Many companies offer attractive benefit packages to their employees. Some of the benefits may include pension plans. Pension plans are typically tax-exempt.
The employer makes contributions towards funds set aside for the employee’s retirement. The employee transfers part of his own income to a retirement fund which is in turn invested on his behalf.
There are two main types of pension plans: defined contribution plans and defined benefit plans.
With defined contribution plans, the employer pays specifically defined amounts each year to a third party, a trustee or insurance company, in order to purchase employee annuities. How much an employee receives depends on a variety of factors. An employer may gauge it on the employee’s wage levels, years of service with the company, the age of the employee etc. For accounting purposes, the amounts payable each year are an expense for that year. If any contributions are left unpaid at the end of the year, they are recorded as current liabilities.
With defined benefit plans, each year the employer estimates the current cost of future retirement payments. Yearly, the employer puts the estimated amount into investments. Under this plan, the employer guarantees the employee will receive a specified amount upon retirement. The amount is not dependent on the investments performance like it is with defined contribution plans.
The defined benefit plans costs and liabilities are more difficult to calculate. The gains and losses are hard to predict because they are never the same as those forecasted. If an employer provides benefits for past service with the company when a defined benefit plan is started, the cost is amortized.