In this video, we walk through 5 BAR practice questions on net pension liability for defined benefit pension plans. These questions are from BAR content area 3 on the AICPA CPA exam blueprints: State and Local Governments.
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
Net Pension Liability for Defined Benefit Pension Plans
Accounting for pensions can seem intimidating because of the terminology involved, but this blueprint topic is built around a few core ideas. If you understand who reports the liability, what creates it, and how it is measured, you’ll have a solid foundation for answering most questions.
The key is to remember that a defined benefit pension plan promises employees a specific pension benefit in retirement. Since the government has made that promise, it may have a pension obligation if the assets set aside to pay those benefits are not enough.
Recognition: When Does a Government Recognize a Net Pension Liability?
A defined benefit pension plan can create a net pension liability for the employer government.
Think of it this way. A city promises to pay retirement benefits to its employees over many years. Those promised benefits represent an obligation. The city also sets aside money in a pension trust fund to help pay those benefits. If the pension obligation is larger than the resources available in the pension plan, the city has a net pension liability.
For example, suppose a county’s actuaries determine that employees have earned pension benefits with a present value of $900,000. The pension plan currently has $750,000 available to pay those benefits.
Because the obligation is greater than the resources available, the county has a net pension liability.
One point that often causes confusion is who reports the liability.
The employer government reports the net pension liability. The pension trust fund does not report the net pension liability as its own liability because the trust fund’s role is simply to hold and manage the resources that will eventually be used to pay pension benefits.
A helpful way to think about this is:
- The employer government is responsible for the pension promise.
- The pension trust fund is responsible for holding the resources that help fulfill that promise.
The trust fund reports what it has available, while the employer reports whether those resources are enough to cover the pension obligation.
Measurement: How Is the Net Pension Liability Calculated?
Once you know that the employer may have a liability, the next step is measuring it.
The formula is straightforward:
Net Pension Liability = Total Pension Liability − Fiduciary Net Position
This is one of the most important formulas for this blueprint topic.
For example:
- Total pension liability: $620,000
- Fiduciary net position: $560,000
Net pension liability:
$620,000 − $560,000 = $60,000
The employer government would report a $60,000 net pension liability.
Notice that the calculation does not involve current-year pension contributions or benefits paid during the year. Instead, it compares two broader measures:
- the government’s pension obligation, and
- the resources currently available to satisfy that obligation.
What Is Total Pension Liability?
Don’t mistakenly think total pension liability is simply the employer’s annual contribution. It is not.
The total pension liability is an actuarial measure of the pension benefits that employees have earned through their service.
Actuaries estimate this amount using several assumptions, including:
- projected future pension benefit payments,
- employee service already provided,
- expected retirement dates,
- life expectancy, and
- an appropriate discount rate to determine the present value of future benefits.
Because of this, total pension liability is not determined by looking at cash activity during the year.
For example, suppose a city contributes $50,000 to its pension plan this year.
That does not mean the city’s total pension liability is $50,000.
Instead, actuaries might determine that employees have earned pension benefits with a present value of $800,000. That actuarially determined amount is the total pension liability.
The annual contribution is simply one transaction that helps fund the plan. It does not determine the amount of the pension obligation.
What Is Fiduciary Net Position?
If total pension liability represents the obligation, fiduciary net position represents the resources available to pay that obligation.
You can think of fiduciary net position as the pension plan’s available assets after considering its obligations within the trust fund.
Several transactions increase fiduciary net position, including:
- employer contributions,
- employee contributions, and
- investment earnings.
Other transactions reduce fiduciary net position, including:
- pension benefit payments to retirees, and
- administrative expenses of the pension plan.
For example, suppose a pension plan begins the year with $300,000.
During the year:
- employer contributions are $40,000,
- investment earnings are $15,000,
- benefits paid are $25,000, and
- plan expenses are $5,000.
The ending fiduciary net position is:
$300,000 + $40,000 + $15,000 − $25,000 − $5,000 = $325,000
That ending amount is then used when calculating the employer’s net pension liability.
Putting It All Together
A simple example ties all of these concepts together.
Suppose a town sponsors a defined benefit pension plan.
At year-end:
- Total pension liability = $700,000
- Fiduciary net position = $640,000
First, compare the two amounts.
Since the total pension liability is greater than the fiduciary net position, the town has a net pension liability.
Next, calculate the difference:
$700,000 − $640,000 = $60,000
The employer government reports a $60,000 net pension liability.
Notice how each concept fits together:
- The defined benefit plan creates the potential obligation.
- The total pension liability measures the pension benefits employees have earned.
- Fiduciary net position measures the resources available to pay those benefits.
- The difference between the two amounts is the employer’s net pension liability.
