Updated for the 2026-2027 CFA® Level I curriculum.
Companies compensate employees beyond salary through retirement plans and equity awards. How a company reports these plans changes its balance sheet, income statement, and cash flow statement in very different ways. For Level I, you need to know who bears the investment risk in each plan type, how each one hits the financial statements, and how to calculate and interpret the funded status of a defined benefit plan.
Quick Answer
There are three main employee compensation plan types tested at Level I: defined contribution plans, defined benefit plans, and stock-based compensation. Defined contribution plans shift investment risk to the employee and create no balance sheet liability beyond unpaid contributions. Defined benefit plans keep the risk with the employer and require reporting a net pension asset or liability equal to the plan's funded status. Stock-based compensation is expensed at fair value over the vesting period and dilutes EPS.
Key Takeaways
Defined contribution plans expense the employer's contribution each period. There is no long-term pension liability on the balance sheet.
Defined benefit plans require the employer to report funded status: fair value of plan assets minus the pension obligation.
An underfunded plan (obligation exceeds plan assets) creates a net pension liability. An overfunded plan can create a net pension asset, subject to any applicable asset-ceiling restriction.
Actuarial assumptions, including the discount rate, the expected return on plan assets, and the compensation growth rate, directly change the reported pension obligation and expense.
Equity-settled stock-based compensation is generally measured at fair value on the grant date and expensed over the vesting period, not expensed all at once.
Stock-based compensation is a non-cash expense that still reduces net income and increases diluted shares outstanding.
What You Need to Know for CFA Level I
The LOS asks you to explain, not calculate complex actuarial figures. Focus on the financial reporting logic, not actuarial science.
Know which party bears investment risk in each plan type. This single distinction drives every reporting difference.
Be able to calculate and interpret funded status: fair value of plan assets minus the pension obligation.
Understand that this note covers the existence and reporting of these plans. Detailed share-based compensation disclosures (option pricing inputs, vesting schedules in footnotes) belong to the next note in this sequence.
The most common trap is assuming a higher discount rate increases the pension obligation. It does the opposite.
Defined Contribution Plans: The Employee Carries the Risk
In a defined contribution (DC) plan, the employer promises a contribution, often a percentage of salary, into an employee's retirement account. The employer has no obligation beyond that contribution.
The employee decides how the funds are invested and bears all investment risk. If the investments perform poorly, the employee's retirement balance suffers, not the employer's balance sheet.
Reporting is simple. The employer recognizes pension expense for contributions owed for employee service in the period, whether already paid or still payable. If a contribution is accrued but unpaid at period end, the employer reports a small current liability for that unpaid amount. There is no long-term pension asset or liability, because the employer has no further obligation once the contribution is made.
Defined Benefit Plans: The Employer Carries the Risk
In a defined benefit (DB) plan, the employer promises a specified future benefit, often based on salary and years of service. The employer invests plan assets to fund that promise, and bears the risk that those assets underperform.
Because the employer's obligation does not end at the contribution date, DB plans require more complex reporting.
Funded Status: Is the Plan Overfunded or Underfunded?
The core reporting requirement is the funded status of the plan.
Funded status = FVPA - PBO
where:
FVPA: fair value of plan assets, the current market value of assets held in the pension trust,
PBO: the pension obligation (called the projected benefit obligation under US GAAP or the defined benefit obligation under IFRS), the present value of benefits the employer owes employees.
If funded status is positive, the plan is overfunded and the employer reports a net pension asset. If funded status is negative, the plan is underfunded and the employer reports a net pension liability. This net asset or liability appears on the balance sheet. It replaced older reporting methods that allowed companies to hide unfunded obligations off the balance sheet.
What Drives Pension Expense
Assumptions affect different pension measures. Distinguish obligation measurement from expense recognition:
Assumption | Effect of an Increase |
|---|---|
Discount rate | Lowers the present value of the obligation (PBO falls) |
Expected return on plan assets | Lowers reported pension expense |
Compensation growth rate | Raises the projected obligation (PBO rises) |
The discount rate is tied to relevant market yields and cannot be chosen arbitrarily. A higher discount rate reduces the measured obligation. Under US GAAP, a higher expected asset return can reduce pension expense but does not itself change the obligation or funded status; IFRS uses the discount rate for net interest rather than a separate expected-return assumption. This is why analysts compare assumptions across companies rather than taking funded status at face value.
Stock-Based Compensation: Paying Employees with Equity
Stock-based compensation (SBC) includes stock options, restricted stock, and similar equity awards granted to employees as part of compensation.
For an equity-settled employee award, the employer measures compensation using grant-date fair value. Restricted-share value generally starts from the share price, with relevant award terms considered; option fair value requires a valuation model. Cash-settled awards create a remeasured liability instead.
The employer does not expense the full fair value immediately. Instead, it spreads the expense over the vesting period, the time the employee must work before the award becomes unconditional. This matches the expense to the service period the award is meant to compensate.
Equity-settled SBC expense reduces net income without a cash payment when recognized, so it is added back under the indirect CFO reconciliation. Potential dilution still matters for shareholders. Cash-settled compensation is different: it creates a liability and ultimately requires a cash payment.
Working Example
Orchard Robotics sponsors a defined benefit pension plan. At the end of the current year:
Fair value of plan assets: $148 million
Pension obligation (PBO): $162 million
The company's actuary also reports that raising the discount rate assumption by 0.5% would reduce the PBO to $154 million, with no change to plan assets.
Step 1: Calculate current funded status
Funded status = 148 - 162 = -14.
The plan is underfunded by $14 million. Orchard reports a net pension liability of $14 million on its balance sheet.
Step 2: Evaluate the effect of the discount rate change
Funded status (revised) = 148 - 154 = -6.
Raising the discount rate assumption would shrink the reported net pension liability from $14 million to $6 million, with no actual change in the plan's assets or the benefits owed to employees.
Orchard's pension plan is underfunded today. An analyst reviewing Orchard's footnotes should check whether the discount rate assumption is reasonable compared to peers. A company can reduce its reported pension liability simply by raising this assumption, so comparing funded status across companies requires comparing their actuarial assumptions too.
Recognizing an Equity Award Over the Service Period
In a separate example, an employer grants 30,000 equity-settled restricted shares on January 1. Grant-date fair value is $12 per share. Employees must complete three years of service before the entire award vests. Assume all awards are expected to vest, no modifications occur, and the service is recognized evenly as an expense.
After Year 1, cumulative compensation expense is $120,000 and the corresponding credit is in equity. After Year 2, cumulative expense is $240,000. A subsequent change in the share price does not remeasure the grant-date fair value of this equity-settled award.
Under the indirect cash-flow method, the non-cash $120,000 expense is added back when reconciling net income to CFO. That adjustment does not make employee services free: shareholders have supplied an ownership interest as compensation.
A cash-settled award follows a different path. It creates a liability that is remeasured as required until settlement and ultimately uses cash. Keep the settlement terms clear before describing an award as non-cash or predicting its balance-sheet effect.
Common Exam Traps
Reversing the discount rate effect
Candidates often assume a higher discount rate increases the pension obligation, the same way a higher interest rate might seem to increase a loan balance. It is the opposite. A higher discount rate lowers the present value of future benefit payments, so the PBO falls.
Treating DC plans like DB plans
Some candidates assume any employer-sponsored retirement plan creates a long-term balance sheet liability. Only DB plans do this. DC plans create, at most, a small current liability for unpaid contributions.
Ignoring the funded status sign
An overfunded plan (assets exceed the obligation) creates a net pension asset, not a liability. Mixing up the direction of this subtraction is a frequent stem-reading error under time pressure.
Treating SBC expense as a cash item
Equity-settled SBC expense reduces net income without a cash payment at recognition and is added back under the indirect method. Check settlement terms before extending this description to cash-settled awards.
Confusing this note's scope with share-based compensation disclosures
This page covers how DC, DB, and SBC plans are recognized and reported. Vesting schedule details, grant-date disclosures, and option-pricing inputs are covered in the next study note.
Practice Question
Hartline Industries sponsors a defined benefit pension plan. At year-end, the fair value of plan assets is $210 million and the pension obligation (PBO) is $195 million. Which statement correctly describes how Hartline reports this plan?
The plan is underfunded by $15 million, and Hartline reports a net pension liability of $15 million.
The plan is overfunded by $15 million, and Hartline reports a net pension asset of $15 million.
The plan is overfunded by $405 million, and Hartline reports a net pension asset of $405 million.
Correct Answer: B
Funded status = 210 - 195 = 15.
Plan assets exceed the pension obligation by $15 million, so the plan is overfunded. Hartline reports a net pension asset of $15 million on its balance sheet (subject to any asset ceiling limits under the applicable standard).
Option A: Reverses the funded status calculation. The candidate likely subtracted plan assets from the obligation instead of the obligation from plan assets, producing the wrong sign and the wrong conclusion about asset versus liability.
Option C: Adds the two figures instead of subtracting them, a basic arithmetic error that produces a number far larger than either input.
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FAQs About Employee Compensation Plans: Defined Contribution, Defined Benefit, and Stock-Based Compensation
What is the difference between a pension fund and a pension plan?
A pension plan is the employer's promise or program for retirement benefits. A pension fund is the pool of assets set aside to pay those benefits, typically held in a separate trust. Analysts review both the plan's obligation and the fund's assets to calculate funded status.
Why does a defined benefit pension plan create a balance sheet item but a defined contribution plan does not?
A defined benefit plan leaves the employer on the hook for a future promised payment, so the obligation must be measured and reported. A defined contribution plan ends the employer's responsibility once the contribution is made, so there is nothing further to report.
Does stock-based compensation affect cash flow?
Equity-settled compensation is non-cash when expensed and is added back in the indirect CFO reconciliation. It still compensates employee services through ownership interests. A cash-settled award creates a liability and ultimately uses cash, so settlement terms matter.
How do actuarial assumptions affect the funded status of a pension plan?
Assumptions like the discount rate, expected return on plan assets, and compensation growth rate all change the measured pension obligation or expense. A higher discount rate lowers the obligation, which can make an underfunded plan look healthier without any real change in assets or benefits owed.
Is pension expense the same as the employer's cash contribution to the plan?
Not always. For defined contribution plans, expense equals contributions attributable to the period's employee service; cash paid can differ because of accruals. For defined benefit plans, reported pension expense reflects service cost, interest cost, and return assumptions, and can differ from the actual cash the employer contributes to the plan that year.