Definition
The term pension interest cost refers to the annual interest accrued on the beginning balance of the projected benefit obligation. Since the company's projected benefit obligation (PBO) is the present value of the retirement benefits earned by employees, the company incurs an annual expense equal to the discount rate used to determine the PBO multiplied by the starting balance of the PBO.
Calculation
Pension Interest Cost = Projected Benefit Obligation x Pension Discount Rate
Where:
Projected Benefit Obligation = the obligation calculated at the beginning of the current year
Explanation
Companies provide employees with a pension plan as part of a larger array of employment benefits. The FASB Statement of Financial Accounting Standards No. 87 requires firms to measure and disclose pension obligations as well as the performance and financial condition of their plans at the end of each accounting period.
The company's pension benefits obligation is stated in terms of its present value. The value used to discount these future obligations is typically a relatively conservative rate such as those earned on high-quality, fixed-income investments. As each year passes, employees participating in the pension plan are one year closer to receiving their retirement benefit. Therefore, the company incurs a cost that is equal to the discount rate multiplied by the balance in the PBO at the start of the year.
Interest cost is typically the second largest component of a company's pension expense each year. The overall level of funding will also depend on variables such as the return on the fund's assets, service costs, prior service costs, changes to the plan's formula, and the plan's gains and losses.
Related Terms
pension plan, defined benefit plan, defined contribution plan, pension obligation, accumulated benefit obligation, vested benefit obligation, projected benefit obligation, service cost, amortization of prior service cost, actuarial gains and losses, pension expense, pension funded status, return on plan assets
