Pension expense is the amount that a company reports on its income statement related to its obligations to provide future retirement benefits to its employees. It’s a measure of the cost incurred by the company during a period to fund the pension plan or due to changes in the pension plan’s obligation.
The calculation of pension expense can be complex and often includes several components:
- Service Cost: This is the present value of the pension benefits earned by employees during the current period. It’s typically a function of the employees’ salary levels, years of service, and the terms of the pension plan.
- Interest Cost: This is the increase in the pension obligation due to the passage of time. It’s calculated as the product of the discount rate and the beginning balance of the pension obligation.
- Plan Assets Return: The pension plan assets are typically invested to generate returns and help fund the future pension payments. The actual return on plan assets can be a gain (reducing pension expense) or a loss (increasing pension expense).
- Amortization of Prior Service Cost: If the terms of the pension plan change (for example, if the company improves the pension benefits), the change in the obligation due to past service is usually amortized over the remaining service period of the affected employees.
- Actuarial Gains or Losses: These are adjustments due to changes in actuarial assumptions or differences between the actuarial assumptions and the actual outcome. These can be related to factors like life expectancy, salary increases, and the discount rate.
In general, pension expense is a significant cost for companies that offer defined benefit pension plans, and it can have a material impact on the company’s financial statements. The calculation and reporting of pension expense are subject to specific accounting standards and regulations.
Please note that different countries may have different rules and standards for calculating and reporting pension expense. For instance, in the United States, the rules are set by the Financial Accounting Standards Board (FASB), while in many other countries, the International Financial Reporting Standards (IFRS) are used.
Example of Pension Expense
Assume that a company has a defined benefit pension plan for its employees. Here are some details:
- The Service Cost for the year (the present value of the new benefits earned by employees during the year) is $100,000.
- The Interest Cost for the year (the interest on the liability due to the passage of time) is $50,000. This is calculated based on the beginning balance of the pension liability and the discount rate.
- The Actual Return on Plan Assets for the year (the income from the investments in the pension fund) is $40,000.
- The Amortization of Prior Service Cost for the year (the cost of providing retroactive benefits due to changes in the pension plan) is $10,000.
- There are no Actuarial Gains or Losses in this year.
The pension expense for the year would be calculated as follows:
Pension Expense = Service Cost + Interest Cost – Actual Return on Plan Assets + Amortization of Prior Service Cost
Pension Expense = $100,000 + $50,000 – $40,000 + $10,000 = $120,000
So, in this example, the company would report a pension expense of $120,000 on its income statement for the year.
Remember, this is a simplified example. In practice, the calculation of pension expense can be more complex and would need to consider additional factors and adjustments.