Financial Accounting Theory and Analysis, 15th Edition

14Pensions and Other Postretirement Benefits

A pension plan is a financial arrangement designed to provide individuals with an income during retirement, a time when they are no longer earning a steady income from employment. The first employer‐sponsored retirement plan was established in 1875 by the American Express Company. Other companies in the utilities, banking, and manufacturing sectors soon followed suit. Pension plans gained significant popularity during World War II when wage freezes prevented direct increases in workers’ pay.

Typically, companies provide pension benefits by making periodic payments to an outside funding agency. The agency then assumes responsibility for investing the pension funds and making periodic benefit payments to the recipients. The two most commonly encountered types of pension plans are defined contribution plans and defined benefit plans. Additionally, some companies participate in multiemployer plans.¹

A defined contribution plan specifies a fixed amount that the employer is required to contribute to the plan each period. For example, the plan may mandate that the employer contributes 8% of the employee's annual salary. However, there are no guarantees regarding the ultimate benefits to be paid out. The retirement benefits ultimately received by the participants depend on the returns earned on the pension funds invested over the investment period.

In contrast, the specifics of a defined benefit plan agreement outline the pension benefits ...