8. Pension Benefit Accounting

Question 1

Why are pension cost calculations very subjective?

Answer 1

Pension cost calculations are based on a lot of assumptions. For example, assumptions about:
- Salary throughout employment (rate of annual increase)
- Employee’s expected work duration before retirement
- Employee’s expected life expectancy after retirement

Question 2

Identify risks that a firm is exposed to from providing a defined benefit pension plan to its employees.

Answer 2

• Market risk: The risks arising from short-term changes in market prices of invested assets.
• Longevity risk: The risk that retired employees live longer than the firm has allowed for in its modelling of the cost of the defined benefit obligation (good for pensioners, not good for shareholders).
• Salary inflation risk: The risk that salaries increase at a faster rate than the firm has allowed for in its modelling of the defined benefit obligation.
• Investment risk: The risk that the returns on the invested assets are insufficient to meet the plan’s obligations when they fall due.

Question 3

What are the key differences between a defined benefit and a defined contribution pension plan?

Answer 3

Defined contribution plan:
- Employer contributions are expensed in the period they are made.
- Employee has no guarantee of future pension payments.
- All of the investment risk lies with the employee.

Defined benefit plan:
- Employer guarantees certain defined benefits when scheme members retire.
- Annual pension payments usually based on number of years service and final or career average salary, and are for life after retirement.
- All of the investment risk lies with the employer. Pension’s net value is an asset or liability for the company.
- Employer also faces actuarial risk ‒ the risk that benefits will cost more than expected.