Pension Plans
Following from the preceding section focusing on long-term liabilities, this section focuses on a special long-term liability, the pension fund. For many companies, this is a very large liability and, for the most part, it is not captured on the balance sheet. We could say that pensions are a type of off-balance-sheet financing. Pension fund accounting is complicated and the footnotes are often torturous in length, but the good news is that you need to understand only a few basics in order to know the most important questions to ask about a company with a large pension fund.
There are various sorts of pension plans, but here we review only a certain type: the defined benefit pension plan. With a defined benefit plan, an employee knows the terms of the benefit that he or she will receive upon retirement. The company is responsible for investing in a fund in order to meet its obligations to the employee, and so, the company bears the investment risk. On the other hand, in a defined contribution plan (e.g. 401k), the company probably makes contributions–or matching contributions–but does not promise the future benefit to the employee. As such, the employee bears the investment risk.
Among defined benefit plans, the most popular type bears a promise to pay retirees based on two factors: 1. the length of their service and 2. their salary history at the time of retirement. This is called a “career average” or “final pay” pension plan. Such a plan might pay retirees, say, 1.5% of their “final pay,” their average pay during the last five years of employment, for each year of service (up to a maximum number of years). Under this plan, an employee with 20 years of service would receive a retirement benefit equal to 30% (20 years x 1.5%) of their final average pay. But formulas and provisions vary widely; for example, some will reduce or “offset” the benefit by the amount of social security the retiree receives.
Taken From : Advanced Financial Statements Analysis