What it means
A defined benefit pension plan is a long-term promise, so the company cannot simply expense whatever it pays in each year. Accounting rules spread the cost of the promise over the working lives of the employees who earn it.
The yearly charge that results is the net periodic pension cost. The charge is built from several pieces.
Service cost is the value of the extra pension employees earned by working this year, and interest cost is the growth in the total promise because it is one year closer to being paid. Against these, the company subtracts the return the plan assets are expected to earn.
Smaller adjustments are added for items that are spread over time rather than hit at once. These include the cost of benefit improvements granted for past service and gains or losses that arose because actual results differed from the assumptions.
Spreading them keeps the annual charge from swinging wildly with the stock market. The assumptions matter enormously.
A change to the discount rate (the interest rate used to turn future payments into today's value) or the expected return on assets can move the charge by hundreds of thousands of dollars without any change in the real business. Managers and analysts should therefore read the notes to the accounts as closely as the headline figure.
The treatment differs under different accounting standards. Some standards use an expected return on assets, while others apply the discount rate to the net position and show remeasurements elsewhere in the accounts.
Check which standard a company reports under before comparing two sets of figures.
In practice
Real-world examples
Example 1
A manufacturer with a legacy pension plan reports a $1,250,000 pension charge in its operating costs. The finance director explains to the board that only $800,000 was actually paid into the fund, so the difference sits on the balance sheet. The board asks for a funding plan rather than relying on the charge alone.
Example 2
An analyst comparing two airlines notices that one reports a much lower pension cost. The difference comes from an assumed 7.5% return on assets against 5.5% for the other. She adjusts both to the same assumption before comparing profit margins.
Example 3
A sales manager at a mid-sized utility is told that the new labour agreement will raise service cost by $300,000 a year. The extra expense appears in the company results even though no cash leaves until retirees are paid. He understands why profit forecasts have been trimmed.
Think of it
Imagine running a car lease where you pay a monthly fee, but the rental company also charges or credits you based on estimated wear and tear and how well the vehicle's value holds up in the market.
Formula
Calculation
Net periodic pension cost = service cost + interest cost - expected return on plan assets + amortisation of prior service cost + amortisation of actuarial losses (less gains)
Suppose a company has a pension obligation of $18,000,000 and a discount rate of 5%, so interest cost = 18,000,000 x 5% = $900,000. Plan assets are $16,000,000 with an expected return of 6.25%, so expected return = 16,000,000 x 6.25% = $1,000,000. Service cost is $1,200,000, amortisation of prior service cost is $100,000 and amortisation of actuarial losses is $50,000. Net periodic pension cost = 1,200,000 + 900,000 - 1,000,000 + 100,000 + 50,000 = $1,250,000.Case study
Seen in the real world
Harlow Foundry Ltd is a fictional metal casting business created for this illustration. It runs a defined benefit plan for 400 employees, and its annual pension charge had been steady at around $900,000 for years.
After the board approved a benefit increase for long-serving staff, the cost of past service was recognised and spread over the following years. The charge rose to $1,150,000 even though trading was unchanged, and the finance director had to explain the movement to lenders who tracked operating margin.
The illustrative lesson is that a pension charge can change for reasons that have nothing to do with day-to-day trading. Harlow now shows lenders a margin figure before and after pension items, so the underlying performance is easy to see.
Watch out
Common mistakes
- Assuming the charge equals the cash the company pays into the pension fund, when the two figures are measured differently and often diverge.
- Ignoring the assumptions behind the number, when small changes in the discount rate or expected return can shift the charge materially.
- Comparing companies without checking which accounting standard they use, since the standards build the charge differently.
Questions
People also ask
Does a defined contribution plan have a net periodic pension cost?
No, because the company's cost is simply the contribution it agrees to pay, and the investment risk sits with the employee.
Where does the charge appear in the accounts?
The service cost normally sits in operating costs, while some standards present the other components separately, so check the notes.
Why is expected return subtracted?
Because the assets in the fund are expected to earn income that offsets part of the growth in the obligation, which reduces the net cost to the company.