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At this primary level, a pension plan is simple: the company (called the "plan sponsor" in this context) contributes to its pension fund; the pension fund is invested into bonds, equities, and other asset classes in order to meet its long-term obligations; and retirees are then eventually paid their benefits from the fund.
Three things make pension fund accounting complicated. First, the benefit obligation is a series of payments that must be made to retirees far into the future. Actuaries do their best to make estimates about the retiree population, salary increases, and other factors in order to discount the future stream of estimated payments into a single present value. This first complication is unavoidable.
Second, the application of accrual accounting means that actual cash flows are not counted each year. Rather, the computation of the annual pension expense is based on rules that attempt to capture changing assumptions about the future.
Third, the rules require companies to "smooth" the year-to-year fluctuations in investment returns and actuarial assumptions so that pension fund accounts are not dramatically over- (or under-) stated when their investments produce a single year of above- (or below-) average performance. Although well-intentioned, smoothing makes it even harder for us to see the true economic position of a pension fund at any given point in time.
Let's take a closer look at the two basic elements of a pension fund:
On the left, we show the fair value of the plan assets. This is the investment fund. During the year, wise investments will hopefully increase the size of the fund. This is the "return on plan assets." Also, employer contributions, cash the company simply gives from its own bank account, will increase the fund. Finally, benefits paid (or disbursements) to current retirees will reduce the plan assets.
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