How Pension Plans Work

The purpose of this paper is to provide an overview of how pension plans work and what types of pension plans are available. Included will be an explanation of the effect of pension plans on financial statements if the cash contribution amount is more or less than the anticipated pension expense, and a discussion of how pensions are accounted for on the company's financial statements.

How Pension Plans Work

The purpose of a pension plan is to provide enough savings that individuals receive ample income during their retirement years. "This is accomplished by setting aside funds during the employee's working years so that at retirement the accumulated funds plus earnings from investing those funds are available to replace wages" (Spiceland et al., p. 828). Qualified pension plans are plans which are created in accordance with rigid guidelines. Qualified plans provide the employer "an immediate tax deduction for amounts paid into the pension fund" (Spiceland et al., p. 829). It is important to note that there are specified limits to the amounts that employers may deduct. General requirements for meeting the guidelines of a qualified pension plan include: 1) It must cover at least 70% of employees; 2) It cannot discriminate in favor of highly compensated employees; 3) It must be funded in advance of retirement through contributions to an irrevocable trust fund; 4) Benefits must vest after a specified period of service, commonly five years; and 5) It complies with specific restrictions on the timing and amount of contributions and benefits (Spiceland et al., p. 829).

Generally, a pension plan is comprised of employer, employee, or both employer and employee contributions into an interest bearing account, such as mutual funds, stocks, bonds, certificates, etc. Earnings in a qualified pension plan accumulate tax free, which provides an additional tax benefit to the employee.

Types of Pension Plans