Hello and welcome everyone to our lesson today. In today's lesson, we are going to introduce pensions. We will understand the basics of accounting and the details for pensions. Periodic pension costs constitute one of the largest expenses many companies report and the corporate liability for providing pension liability is just huge. The United States pension funds total more than $15 trillion. Obviously, then the financial reporting responsibility for pensions has important social and economic implications. Pension plans are designed to provide income to individuals during their retirement years. This is accomplished by setting aside funds during an employee's working years so that at retirement, the accumulated funds plus the earnings from investing those funds are available to replace the wages. Sometimes employers agree to annually contributes specific amount of pension fund on behalf of the employee but make no commitment regarding the benefits that will be paid at retirement. In other arrangements, employers don't specify the amount of the annual contributions but promised to provide specific amounts at retirement. These two arrangements describe defined contribution pension plans versus defined benefit pension plans. Let's take a look, a brief look at each one of them. Let's start with the defined contribution pension plans, which promised fixed annual contributions to a pension fund. It could be a certain amount or a certain percentage of the employees pay. Or sometimes the employer will make an amount that matches the employee's contribution. Employees choose at that time from a specific list of options where those funds are invested. Usually, it could be invested in stocks or bonds or fixed income securities, whatever each employee chooses. The retirement pay depends on the size of the fund at retirement by the investment and the earnings on those funds at retirement age. Accounting for these plants is very easy. Each year, the employer simply records the pension expense equal to the amount of the annual contribution that was made. For example, let's suppose a plan promises an annual contribution equal to 3 percent of the employee's salary. So if an employee has a salary of 110,000 in a particular year, then the employer would simply recognize pension expense in the amount of the contribution, which is $3,300 in this case. In such a case, we will debit the pension expense for the 3,300 and credit cash for the same amount for the same 3,300. That's basically what the accounting for the whole thing with defined contribution pension plans. Let's move to that defined benefit pension plans, where the promise is in terms of fixed retirement benefits defined by a designated formula. Typically, the pension formula bases retirement pay on employees years of service, the annual compensation, often final pay or average for the last few years. So whatever the employee ended up the last year before retirement, or an average for a certain number of years and also the age of the employee at retirement. Employers are responsible for ensuring that the sufficient funds that will be available to provide those promised benefits. That's why I'm saying that those are defined benefit pension plans because I'm specifying the benefits that I will pay. It's the employer's responsibility obviously to make sure that the funds will be enough for paying those pensions. Accounting for those plans is actually quite challenging because of the formula. Let's take a look, for example, of a formula when we use such a pension plan which have defined benefit plans. Here is an example of a formula that gives you 1.5 percent of the employees years of service multiplied by the final year salary. That last item could be the average of the last two years, whatever. But for that particular, it says simplified formula 1.5 times the years of service times the final year salary. By this formula, the annual benefit to an employee who retires after 30 years of service with a final salary at retirement of 100,000 would be, as you can see in front of you, 1.5 percent times that 30 years times the 100,000 will give you $45,000. When setting aside cash to fund a pension plan, the uncertainty surrounding the rate of return on plan assets is but one of several uncertainties inherent in a defined benefit pension plans. Another one, employee turnover affects the number of employees who ultimately will become eligible for retirement benefits at the end. The age at which employees will choose to retire, as well as life expectancies, will impact both the length of the retirement period and the amount of the benefits but as well we consider inflation rate, future compensation plans. Interest rates also have a lot of influence on the eventual benefits that will be paid off to the employees at retirement. Obviously, we named a lot of factors and that's why in summary, unlike accounting for defined contribution pension plans, defined benefit pension plans can be very challenging because of the numerous uncertainties that are inherent in such plans. Typically, a firm will hire an actuary. What is an actuary? An actuary is a professional trained in particular branch of statistics and mathematics to assess the various uncertainties, like what we talked about, employee turnover, future salary levels, mortality, etc. All of those factors that we talked about and to ask them at the company's obligation to employees in connection with its pension plan. That's the function of the actuary. Such estimates are inherently subjective. So regardless of the scale of the actuary, in estimates, in variably deviate from the actual outcome to one degree or another. Adding additional difficulty to accountants when they account for those defined benefit pension plans. Thank you.
