and employee know exactly how much will be paid in each year. With this plan, the contributions will be paid by the company into a separate entity. At retirement, the employee may choose to receive this sum as a fixed annuity each year. The total amount of the pension at retirement is unknown because as contributions are invested, the value of the pension could increase or decrease up until retirement.
The pension received by the employee depends on the investment performance of the pension fund. The employee bears the investment risk since the plan sponsor does not guarantee the amount ultimately paid out as a pension. If the plan’s assets are invested wisely, the employee will benefit from higher pension payments, and vice versa.
The accounting is very straightforward for this type of plan. The only liability facing the company is the set contributions into the pension scheme. As the contribution expense is related to employee compensation, it will be treated as an operating expense and thus deducted in calculating net income in the income statement. The expense is very similar to the accounting treatment of salaries.
Defined Contribution Vs. Defined Benefit Plans
In contrast to a defined contribution plans, for a defined benefit plan, the pension payment to the employee during retirement is set by the sponsoring employer. Typically, the benefit is calculated as a percentage of an employee’s final salary and the number of years they have worked for the company. By setting the eventual post-employment benefit, the employer takes on the investment risk. A pension fund is established to invest the contributions of the employer and, potentially, the employees as well. If there are not enough assets within the pension fund to enable the pension payments during retirement, the company will need to fund the difference. Defined benefit plans are less common, and many employers are reducing the existing provisions of these plans.
Example: Defined Contribution Plans
Amarallo, Inc. operates a 401K plan, which matches employee contributions up to 7% of salary. Here is some information on the salaries and personal contributions of two employees. The contribution to be made by Amarallo, Inc. to the pension plan on behalf of the employees is shown below.
The employer’s contribution will be the minimum of the two values: 1) 7% of the employee’s annual salary, and 2) The employee’s personal contribution. Using the “minimum” function in Excel, we calculate the employer’s contributions as follows:
The employer is required to contribute 9,993.6 to the pension plan for both employees. Edwina’s personal contribution is matched by Amarallo since they are less than 7% of her salary, but Amarallo’s contributions for Brenda are capped at 7% of her salary since her personal contributions were high than that. Since this is a defined contribution plan, there are no guarantees about the eventual pension, and therefore, there is no obligation. The pension received by the employee will depend on the investment performance of the pension plan.