What are the key accounting differences between defined contribution and defined benefit pension plans?
I'm studying employee benefits for CFA Level I and I understand the basic concept — DC plans have fixed contributions while DB plans promise fixed payouts. But I'm unclear on how the accounting differs. For a DC plan, is the pension expense simply equal to the employer contribution? And for DB plans, why is the accounting so much more complex? A side-by-side comparison would help.
The accounting complexity differs dramatically between these two plan types because of where the investment risk sits.
Defined Contribution (DC) Plan:
The employer contributes a fixed amount (or percentage of salary) each period. The employee bears all investment risk — if the fund underperforms, the employee gets a smaller retirement benefit.
Accounting is simple:
Pension expense = Employer contribution for the period. Full stop.
Example: Oakdale Technologies contributes 5% of each employee's salary to a 401(k) plan. Total eligible salaries in 2025 = $8,000,000.
Pension expense = $8,000,000 x 5% = $400,000
| Account | Debit | Credit |
|---|---|---|
| Pension Expense | $400,000 | |
| Cash (or Pension Payable) | $400,000 |
No asset or liability appears on Oakdale's balance sheet (assuming contributions are paid on time). There is no obligation to pay any specific benefit amount in the future.
Defined Benefit (DB) Plan:
The employer promises a specific pension benefit at retirement (e.g., 1.5% x years of service x final salary). The employer bears the investment risk — if plan assets underperform, the employer must make up the shortfall.
Accounting is complex because you must estimate:
- Projected Benefit Obligation (PBO) — the present value of all future benefits earned to date, using actuarial assumptions about salary growth, mortality, discount rates, and turnover.
- Plan assets at fair value — the investments held in the pension trust.
- Funded status = Plan assets - PBO (reported on the balance sheet as a net asset or net liability).
DB Pension Expense Components (simplified for Level I):
| Component | Effect on Expense |
|---|---|
| Current service cost | Increases expense |
| Interest cost (discount rate x PBO) | Increases expense |
| Expected return on plan assets | Decreases expense |
| Amortization of actuarial gains/losses | Increases or decreases |
| Past service cost amortization | Increases expense |
Key balance sheet difference:
- DC plan: No pension-related asset or liability (assuming current on contributions)
- DB plan: Net pension liability (if PBO > plan assets) or net pension asset (if plan assets > PBO)
Why this matters for analysts:
DB plans create significant off-balance-sheet-like risk. Changes in discount rates, asset returns, and demographics can cause large swings in the funded status. Analysts must examine footnotes to assess the true economic obligation.
Exam tip: CFA Level I focuses on understanding the conceptual differences and basic components. CFA Level II dives much deeper into the income statement vs. OCI split for DB plans.
For more on employee benefits accounting, check our CFA Level I FRA course.
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