What are future pension obligations?
Future pension obligations are the liabilities a pension plan has to pay the pensions for current employees when they retire, and also to pay the pensions of employees who have already retired.
The plan’s obligations are estimated by an actuary, using a number of estimates and assumptions, such as the expected lifespan of the employees, and interest rates.
The pension obligations won’t become payable until the employees retire, which could be many years away.
Discounting to a present value
So the plans obligations are discounted to a present value for accounting purposes.
The PV of a pension plan’s obligations is the current value of pension liabilities, which changes each year.
The obligations are recorded as a present value, so as each year progresses, the discount unwinds, which is another way of saying interest is charged.
This increases the present value of the obligations.
Pension obligations and liabilities
Employees who have worked for the company for the extra year will now be entitled to more of a pension when they retire, if its based on how many years service they have provided.
These current and past service costs add to the pension obligations.
The obligations will decrease as payments are made to pensioners or retired employees.
The payment of the pension is actually a payment of some of the plan’s obligations, and reduces the assets of the pension plan, but also the liabilities.
Liabilities brought forward from last year will be given to us; these are the present value of all future payments likely to be made on the pension.
The actuary will predict how much we’ll have to pay out on the future; this figure is a long term liability and will be discounted to reflect the present value of the obligation.
Applying interest to the discounted long term liability
Each year brings us closer and closer to paying the pensions to retired employees, so we must unwind the discount to keep the liability at present value.
Otherwise we might end up having a liability that was valued a few years ago, but is actually much more now.
The unwinding of the discount is just another name for applying interest.
If the present value of the liability last year was 100 and this year it’s 110, without any other changes, you could say the interest rate is 10%.
The basic journal entries for unwinding a discount, and applying interest is:
| DR | Interest (Expense I/S) | XX | ||
| CR | Liability (SOFP) | XX |
Charging interest on the liability
The way to calculate the interest charged on the liability each year is to take the closing balance of last years pension liability, that should also be the opening balance this year, if you’re stuck.
Then apply an appropriate discount rate. This may be given to you in an exam, the company will usually compare it to corporate bonds, so look out for that rate in the question.
To calculate the interest, take the opening balance of the pension liabilities.
Then apply the appropriate discount rate given, and this will give you the interest cost of the pension liabilities for the period.
If the pension liabilities brought forward equal 500,000 and the appropriate discount rate is 9%, the interest charged will be 45,000 and, if nothing else happens to increase the liability, such as contributions, the closing liability will be 545,000.