What is a pension?
A pension is a benefit that is available to employees only on leaving employment. It is a fund to which contributions both from the employee and employer are added to support the employee during retirement from work. In addressing pension related transactions, it can be looked at from pension scheme accounting and accounting for pension costs.
Pension scheme accounting deals with necessary accounting records for a trust fund or company set up to administer a pension scheme. Eg PFAs, PCs (IAS 26). As regards Accounting for pension costs, emphasis is on the amount to be included in the employing company’s financial statements from where the pension benefit is paid (IAS 19).
Classification of Pension Funds
Pension arrangement can be classified under the general headings of:
- State Schemes
- Private schemes
State Schemes: A state scheme is a pension that is controlled directly or indirectly by the Government e.g National provident fund (NPF), National Pension Commission (NPC). In some other countries the involvement of the Government in pension arrangement is much deeper even to the extent of providing unemployment compensations.
Private schemes: These are pension arrangements that are controlled by individuals and private organizations. Private schemes can be sub-divided into:
a)Insured Scheme: This is what is obtained when an insurance company agrees to underwrite certain pension benefits which are determined at the onset in relation to premium paid.
b) Self-administered scheme: This is a scheme that is operated by a company on behalf of its employees.
To have this kind of scheme the following factors have to be considered:
- Number of employees
- Size of the fund
- The annual cash flow of the fund
- Willingness of the company to undertake administrative responsibility
- Ability of the company to provide or pay for necessary investment expertise.
c) Personal pension plan: It is a pension plan which is a pension arrangement for a self-employed individual i.e A kind of organized and enforced savings aimed primarily to provide for the future.
This sort of pension may be undertaken by:
- Any person engaged in a trade or profession on his own accountor in partnership.
- A director or employee of a company who for any reason is a non-pensionable employee.
- An employed person who has other earnings.
- Supplementary arrangement to other pension benefits
d) Managed pension plan: This a pension plan where the pension scheme or individual participates in the investment portfolios of one of the life companies managed funds.
With the new pension practice introduced in the country with effect from 2003, the wide disparity between private and state schemes has been removed. All organizations with 5 or more employees, whether private or government are expected to open retirement savings accounts on behalf of their employees with Pension Fund Administrators (PFAs).
They are also to remit monthly deductions from employees salary (2004 Act, min 7.5%; 2014 Act 8 %) and the employers contribution (2004 Act, min 7.5% ; 2014 Act, Min 10%) to relevant pension fund custodian (PFCs) engaged by their PFA. An employercan also elect to bear all pension costs of the employee in which case a minimum of 20% of the employee’s monthly emolument is to be remitted to the PFA.
The exemptions to this rule are as contained in Section 5 of the 2014 Act pertaining to members of the armed forces etc.
Possible variations in Scheme
The nature and arrangement of pension plans varies from one situation to the other and from one company to the other. Specifically possible variations in scheme will include:
- Some authorities whereas others are not contributory
- Where there are contributory, the percentage of contribution varies from one company to another.
- Another possible variation is with regards to retirement age. This generally varies between 55-65 years but provision may be made for early retirement.
- Some provide for dependents, others have no such provisions.
Again, note that these variations have been narrowed down as virtually all pension arrangements, private or state are now contributory. The retirement age of 60 years is recognized by the pension reform act but early retirement on attaining minimum age of 50 years is permitted.
All amount realized from members and company will normally be credited to the pension fund account, pension payments and other expenses incurred will be debited to this account.
To monitor the pension fund investment activities it will be necessary for investment accounts to be opened to determine the profit of loss on each type of investment. Income for the period will then be transferred either to the pension fund account or interest income account where a separate income statement is prepared.
Occasionally, the system of maintaining account in a privately managed pension is to create a separate account for contribution by member and another separate account for the contribution of the company. Usually in this situation, income earned is credited to a separate account from where interest at an agreed percentage is credited to both member’s contribution account and company’s contribution account.
With the new practice, PFAs (Pension fund administrators) will debit PFCs (Pension fund custodians) with pension contributions (staff and employers) and credit RSA (Retirement statement accounts) of concerned employees. Income from investment of pension contributions as advised by PFCs will also be credited to RSA accounts in the PFA books. Pension benefits processed and paid will be debited to respective RSA and the credit to PFCs account.
In PFcs books, pension benefits paid and applicable administrative charges will be debited against the PFAs account.
Characteristics required in pension fund accounting:
The investment policy scheme should be aimed at achieving the rate of interest required to sustain the pension payments. This will mean keeping a careful watch on yield from different types of investments. At the same time, the fund should attempt to protect the real value of its investment i.e it is not normal pension fund policy to concentrate on achieving capital gains or taking unnecessary risks.
Specifically, the characteristics are:
- Security of invested capital; i.e sufficient flexibility to allow switching of funds as appropriate.
- Diversification of risk. i.e By spreading the investment over secured loans, convertible, stocks and equities in selected industries.
- Certainty of income sufficient to meet contractual payments.
- Balance between the present value of funds investments, income and future payments under the scheme.
Possible Problems that may Arise in Practice
- Reconciling number of shareholdings as per books with available share certificates
- Certain investments will be held in the name of the nominees. It will be necessary to seek clarification from such nominees and to ascertain that they are still in
- The pension investment programme should be planned in such a way that necessary fund will be available to meet commitments to retirees.
- Basis of valuation of investment that are not quoted may sometimes pose a problem.
Note: Pension funds do not pay tax on their income and they are able to claim back the tax credits deducted at source from their investment income.
Accounting for pension cost:
Schemes may be designed according to the method of calculating benefit onto defined contribution scheme and defined benefit schemes. In a defined contribution scheme, the employer makes agreed contributions to the scheme, based on the salary levels of each employee. The benefits to be derived by the employees are defined in monetary terms for each year’s contribution. Thus the cost to the employer can be measured with reasonable certainty.
In a defined benefit scheme, the benefits will usually depend on an employee’s salary at or near retirement age. In these circumstances, it is impossible to be certain in advance that the contributions to the scheme, plus the income derived from the capital fund created, will be sufficient to cover the benefits to be paid. In spite of the uncertainty, the employer may have entered into a legal obligation to provide any unforeseen short fall in funds, and even if he has not, may find it necessary to do so in the interest of maintaining good employee relations. On the other hand, the employer may be entitled to reduce contributions or even take a refund, if a surplus arises. Other methods of classifying pension schemes are:
Funded or unfunded: A funded pension scheme is one which the future liabilities for benefits are provided for by the accumulation of assets held externally to the employing company’s business. An unfunded scheme is one in which pensions are paid out of the current income with no attempt to accumulate assets.
The trustees of a funded scheme may make use of the services of an insurance company, but it is important to realize that such an arrangement does not relieve the employer of the responsibility to ensure that the scheme is adequately financed. In other words it is the employer who continues to take much of the risk associated with the build-up of the funds.
Contributory or non-contributory: The employees may or may not make contributions to the scheme as well as the employer. There are some employers that might decide to take on the responsibility of paying into employee’s accounts without deducting from the employees income. They bear the full cost of pension contributions, and this is known as a non- contributory scheme, meaning that the employees do not contribute towards their pension plans. Contributory schemes are those requiring the employer and employees to contribute towards the scheme.
In accordance with the accruals (matching) concept, the accounting objective should be for the employer to recognize the cost of providing a pension over a period during which he benefits from the benefits from the employee’s services. Many companies have until now simply charged as the pension cost the contributions payable to the pension scheme in each accounting period. The pension cost may, however, be different from the amount funded. It will therefore be necessary for the employer to consider whether the funding price provides a satisfactory basis for allocating the pension cost of particular accounting periods.
Defined Contribution Schemes: In a case of defined contribution scheme, the employer’s obligation at any point in time is restricted to the amount of contribution payable to date. The pension cost is therefore the amount of a contribution payable in respect to the particular accounting period. Note that this is what is largely applicable now in the country with the new pension reform act.
Defined benefit schemes: These are potentially far more complex. There are two basic approaches to accounting for pension costs with respect to defined benefit schemes, which may be termed the income approach.
The income approach aims to match the cost of pensions directly with the services received from employees. The estimated ultimate cost is allocated to the profit and loss accounts of individual periods matching with employees ‘ pensionable pay or by some other systematic and rational method. In the balance sheet the cumulative cost not yet discharged through payment of contribution or directly paid pensions is accrued as a provision and excess of contributions over cumulative cost is shown as an asset.
Under the balance sheet approach the net actuarial pension liability or asset at the beginning and end of the period is estimated strictly by reference to information relating to those points in time and charge for the period is derived from the change therein, adjusted for payments made during the period.
By focusing on an actuarial “liability” or “asset” this approach tends to produce a pension charge with fluctuates materially from period to period. The fluctuations arise because the pension cost charge in a particular period aggregates the effect of estimated changes which will only take place, if at all over many years.
The long term nature of pension obligation and the inherent uncertainties in the calculation of the obligation are such that the pension cost recognized in any period can, at best, only be an informed estimate which may often be subject to revision, of the eventual outcome of a series of future events. Since revisions usually relate to the total period over the which the pension accrues. It is preferable to recognize them in a controlled manner, normally by adjustment over all accounting periods over which the cost accrues. The income approach which involves such adjustments is considered to match the cost and benefit on a more rational basis than the “balance sheet approach”
The total cost of pensions in a year can rationally be divided into regular cost, which is the consistent ongoing cost recognized under the actuarial method used, and variations in the cost arising from experience deficiencies and surpluses changes in assumptions affecting past service retroactive changes in benefits or conditions for membership and increase to pensions in payment or deferred pensions not previously provided for.
For regular contributions it is common place for actuaries to aim for a stable contribution rate expressed as a percentage of pensionable earnings. Where this has been done, charging the contribution payable by the employer would normally meet the accounting objective. This is considered to be the most appropriate method of matching the cost of pensions with the benefit derived from the services of employees, on the grounds that remuneration provides the best yardstick for measuring the worth of those services. It is also consistent with the prominent of other employment overheads and gives a relative stable cost in proportion to pay from year to year. Many companies already use this basis.
Variations from regular cost should be allocated over the expected average remaining service lives of employees in the scheme, unless prudence dictates adopting a shorter number of years in respect of a material deficiency. However, to the extent that a material surplus sufficiency is directly caused by extraordinary events, it should be recognized in the same period as, and treated in the same way as any other extraordinary item that relates to the same event.
Where there has been a long standing practice of granting increases to pensions in payment or deferred pensions on a regular basis such that an expectation is created that further increases will occur in the following years, such increases come to form part of the employer’s commitments. Allowance should be made for such increase in the actuarial assumptions. Where there is no such practice but pensions in payment are increased for the current and all future periods but with no expectation or any further increase, the capitalize amount of the increase could, to the extent not covered by a surplus, be charged against profits in the period in which it is initially granted. A one of increase which will not affect pensions paid in future periods should to the extent not covered by a surplus, be charged in the period in which it is granted.
Other Highlights of the Pension reform act 2014
- Monthly emolument on which pension contribution is based expanded to total emoluments provided it is not less than the addition of basic, housing and transport.
- The scope of investment of pension funds expanded to include special investment funds and other financial investments approved by the commission.
- Stiffer penalties provided for contraventions.
- Employees disengaged from service before attaining 50 years can after failing to secure new employment in 4 months apply for 25% of the balance on his RSA.
- Pension protection fund created and is to be funded by subvention from federal government representing 1% of total wage bill of public sector employees
Frank Fabozzi., Pension fund investment management