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Balance Sheets Best Practice

Valuing Pension Fund Liabilities on the Balance Sheet

by Steven Lowe

Executive Summary

  • Accounting standards affect how pension liabilities are reported in company accounts. FAS 158 requires that the net of pension fund assets and liabilities are reported in the main accounts. Traditional accountancy measures allow a more subjective measurement, and relegate pension information to the accounting notes.

  • The real issue is how a company calculates and values the projected liability—which depends on the discount rate selected, the actuarial assumptions relating to future inflation, wage increases, and, most importantly, the expected longevity of employees.

  • Different pension stakeholders will favor different liability measures, resulting in differing investment risk tolerances and strategies, which in turn can impact the corporate balance sheet.

  • Accounting measures and buyout measures of pension liabilities differ. Finance directors need to be aware of both types of measure, their assumptions, and the interaction between them, as they can impact pension strategies and, consequently, financial reporting.


With a pension plan, companies agree to provide certain benefits to their employees, by specifying either a defined contribution (where a fixed contribution is made to the plan each year by the employer, with no promises as to the future benefits that will be delivered by the plan) or a defined benefit (where the employer undertakes to pay a certain benefit to the employee at some point in the future). Under the latter, the employer has to put sufficient money into the plan each period such that the amounts, with reinvestment, are sufficient to meet the defined benefits due as plan members retire.

With a defined contribution plan, the firm meets its obligation once it has made the prespecified contribution to the plan, and its valuation on the balance sheet is reasonably straightforward. With a defined benefit plan, the firm’s obligations are much more difficult to estimate, since they will be determined by a number of variables, including the benefits that employees are entitled to (which will change as their salary and employment status change), the prior contributions made by the employer (and the returns they have earned), the expected retirement date of employees, and the rate of return that the employer expects to make on current contributions.

As these variables change, the value of the pension fund assets can be greater than, less than, or equal to the pension fund liabilities (which include the present value of promised benefits). Recent changes to accounting regulations have increased the transparency of pension funding, and this has sparked an increased debate about the goals of defined benefit pension funds. The stakeholders of a pension fund (sponsor, trustees, and the various classes of pensioner) often have different goals, and therefore require the asset and liability information to be presented using different assumptions. These assumptions can materially affect both profit and loss (P&L) and balance sheet statements.

A pension fund whose assets exceed liabilities is an overfunded plan, whereas one in which assets are less than liabilities is underfunded, and disclosures to that effect have to be included in financial statements. When a pension fund is overfunded the firm has several options: It can withdraw the excess assets from the fund, it can discontinue contributions to the plan, or it can continue to make contributions on the assumption that the overfunding is a transitory phenomenon that could well disappear by the next period. When a fund is underfunded, the firm has a liability that must be recognized on the balance sheet.

Accounting Standards

In late 2006, the Financial Accounting Standards Board issued its final Statement of Financial Accounting Standards No. 158 (FAS 158), which deals with the rules for reporting the obligations and expenses of pension plans, retiree health plans, nonqualified deferred compensation plans, and other post retirement benefits. Among many changes, FAS 158 moved information about the funded status of pension plans and other postretirement employee benefit plans from the footnotes of the financial statements to the balance sheet itself. The idea behind FAS 158 was to create more transparency and to make information about pension plans and other postretirement employee benefit plans available to investors. It requires companies to include on the balance sheet the full net value of pension assets and obligations. These are to be measured as the difference between the fund assets and the projected benefit obligations. A company does not have to show the full value of assets and the full value of liabilities—just the net of the two. If the fund assets are higher than the pension obligation, it will show as an asset; if not, it will be a liability.

Before FAS 158, the effects of certain events, such as plan amendments or actuarial gains and losses, could be given delayed recognition in the balance sheet. Alternatively, market returns could be smoothed over several years rather than recognized at once. As a result, a plan’s funded status (plan assets less obligations) rarely reflected the true position and so was not reported on the balance sheet. FAS 158 requires companies to report their plan’s funded status, which is likely to cause reported pension liabilities to rise significantly. The traditional actuarial approach is incorporated to a degree in International Accounting Standard 19 (IAS 19), which means that the balance sheet generated on an IAS 19 basis does not necessarily reflect the full net asset or liability position of the pension plan. Whichever accountancy basis is adopted, the real issue is how to identify the projected benefit obligation.

Typically, the assets held by the sponsor’s pension fund are liquid, have publicly accessible pricing data, and are subject to market value fluctuations. The liabilities, however, are rarely traded, are particular to the individual pension scheme, and, depending on the valuation method adopted, can be considerably less volatile. Assets are measured at market value, whereas the discount rate for valuing liabilities is based on the actuaries’ assessment of long-run returns on the assets in the pension fund.

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Further reading


  • Fridson, Martin, and Fernando Alvarez. Financial Statement Analysis: A Practitioner’s Guide. 3rd ed. New York: Wiley, 2002.


  • Financial Education. “Balance sheet recognition of pension liabilities under International Accounting Standards (IAS).” Online at:
  • JP Morgan. “Implementing FAS 158 for year-end financial reporting.” January 18, 2007. Online at:
  • Juliens, Dennis. “The impact of pension accounting on financial statements and disclosures.” CFA Institute Publications. Online at:
  • Riley, Leigh C., and Katherine L. Aizawa. “Pension fund issues in the boardroom: Is your pension plan becoming too expensive?” Chicago, IL: Foley & Lardner, 2007. Online at:
  • Zion, David. “Beginning to overhaul the pension accounting rules.” CFA Institute Conference Proceedings Quarterly 24:2 (2007): 38–44.

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