FAR · Select balance sheet accounts · 6 practice questions
Defined Contribution vs Defined Benefit: Risk and Expense
Defined contribution plans promise contributions, while defined benefit plans promise retirement benefits. Compare how that promise determines investment risk, pension expense, liabilities, and plan notes.
Try one first
Hint
Ask whether the plan promises a retirement benefit amount or only an annual contribution.
Answer B. A plan that promises a specified retirement benefit is a defined benefit plan, so the employer bears the investment risk. A plan that specifies only the annual contribution and pays whatever the account grows to is a defined contribution plan, so the employee bears the investment risk.
Why not A: This assumes employees always bear retirement plan investment risk. That fails for a fixed pension promise because the employer is responsible for providing the promised benefit regardless of asset performance.
Why not C: This assumes employers always bear retirement plan investment risk. That is true for a defined benefit promise, but not for a defined contribution account whose value depends on the employee's account investments.
Why not D: This reverses the risk allocation. In a fixed-benefit pension, the employer must make up investment shortfalls, while in an individual account plan the employee's benefit rises or falls with investment performance.
Side by side
| Defined contribution plan | Defined benefit plan | |
|---|---|---|
| Employer promise | Make contributions required by the plan formula. | Provide retirement benefits earned under the plan. |
| Investment risk | Participants bear the risk through their account balances. | The employer bears the risk of insufficient plan assets. |
| Pension expense | Required employer contribution for current-period service. | Service cost + interest cost - expected return, adjusted for amortizations. |
| Year-end liability | Required contributions still unpaid. | Projected benefit obligation (PBO) minus plan assets at fair value, if positive. |
| Cash contributions | Payments reduce the contribution payable. | Contributions fund the plan; they do not determine pension expense. |
| Discount rate | Not needed to calculate current-service contribution expense. | Used to measure the obligation and interest cost. |
| Account structure | Actual participant accounts. | May use hypothetical cash balance accounts with pay and interest credits. |
| Plan notes | Plan description and cost recognized for the period. | Includes a beginning-to-ending PBO reconciliation. |
Key points
- Remember: Ask what the employer promises: a contribution input or a retirement benefit outcome.
- Paying a prior-year contribution clears a payable; it does not create current-year expense.
- Benefits paid from plan assets are not the employer's defined contribution expense.
How the exam traps you
- Using cash paid as pension expense for either plan. Use required current-service contributions for defined contribution expense and net periodic pension cost for defined benefit expense.
- Calling a cash balance plan defined contribution because it shows individual balances. Hypothetical accounts with pay and stated interest credits describe a cash balance defined benefit plan.
- Recording participant investment losses as an additional defined contribution liability. Participants bear those losses; the employer owes only unpaid required contributions.
Question 2
Hint
Compute the employer's required contribution for the current year, then subtract amounts already paid for that same year.
Answer B. For a defined contribution plan, the employer reports a liability for required contributions that remain unpaid at the balance sheet date. Year 1's required contribution is $80,000, and $50,000 of that amount was paid during Year 1. The remaining $30,000 is the liability. The Year 0 accrual was settled and does not remain in ending liabilities.
Why not A: This answer comes from accruing the full current-year required contribution without reducing it for payments already made. Only the unpaid portion remains as a year-end liability.
Why not C: This answer results from treating the amount paid during Year 1 as the liability. A liability is the unpaid required contribution, not the portion already remitted to the plan.
Why not D: This answer comes from focusing on the beginning accrued contribution. That amount was paid during Year 1, so it is no longer outstanding at Dec 31, Year 1.
Question 3
Hint
Focus on whether the employer's commitment is a funding input or the retirement payment outcome.
Answer C. In a defined benefit plan, the employer's obligation is tied to the retirement benefits participants earn under the plan, not merely to a set contribution. The employer bears the risk that plan assets and investment returns will be insufficient to satisfy those payments. Plan assets affect funded status, but they do not cap the employer's underlying obligation.
Why not A: This treats the pension trust as the sole source and limit of the obligation. Although trust assets are used to pay benefits, the employer remains responsible if those assets are insufficient.
Why not B: This assumes investment performance is passed through to participants. In a defined benefit plan, the employer generally bears investment and actuarial risk rather than automatically changing retiree payments for trust returns.
Why not D: This results from confusing a defined benefit plan with a defined contribution plan. A fixed contribution formula describes the employer's obligation in many contribution plans, but a defined benefit plan obligates the employer for the benefits owed.
Question 4
Hint
Focus on what the employer promises in a defined contribution plan, not on the plan's investment results.
Answer B. Under a defined contribution plan, the employer's obligation is to make the contributions required by the plan. Once those contributions have been made, investment performance affects participant account balances rather than creating additional employer pension obligations. Oak should not recognize an additional pension liability for the decline.
Why not A: This treats the investment decline as part of measuring a benefit obligation. A defined contribution plan does not require the employer to measure a promised benefit obligation affected by investment performance.
Why not C: This borrows treatment associated with certain defined benefit pension remeasurements. A defined contribution plan does not put participant account investment losses in the employer's other comprehensive income.
Why not D: This assumes Oak must make participants whole for market losses. In a defined contribution plan, the employer's liability is limited to unpaid required contributions, and Oak made the required deposits.
Question 5
Hint
When a plan looks like an account but uses hypothetical balances and stated credits, do not assume it is defined contribution.
Answer C. A cash balance plan is a defined benefit plan even though it is presented as a hypothetical account with pay and interest credits. The employee does not own an actual individually invested account, so the employer accounts for the promised benefit under defined benefit guidance.
Why not A: This answer comes from treating the annual pay credit like a contribution to the employee's own account. In a profit-sharing plan, the participant has an actual individual account, not a hypothetical account used within a defined benefit structure.
Why not B: This answer comes from focusing on the fixed 5% credit and assuming that makes the plan a fixed-contribution arrangement. A money purchase plan uses actual participant accounts, whereas this fact pattern describes a hypothetical balance feature typical of a cash balance plan.
Why not D: This answer comes from noticing that the employer ultimately promises retirement benefits and stopping there. A traditional defined benefit plan normally expresses the benefit as an annuity formula, not as a hypothetical account balance with annual pay and interest credits.
Question 6
Hint
Defined contribution notes focus on current-period cost and plan description. Defined benefit notes add obligation and plan asset information.
Answer D. Defined benefit plan disclosures include detailed information about the benefit obligation, plan assets, and funded status. A reconciliation of the projected benefit obligation is part of that defined benefit package. Defined contribution disclosures are much narrower and do not include obligation reconciliations.
Why not A: This mistake assumes only defined contribution plans focus on current-period expense. Both plan types disclose cost recognized, although defined benefit plans provide much more detail about its components.
Why not B: This choice reflects confusing general plan description with obligation-specific data. Basic descriptive information about who participates is disclosed for defined contribution plans and can also appear in defined benefit disclosures.
Why not C: This choice comes from treating contribution mechanics as a pension-specific funding disclosure. Under U.S. GAAP, defined contribution plans disclose how employer contributions are determined, so this item can appear in the 401(k) note.
Common questions
Who bears investment risk in defined contribution and defined benefit plans?
Participants bear investment risk in a defined contribution plan. In a defined benefit plan, the employer remains responsible for promised benefits even when plan investments lose value.
How is pension expense calculated for each plan type?
Defined contribution expense equals required employer contributions for current-period service. Defined benefit expense combines service cost and interest cost, subtracts expected return on plan assets, and includes amortization adjustments.
What pension liability is reported for each type of plan?
A defined contribution plan reports required contributions that remain unpaid. An underfunded defined benefit plan reports the projected benefit obligation minus the fair value of plan assets.
Watch it solved
A full CPA FAR task-based simulation on Pensions and other postretirement benefits, worked step by step.
Defined Benefit Pension Cost & Funded Status | CPA FAR TBS on YouTube
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