A defined contribution plan is a retirement plan whereby the firm contributes a certain sum each period to the employee’s retirement account. The firm’s contribution can be based on any number of factors including years of service, the employee’s age, compensation, profitability, or even a percentage of the employee’s contribution. In any event, the firm makes no promise to the employee regarding the future value of the plan assets. The investment decisions are left to the employee, who assumes all of the investment risk.
The financial reporting requirements for defined-contribution plans are straightforward. Pension expense is simply equal to the employer’s contribution. There is no future obligation to report on the balance sheet.
In a defined-benefit plan, the firm promises to make periodic payments to the employee after retirement. The benefit is usually based on the employee’s years of service and the employee’s compensation at, or near, retirement.
The difference in the benefit obligation and the plan assets is referred to as the funded status of the plan. If the plan assets exceed the pension obligation, the plan is said to be “overfunded.” Conversely, if the pension obligation exceeds the plan assets, the plan is “underfunded.”