What Does Amortization Mean in the Context of a Pension Plan?

There are two primary needs for amortization within the context of a company’s pension plan. The first instance might include a company determining whether to apply current or new pension benefits retroactively to employees who performed services before the current iteration of the pension plan was implemented.

The second type of amortization applies to deferring current gains or losses in the pension account resulting from either an experience different from what had been assumed or from changes in actuarial assumptions.

Key Takeaways

• A pension is a defined-benefit retirement plan that guarantees a specific payout, typically for the rest of an employee’s life.
• Amortization can be used with pensions in two main ways.
• 401(k)s are largely replacing pensions in the private sector.

Amortization of Prior Service Cost

When a pension plan provider decides to implement or modify a plan, the covered employees almost always receive a credit for any qualifying work performed prior to the change. The extent to which past work is covered varies from plan to plan. When applied in this way, the plan provider must cover this cost retroactively for each employee in a fair and equal way over the course of his or her remaining service years.

Important

Even though the word “amortization” is almost always applied to loan payments (such as an amortization schedule for a home mortgage), the concept of amortization really just means a smoothing out of financial figures over a period of time.

As it pertains to prior service costs, amortization represents an accounting technique used to spread costs over time that might otherwise compromise current cash flow or financial reports.

Amortization of Actuarial Gains and Losses

The accounting for pension plans requires providers to estimate the expected return on plan assets. Whenever there are discrepancies between actual and expected returns—and there often are—the plan provider must report those as either a gain or a loss.

There is more than one way to estimate expected returns. If a company changes from using one valuation method to another, the changes must be recognized in the net periodic benefit cost and must be applied consistently from year to year across each asset class. Accountants amortize these gains and losses to ensure that consistent application.

What Is Amortization of a Loan?

With a loan, amortization is what happens when you pay off the principal bit by bit. The debt gradually gets smaller. This might be with a mortgage, for example.

You can use an amortization calculator to see your repayment progress in the future, sometimes many years in the future. The calculator tells you how much of your payment is going towards interest, and how much of your payment is going towards the principal. In the early days of your mortgage, most of your payment goes towards the interest. In later years, however, more of your payment will chip away at the principal. This will continue until you make your final payment, and the loan is finally paid off.

A mortgage is like other fixed-payment loans (like auto loans): the longer the loan term the more interest you’ll pay. With a home loan, this might be 30 years vs. 15 years. With an auto loan, this might be six years vs. three years. With a longer loan, you’re also building equity in your home (or vehicle) more slowly.

What Is a Pension?

A pension is a defined-benefit retirement savings plan that is managed and administered by an employer. The payout during retirement is based on a formula that takes into account the number of years an employee worked at the company, government body, or organization, plus their highest salary.

Depending on the plan’s rules, the payout may be taken as a lump sum or converted into an annuity, which will distribute regular benefits on a periodic basis over time. Typically, payments are guaranteed for the rest of the employee’s life.

How Are a Pension and a 401(k) Different?

A pension is a defined-benefit plan whereas a 401(k) is a defined-contribution plan. With a pension, the employer is responsible for managing the investments. The payout to the employee is guaranteed, so the employer takes on the risk. A 401(k) positions the risk elsewhere: it’s the employee, not the employer, who manages the investments. Benefits are not guaranteed.

Are 401(k)s Replacing Traditional Pensions?

Yes, for a few decades, 401(k) plans have been replacing traditional pensions. Many employers appear to prefer 401(k)s, which place more responsibility on employees than pensions do.

The Bottom Line

With a company’s pension plan, there are two major reasons why amortization might be used. In this article, we outlined those needs: amortization of prior service cost, and amortization of actuarial gains and losses. If you have any questions, reach out to your pension plan provider.