## **Learning Outcomes**

This article explains how pensions and other post-employment benefits are measured, recognized, and analyzed in the context of the CFA Level 2 curriculum. It focuses on distinguishing clearly between defined contribution and defined benefit plans, linking each plan type to its specific balance sheet, income statement, and cash flow effects. It shows how to compute and interpret funded status, pension expense components, and key liability measures such as the projected benefit obligation, and how to relate these numbers to plan assets. The article also details how discount rates, salary growth assumptions, and expected returns on plan assets influence reported obligations, expenses, and equity. In addition, it examines how underfunded or overfunded plans affect leverage, profitability ratios, and prospective cash funding needs, and highlights common exam traps around contributions versus expense recognition. Finally, it provides a structured framework for evaluating disclosures on pensions and other post-employment benefits so that analysts can make consistent analytical adjustments when comparing companies across different reporting standards and funding policies.

## **CFA Level 2 Syllabus**

For the CFA Level 2 exam, you are expected to understand how pensions and other post-employment benefits affect financial statements, with a focus on the following syllabus points:

- Differentiating between defined contribution and defined benefit plans, and their respective financial statement impacts
- Evaluating the recognition, measurement, and disclosure of post-employment benefit obligations
- Calculating and interpreting a company's pension expense and its funded status
- Identifying the effects of key actuarial assumptions on pension obligations and expenses
- Assessing the analytical and valuation implications of pension plan funding and structure

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. Which pension plan type obligates the employer to guarantee future benefits: defined contribution or defined benefit?
2. True or false? The funded status of a defined benefit plan is reported as a net asset if plan assets exceed the projected benefit obligation.
3. A company increases its assumed discount rate for its pension obligation. What is the immediate effect on its reported pension liability?
4. For a defined contribution plan, when does the company recognize pension expense?

## **Introduction**

Pensions and post-employment benefits represent a major category of employee compensation. For the CFA exam, you must clearly distinguish between defined contribution and defined benefit plans and understand their differing effects on financial statements and company valuation. Accounting for post-employment benefits involves complex actuarial assumptions, opens room for managerial discretion, and can significantly alter reported profitability, gearing, and cash flows.

> **Key Term: defined contribution plan**
> A retirement plan where the employer contributes a set amount to an employee’s account. The employee assumes the investment risk, and the employer has no obligation for future benefit levels.
>
> **Key Term: defined benefit plan**
> A retirement plan where the employer promises a specified benefit to employees, typically based on salary and years of service. The company bears all investment and actuarial risks.
>
> **Key Term: funded status**
> The difference between the fair value of plan assets and the present value of the projected benefit obligation. Indicates whether a pension plan is overfunded or underfunded.
>
> **Key Term: pension expense**
> The amount recognized in the income statement relating to a company’s pension plan, typically including service cost, interest cost, expected return on plan assets, and changes in actuarial assumptions.

## **Recognizing and Measuring Pension and Other Post-employment Benefit Obligations**

### Defined Contribution Plans

For a defined contribution plan, the accounting is straightforward:

- The company records an expense equal to the cash contribution owed for the period.
- No pension liability or asset is recognized beyond any unpaid contributions at period-end.

Once the contribution is made, the company has no further obligation. Investment performance and longevity risks are borne by the employee.

### Defined Benefit Plans

Defined benefit plans are more complex. The employer promises a specific post-retirement benefit, which results in:

- Recording a pension obligation (projected benefit obligation, PBO) based on various actuarial assumptions (e.g., discount rate, future salary growth)
- Recognizing a plan asset for actual amounts set aside
- Measuring the _funded status_: plan assets minus PBO

If the plan is underfunded, a net pension liability is recognized; if overfunded, a net pension asset is recognized (subject to accounting rules).

Pension expense on the income statement includes:

- Current service cost (the present value of benefits earned during the period)
- Interest cost (on the beginning PBO)
- Expected return on plan assets (reducing expense)
- Amortizations and actuarial gains/losses (per local standards)

Other post-employment benefits (e.g., retiree health care) are typically treated similarly to defined benefit plans for accounting purposes.

> **Key Term: projected benefit obligation (PBO)**
> The present value of all pension benefits earned by employees to date, including estimated future salary increases.
>
> **Key Term: plan assets**
> The fair value of assets held in a separate trust, dedicated to meeting future pension obligations.

### **Worked Example 1.1**

A company sponsors a defined benefit pension plan. At year-end, the PBO is \$100 million and plan assets are \$80 million. What is the reported funded status, and how is it presented?

> **Answer:**
> Funded status = Plan assets (\$80m) – PBO (\$100m) = –\$20 million.
>
> The company reports a net pension liability of \$20 million on its balance sheet.

### **Key Assumptions: Impact and Discretion**

A company’s reported pension obligations and expenses are highly sensitive to several key actuarial assumptions, including:

- Discount rate: Higher rates reduce present value of obligations, lowering liabilities and expense.
- Future salary growth: Higher assumed growth increases the PBO.
- Expected return on plan assets (under some GAAP): Higher assumed return reduces pension expense, but does not change actual cash funding.

Companies may use optimistic (or conservative) assumptions to manage reported results.

> **Key Term: service cost**
> The present value of pension benefits earned by employees in the current period.
>
> **Key Term: interest cost**
> The increase in projected benefit obligation due to the passage of time.
>
> **Key Term: actuarial gain/loss**
> The effect of changes in assumptions or differences between actual and expected outcomes for plan assets or obligations.

### **Worked Example 1.2**

ABC Corp’s PBO at the start of the year was \$5 million. The discount rate is 4%. What is the interest cost included in pension expense for the year?

> **Answer:**
> Interest cost = PBO at start of year × discount rate = \$5,000,000 × 4% = \$200,000.

### **Exam Warning**

> Many candidates mistakenly assume companies recognize only the current period’s contribution as pension expense, even for defined benefit plans. Remember: defined benefit plans require recognition of a liability for the entire obligation, reflecting many actuarial assumptions, not just the current contribution.

## **Valuation and Analytical Issues for Pension and Post-employment Benefit Plans**

### Analytical Impacts

Pension accounting can significantly affect analysis of a company’s financial strength and valuation. Key points include:

- Underfunded plans increase gearing and reduce equity
- Aggressive assumptions can inflate profit and understate liabilities
- Large changes in assumptions can create income statement volatility
- Poor funding may indicate future cash outflows or restructuring needs

When comparing companies, analysts should adjust for differences in assumption quality, plan status, and funding policy.

> **Key Term: other post-employment benefits**
> Non-pension benefits provided to former employees, such as health care, which are usually accounted for similarly to pensions under GAAP and IFRS.

## **Summary**

Pensions and other post-employment benefits can have a material effect on reported profits, liabilities, and equity. Defined contribution plans are accounted for as period expenses, while defined benefit plans require complex measurements based on actuarial assumptions. Analysts should pay close attention to the quality of these assumptions, the plan’s funding status, and disclosures impacting company valuation.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Distinguish between defined contribution and defined benefit pension plans
- Calculate funded status and understand its presentation
- Identify how pension expense is measured and which assumptions affect it
- Recognize the effects of key assumptions on liabilities, expense, and financial analysis
- Assess the impact of underfunded pensions on gearing and company risk

## **Key Terms and Concepts**

- defined contribution plan
- defined benefit plan
- funded status
- pension expense
- projected benefit obligation (PBO)
- plan assets
- service cost
- interest cost
- actuarial gain/loss
- other post-employment benefits

Employee compensation and income taxes - Pensions and other post-employment benefits