Why is there a gain or loss in a pension expense calculation? I am more confused about this every time I read about this topic. Can somebody explain this to me? I have researched and read and still do not understand why.
http://www.investopedia.com/university/financialstatements/financialstatements9.asp#axzz1cUKEtLt1
Calculating pension expense involves several factors that can result in a gain or loss. To understand this concept, let's break it down step by step:
1. Actuarial Assumptions: Pension expenses are calculated based on various actuarial assumptions, such as employee mortality rates, retirement age, salary increases, and expected returns on pension plan investments. These assumptions are estimates and may differ from actual outcomes.
2. Expected Return on Plan Assets: Pension plans typically invest funds to generate returns, which help fund future retirement benefits. The actuary estimates the expected return based on the asset allocation and market conditions. If the actual return on plan assets is higher than the expected return, it results in a gain. Conversely, if the actual return is lower, it results in a loss.
3. Service Costs: Service cost represents the present value of the additional future benefits earned by employees in a particular period. It depends on factors like salary levels and employee turnover. If the service cost increases, it leads to higher pension expense, and vice versa.
4. Interest Costs: Interest cost represents the increase in the present value of the pension liability due to the passage of time. These costs arise because pension benefits are often paid out in the future. If the interest rate used to discount future benefits decreases, it results in higher interest costs and vice versa.
5. Changes in Assumptions: Over time, actuarial assumptions can change due to new data or revised expectations. Changes in these assumptions can impact the pension expense calculation and could result in gains or losses.
Overall, gains and losses in pension expense calculation occur as a result of deviations between expected and actual outcomes, changes in assumptions, differences between estimated and actual returns on plan assets, and fluctuations in interest rates. These gains or losses are recognized in the financial statements in order to provide a more accurate representation of the pension plan's financial status.
To calculate pension expense, ensure you have the necessary data, including actuarial assumptions, estimates of plan assets, and pension liability calculations. By understanding these inputs and their impact on the calculation, you can better comprehend why gains or losses are present in pension expense calculations.