The Basics of
Pension Plans Regulated by ERISA
Pensions Liabilities and FundingHow is a defined benefit pension plan
accounted for in company financial statements?
How is a defined benefit pension plan
funded?
What is the PBGC?
Why do employee pension plans receive deferred tax
treatment?
Q: How is a defined
benefit pension plan accounted for in company financial
statements?
A: The Financial Accounting Standards
Board (FASB) Statements 87 and 88, issued in 1985, set forth the
generally accepted accounting principals for pension plan financial
reporting. The FASB statements define the measures used in plan
sponsors' financial statements to express the cost of their defined
benefit plans and the degree to which the plans are
funded. Within the standards set forth in the FASB
statements, plan sponsors set the discount rate, long term rate of
return on assets, and rate of salary increase used to calculate
these costs. The net periodic pension cost is the amount
recognized in an employer's financial statements as the cost of the
pension plan for a period (such as a year). This cost consists of
service cost, interest cost, expected return on plan assets,
amortization of gain or loss, amortization of unrecognized prior
service cost and amortization of the unrecognized net obligation or
asset existing at the date of initial application of FAS 87.
The Accumulated Benefit Obligation, or ABO, approximates
the plan's present liability. The projected benefit obligation
(PBO) adds to the ABO future increases in compensation. The ratios
of ABO and of PBO to the market value of assets are measures of the
funded status of a company's plans. The net impact of
overfunding (asset) or underfunding (liability) is reported on the
company's balance sheet; the total market value of assets is
reported in the pension footnote to the financial
statements.
The accounting cost of the plan calculated according to FASB
Standards generally differs from the funding requirement calculated
using IRS provisions for cash funding, described below.
Q: How is a defined
benefit pension plan funded?
A: ERISA and the Internal Revenue Code
set forth minimum and maximum funding standards for defined benefit
plans to help assure that sufficient money will be available in
each pension fund to pay benefits to plan participants when they
retire. For private trusteed plans, the plan sponsor obtains
an annual actuarial valuation of the plan, which determines whether
IRS standards require a cash contribution. The level of
minimum required contributions and maximum tax deductible
contributions are a function of the funded status of the
plan. Based on the actuary's findings, the employer makes
periodic cash contributions to a trustee, typically a bank or trust
company, which are then invested in accordance with a trust
agreement.
For private insured plans, the employer pays premiums to an
insurance company, which agrees to provide specific benefits to
plan participants when they retire.
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Q: What is the
PBGC?
A: ERISA established the Pension Benefit
Guaranty Corporation (PBGC) to protect certain pension benefits in
the event an uninsured defined benefit pension plan is not
sufficiently funded to pay the benefits that are or will be
due.
The PBGC's financial responsibilities are met through the
payment of premiums assessed against the employers who provide
uninsured defined benefit plans. Premiums paid to the PBGC
during 1999 were $902 million; PBGC payments to retirees or
their beneficiaries in 1999 totaled $901 million.
Q: Why do employee
pension plans receive deferred tax treatment?
A: Congress grants income tax advantages
to pension funds in order to encourage savings and to provide
security for retirement.
Subject to ERISA and Internal Revenue Code requirements and
limitations, employers' contributions to qualified pension plans,
and participants' contributions in some types of plans, are
deductible from current income for the purpose of computing taxable
income. For the plans themselves, most investment earnings
are not subject to current income tax.
However, for pension plans which qualify for this favorable tax
treatment, plan participants and their beneficiaries must
include all payments from qualified pension plans in their taxable
income at the time they receive the payments. CIEBA estimates
that among its members, the reduction in federal tax revenues
resulting from deferral of contributions is offset by taxes paid by
individuals on their distributions. The tax on the
contributions and earnings has therefore been deferred to the
future rather than eliminated. This policy of deferring taxes
on savings for retirement has contributed to the growth of a
retirement savings pool estimated at $12.3 trillion as of the end
of 1999. In addition to securing benefits and protecting the
PBGC from ruinous claims in the event of a major recession or the
decline of an industry, the pension system (including both private
and public sector retirement plans) provides the single largest
source of institutionalized savings in the United States and
represents a growing and dependable source of capital for
investment in the economy.
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