This video shows how to calculate pension expense and record the pension expense journal entry for a defined-contribution plan (such as a money purchase plan or a 401k).
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How to Calculate Pension Expense for a Defined-Contribution Plan such as a 401k

A defined-contribution plan, like a 401k, is a retirement plan in which the employee contributes a certain percentage of their salary, and the employer may also make contributions. The contribution amount is predetermined, but the eventual benefit is not. Unlike a defined-benefit plan, there is no guaranteed payout in retirement. Instead, the accumulated funds in the plan are invested and can grow or shrink based on market performance.

Calculating the pension expense for a defined-contribution plan involves determining the amount the employer needs to contribute for each employee participating in the plan. This calculation can be complex, and it is essential for employers to accurately determine the expense to ensure compliance and proper financial planning. Below, we outline a step-by-step approach to help employers calculate the pension expense for a defined-contribution plan.

Step 1: Determine the Contribution Rate
The first step is to establish the contribution rate, which is usually expressed as a percentage of the employee’s eligible compensation. The contribution rate can vary among different companies and plans. It is often determined through negotiations with employees or established according to regulations.

Step 2: Calculate the Eligible Compensation
Next, calculate the eligible compensation, which is the portion of an employee’s income that is eligible for calculating the pension expense. This typically includes salary, bonuses, commissions, and other compensation elements that are predetermined in the plan.

Step 3: Determine the Total Eligible Compensation
Once the eligible compensation is calculated for each employee, sum all the eligible compensation amounts to obtain the total eligible compensation for the entire employee base.

Step 4: Calculate the Pension Expense
To calculate the pension expense, multiply the total eligible compensation by the contribution rate determined in step 1. This will provide an estimate of the total employer contribution required for the plan.

Step 5: Account for Other Factors
In some cases, there may be additional factors to consider when calculating the pension expense. These may include employer matching contributions, profit-sharing plans, or other incentives provided to employees. Make sure to include these factors in the calculation to accurately determine the total pension expense.

Step 6: Consider Legal and Accounting Requirements
Employers must comply with legal and accounting regulations that govern pension expenses. These requirements may include disclosing financial statements, adhering to recognized accounting standards, and other tax considerations. Ensure that the calculated pension expense aligns with these rules and guidelines.

Step 7: Review Annually
It is essential to review and update the calculations annually. The contribution rate, eligible compensation, and other factors can change over time. Regular review guarantees that the pension expense remains accurate and up-to-date.

Calculating the pension expense for a defined-contribution plan involves considering various variables and complying with legal and accounting standards. Employers should consult with pension plan administrators, accountants, or financial experts to ensure accurate calculations and adherence to regulations. By carefully determining the pension expense, employers can adequately plan for retirement benefits and provide employees with a secure and beneficial retirement savings plan.