Trustner AcademyTrustner AcademyCourses
Reading 2CFA L2 FSAFull chapter

Pension accounting — defined benefit obligations

In this chapter: Defined benefit vs defined contribution · Projected benefit obligation (PBO) · Funded status · Pension expense components

~3 min readLayer 4 · Professional CertificationsFree

Defined-benefit (DB) pensions create complex accounting because employer promises a future benefit and bears investment + actuarial risk. CFA L2 vignettes test whether you can adjust earnings + balance sheet for pension assumptions.

Foundation

**Defined contribution** (DC): employer pays fixed contribution (e.g., 12% of salary). Employee bears investment risk. Pension expense = contribution. Simple. **Defined benefit** (DB): employer promises future benefit (e.g., 60% of final salary × years of service). Employer bears investment + longevity risk. Complex actuarial accounting. Key DB metrics: - **PBO (US GAAP)** / **DBO (IFRS)**: present value of promised benefits, using projected salaries. - **Plan assets**: investment portfolio set aside (separate trust). - **Funded status** = Plan assets – PBO. Negative = underfunded; positive = overfunded. - Underfunded plans show as net pension liability on balance sheet.

Deep Dive

Pension expense components (US GAAP): 1. **Service cost**: PV of benefits earned this year. 2. **Interest cost**: discount-rate × beginning PBO (unwinding). 3. **Expected return on plan assets**: long-run assumed return × plan assets (reduces expense). 4. **Amortisation of prior service cost**: from plan amendments. 5. **Amortisation of actuarial gains/losses**: corridor approach. IFRS approach is cleaner: - Service cost (P&L). - Net interest cost = (PBO – assets) × discount rate (P&L). - Remeasurements (actuarial gains/losses) → OCI, never recycled. Key assumption sensitivities: - ↑ discount rate → ↓ PBO → looks better. - ↑ expected return → ↓ pension expense (US GAAP) but doesn't change PBO. - ↑ salary growth → ↑ PBO. - ↑ life expectancy → ↑ PBO.

Advanced

CFA L2 trap: companies pick assumptions to manage earnings. - Aggressive expected return on assets reduces reported pension expense (US GAAP). - High discount rate reduces PBO. - Analysts adjust to industry norm or risk-free + spread. For analysis: always use economic pension expense = service cost + interest cost – actual return on assets ± actuarial loss/gain. Don't trust reported expense. Underfunded plans = hidden debt. Add to long-term debt for credit analysis.

Regulatory references
  • Ind AS 19 Employee Benefits
  • Payment of Gratuity Act 1972
  • IAS 19
  • CFA Institute FSA curriculum
Common mistakes & pitfalls
  • Trusting expected-return assumption — economic expense uses actual return.
  • Forgetting that underfunded pension is debt-like obligation.
  • Confusing service cost with total pension expense.

Frequently asked

Why do firms favour high expected return assumptions?
Lower reported pension expense → higher EPS. Critical assumption to scrutinise.
How does pension affect cash flow?
Cash contributions to plan reduce CFO. Service cost is non-cash; interest cost is non-cash.

Practice questions

Click each question to reveal the answer and explanation.

Q 1
In a DB plan, an increase in discount rate:
  1. (a)Increases PBO
  2. (b)Decreases PBO
  3. (c)No effect
  4. (d)Doubles PBO
Correct: (b) Decreases PBO
Higher discount → lower PV of future obligations → lower PBO.
Q 2
Funded status =
  1. (a)PBO – Plan Assets
  2. (b)Plan Assets – PBO
  3. (c)Service cost – Interest
  4. (d)Plan Assets only
Correct: (b) Plan Assets – PBO
Funded status = Plan Assets – PBO. Positive = overfunded; negative = underfunded.
Q 3
IFRS treatment of remeasurements (actuarial gains/losses):
  1. (a)P&L immediately
  2. (b)OCI, never recycled
  3. (c)OCI, recycled to P&L
  4. (d)Off balance sheet
Correct: (b) OCI, never recycled
IFRS: remeasurements → OCI permanently; not recycled.
Q 4
Economic pension expense uses:
  1. (a)Expected return on assets
  2. (b)Actual return on assets
  3. (c)Zero return
  4. (d)Service cost only
Correct: (b) Actual return on assets
Economic = service + interest – actual return. Reported uses expected.
Q 5
Defined contribution plan: who bears investment risk?
  1. (a)Employer
  2. (b)Employee
  3. (c)Government
  4. (d)Plan trustee
Correct: (b) Employee
DC: employee bears investment risk (and reward). DB: employer bears it.
Educational purposes only. The numbers, returns, and examples used in this lesson are illustrative. Past performance does not guarantee future results. Mutual fund and securities investments are subject to market risks. This lesson is not investment advice; for advice tailored to your circumstances, consult a SEBI-registered Investment Adviser. Read our full disclaimer.