What it means
A defined benefit pension plan promises employees a specified income in retirement, usually based on their pay and years of service. Each year of work adds a little to that promise.
The extra pension earned in the current year is the current service benefit. Because the money will be paid many years from now, the employer calculates its cost in today's money.
Actuaries, who are specialists in pension mathematics, estimate how long the employee will work, how much their pay will rise and how long they will live. The result is discounted back to the present, and the answer is the current service cost.
In the accounts, the current service cost is an expense of the year, recorded as part of employee costs. It is separate from other pension items, such as interest on the existing obligation, gains or losses on the plan's assets and the cost of benefit improvements for past service.
Keeping these apart shows readers what the ongoing employment itself costs. For a business, the figure is a guide to the true cost of employing people.
An employee on a $60,000 salary costs more than $60,000 once the pension promise is added, and the current service cost shows by how much. Ignoring it can make a business with a generous pension plan look more profitable than it really is.
Several factors change the number. A higher discount rate lowers the cost because the future payments are worth less today, while longer life expectancy and higher assumed pay rises increase it.
Small changes in assumptions can move the cost by a large amount, which is why auditors review them closely. The term should not be confused with past service cost, which arises when a plan is improved or changed and benefits earned in earlier years are altered.
Nor does it include the cash the company actually pays into the plan, which depends on funding rules and may be higher or lower than the expense.
In practice
Real-world examples.
Example
A manufacturing company with 400 employees in a final salary pension plan receives its actuary's report. It shows a current service cost of $1,500,000 for the year. The finance director includes this in the employee cost line when reporting profit.
Example
A university considers changing its plan from a defined benefit to a defined contribution design. Its finance team compares the current service cost of $4,000,000 with the proposed employer contribution of $2,800,000. The difference of $1,200,000 shows the potential saving each year.
Example
An analyst compares two companies in the same industry. One has a large pension plan with a high current service cost, while the other has only a small contribution plan. She adjusts profit for each company to make the figures comparable.
Formula
Calculation
Pension earned this year = accrual rate x salary. Current service cost = present value of the pension earned this year.
Suppose a plan gives 1.5% of final salary for each year of service, and an employee earns $60,000. The pension earned this year is 0.015 x 60,000 = $900 a year, payable from retirement. Assume the actuary values $1 a year of pension at retirement as $10 (an annuity factor of 10), so the value at retirement is 900 x 10 = $9,000. If the discount factor from retirement back to today is 0.40, the current service cost is 9,000 x 0.40 = $3,600 for this employee.Case study
Seen in the real world.
This fictional story is illustrative only. Ironvale Rail is an invented transport company with a defined benefit pension plan covering 2,000 staff.
The actuary's annual report shows that falling interest rates have raised the current service cost from $6,000,000 to $7,500,000, even though the workforce and pay have not changed. The finance director explains to the board that a lower discount rate makes the future pension promises worth more in today's money. Profit for the year falls by $1,500,000 as a result.
The board asks whether the plan should be changed. After consultation, it decides to close the plan to new staff and offer them a defined contribution plan, while keeping the existing promises for current members. The change is expected to reduce the growth of the pension cost over time.
Watch out
Common mistakes.
- Treating the current service cost as the cash paid into the plan. The expense and the contribution are usually different amounts.
- Ignoring assumption changes. A small change in the discount rate can alter the cost significantly.
- Mixing it up with past service cost. Past service cost relates to changes in benefits for earlier years.
Questions
People also ask.
Does a defined contribution plan have a current service cost?
No, the employer's cost is simply the contribution it agrees to pay each year.
Who calculates the figure?
An actuary, who prepares the valuation using assumptions that management and auditors review.
Why is it recorded as an expense?
The employee's work this year earns a pension promise, and the cost of that promise belongs in the same period as the work.
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