Among employers, there has been a general movement away from defined benefit plans and toward defined contribution plans in recent years.4 In 2019, only 16% of private sector workers in the United States have access to a defined benefit plan, while 64% have access to a defined contribution plan. This is due, in part, to the increasing cost of managing defined benefit plans and higher liabilities associated with such plans because of increases in life expectancy and a reduction in interest rates, not to mention more complex accounting.
Defined benefits plans are employee benefits (other than termination benefits and short-term employee benefits) payable to employees after the completion of employment (before or during retirement). These plans can be funded, meaning the employer sets aside funds to meet its future obligation under the plan. However, the employer’s obligation is not limited to an amount it agrees to contribute to the fund. By contrast, under a defined contribution plan (e.g. 401k plans), an employer makes fixed cash contributions to a fund and has no further obligation to the employee in the event of any shortfall in the fund at the time benefits are due.
4-step accounting for defined benefit plans under IFRS
Step 1: Determine the present value of the defined benefit obligation by applying an actuarial valuation method
The ultimate cost of a defined benefit plan is uncertain and is influenced by variables such as final salaries, employee turnover and mortality, employee contributions and medical cost trends. Therefore, to measure the present value of the defined benefit obligation, entities apply an actuarial valuation method, make actuarial assumptions and attribute benefits to periods of service. IAS 19 mandates the projected unit credit method to determine the present value of the defined benefit obligation and related current service cost.
This method involves projecting future salaries and benefits to which an employee will be entitled at the expected date of employment termination. The obligation for these estimated future payments is then discounted to determine the present value of the defined benefit obligation and allocated to remaining service periods to determine the current service cost. The discount rate is one of the key actuarial assumptions because it can significantly impact the measurement of the defined benefit obligation and subsequent net interest expense.
Step 2: Deduct the fair value of any plan assets
Once the present value of the defined benefit obligation is determined, the fair value of any plan assets is deducted to determine the deficit or surplus.
Step 3: Adjust the amount of the deficit or surplus for any effect of limiting a net defined benefit asset to the asset ceiling
The amount of any deficit or surplus may need to be adjusted for the effect of an asset ceiling, to obtain the net defined benefit liability (asset) to be recognized. An asset ceiling is the present value of economic benefits available in the form of an unconditional right to a refund or reductions in future contributions to the plan. The determination about whether economic benefits are available to the entity requires careful consideration of the facts and circumstances, including the terms of the plan and applicable legislation.
For plan surpluses with an asset ceiling, the asset is measured at the lower of the surplus or the asset ceiling. Plan deficits can also be impacted by asset ceilings if the plan has a minimum funding requirement. For example, if payments under a minimum funding requirement create a surplus, which exceeds an asset ceiling, an additional liability is recognized. Asset ceilings can therefore significantly affect the amount of any surplus or deficit that is recognized and should therefore be carefully assessed.
Step 4: Determine service costs, net interest and remeasurements of the net defined benefit liability (asset)
To be recognized in profit or loss
- Current service cost is the increase in the present value of the defined benefit obligation resulting from employee service in the current period. Generally, current service cost is determined using actuarial assumptions set at the start of the annual reporting period. Similarly, net interest on the net defined benefit liability (asset) is determined using the net defined benefit liability (asset) and discount rate at the start of the annual reporting period.
- Past service cost is the change in the present value of the defined benefit obligation resulting from a plan amendment (e.g. changing the retirement age from 60 to 65) or curtailment (e.g. office closure makes employees redundant). When determining past service cost, IAS 19 requires an entity to remeasure the net defined benefit liability (asset) using the current fair value of plan assets and current actuarial assumptions.
To be recognized in other comprehensive income (OCI)
- Remeasurements of the net defined benefit liability (asset) include actuarial gains and losses, the return on plan assets (excluding amounts included in net interest), and changes in the effect of the asset ceiling (excluding amounts included in net interest), all of which are recognized in OCI. Remeasurements therefore include changes in the net defined benefit liability (asset) attributable to a true-up in actuarial assumptions (differences between actuarial assumptions at the end of the reporting period versus those at the beginning).
