Pensions are a famously dry topic, known to send even the most seasoned of accountants to sleep. Add in their complexity and you’ve got a recipe for a poorly understood aspect of financial statement analysis. Regardless, they can have a profound effect on a company’s balance sheet (and therefore its valuation), and so it is well worth taking the time to understand them. This article is the first of a series and is intended to outline the utmost basics of pension accounting. In later articles, I’ll be looking to delve a bit deeper into pension plan analysis and then apply the knowledge with a case study.
A number of users on the site have requested that we try to incorporate analysis of pensions into our StockReports and we appreciate that many consider it a very important topic. So, with any luck, we’ll get a bit of a conversation going about how the more experienced investors among us think about pensions too. Long term, this is going to shape how we incorporate this kind of information into the site so please do get involved!
The Basics…
In the most basic sense, pensions are essentially a savings agreement between a company and an employee. Employees contribute a small part of their salaries towards a communal pot (a pension fund) and pay annual fees in exchange for the money being managed and invested for the duration of their working lives. Often, the employer also agrees to contribute a certain amount to the employees pot when they pay in too.
When the employee finally retires, the accumulated pension fund is then used to pay them an ongoing retirement benefit. Pensions are the way almost all of us fund at least part of our retirement and they are highly prevalent in the UK - as I’m sure the vast majority are you are aware of from your jobs.
Different Types of Pension Fund…
Broadly speaking, there are two types of pensions you will come across. The first is called a defined contribution pension (these are the easy ones!). The second is called a defined benefit plan (these are not so simple I’m afraid).
A defined contribution plan is where an employee makes a predetermined payment (contribution) into the pension fund every month. It has this name because the ultimate value of the fund is determined only by what has been contributed to the fund over its lifetime. There is nothing in…
