You are reviewing your year-end accounts and a note appears titled ‘retirement benefit obligations’ showing a six-figure liability you did not expect. Your lender asks whether this affects your gearing covenant. Your finance manager mentions actuarial assumptions and discount rates. None of this feels connected to the pension contributions you thought you were simply paying each month. This article explains, in plain terms, why some pension schemes barely touch your accounts while others create a genuine balance sheet liability, and what IAS 19 and FRS 102 Section 28 require you to do about it.
The problem: one pension note, two very different risks
Most SMEs that auto-enrol staff under workplace pension rules run a defined contribution (DC) scheme. You pay a fixed percentage of salary into a pension pot each month and your obligation ends there. It is simple, predictable, and barely different from any other payroll cost. A smaller number of businesses, often older companies or those that inherited schemes through acquisition, run a defined benefit (DB) scheme, where you have promised employees a specific pension outcome, for example two-thirds of final salary. That promise is a liability that must be measured, updated each year (often using actuarial roll-forwards), and shown on your balance sheet. Confusing the two, or not realising which one you actually sponsor, is where most of the surprises come from.
Defined contribution schemes: the easy accounting
Under a DC scheme, your obligation is fixed: you agree a contribution rate, for example 5% of pensionable salary, and once you have paid it into the pension provider, you have no further liability. The employee bears the investment risk and the longevity risk, not you. Accounting for this is straightforward under both IAS 19 and FRS 102 Section 28: you simply recognise an expense equal to the contributions payable for the period, and a creditor for any amount not yet paid at the year end. There is no actuarial valuation, no discounting, and no balance sheet liability beyond unpaid contributions.
| Account | Dr | Cr |
|---|---|---|
| Staff costs – pension contributions (P&L) | 1,667 | |
| Bank | 1,667 |
Monthly employer DC contribution at 5% on £400,000 annual pensionable payroll (£20,000 ÷ 12). No further liability arises once paid.
Defined benefit schemes: why the balance sheet moves around
A DB scheme is a promise, not a payment. You have told employees what pension they will receive, so you must estimate the present value of that promise, compare it with the value of assets held in the pension fund, and show the difference – a surplus or, more often, a deficit – as a single net figure on your balance sheet. Working this out requires an actuary to apply assumptions about salary growth, inflation, life expectancy and the discount rate used to bring future payments back to today’s value. Each year, three things typically happen: the obligation grows because employees have earned another year of benefit (the current service cost) and because time has passed (interest cost); contributions you pay into the scheme reduce the deficit; and actuarial gains or losses arise because the assumptions, or the actual market value of the assets, turned out differently than expected. Crucially, under both IAS 19 and FRS 102, only the service cost and net interest cost hit your profit and loss account. The actuarial gains and losses – the remeasurements – bypass profit entirely and go straight to other comprehensive income (OCI), so they affect reserves but not your reported profit for the year.
| Feature | Defined contribution | Defined benefit |
|---|---|---|
| Who bears investment risk | Employee | Employer |
| Balance sheet impact | Minimal – only unpaid contributions | Full net liability or asset recognised |
| Need for an actuary | No | Periodic valuations (often triennial) with annual updates |
| P&L volatility | Low and predictable | Service cost and net interest only |
| Where surprises land | Rarely | Other comprehensive income (OCI) |
The single most important distinction for an SME owner: DC schemes create a cost, DB schemes create a liability. A liability needs to be measured, monitored and explained to lenders and investors every single year, even if you never change the scheme terms.
Worked example: valuing a small defined benefit scheme
Imagine a manufacturing business that closed its final salary pension scheme to new members years ago but still has around 40 former employees entitled to benefits. At the start of the year, the scheme’s actuary valued the obligation at £1,200,000 and the assets held in the scheme at £1,100,000, giving a net deficit of £100,000 already sitting on the balance sheet. Over the year: the obligation increases by £85,000 for current service cost (benefits earned by any staff still accruing) and by £36,000 of interest cost (unwinding the discount, using a 3% rate on the opening obligation). The company pays in £90,000 of contributions. Benefits of £60,000 are paid out to retirees, reducing both the obligation and the assets equally. Finally, the actuary’s updated assumptions and investment performance produce an actuarial loss of £45,000 on the obligation (it turned out more expensive than expected) and an actuarial gain of £10,000 on the assets (they performed slightly better than forecast).
| Item | Obligation (£) | Plan assets (£) | Net position (£) |
|---|---|---|---|
| Opening balance | 1,200,000 | 1,100,000 | (100,000) |
| Current service cost | 85,000 | – | (85,000) |
| Interest cost / income | 36,000 | 33,000 | (3,000) |
| Employer contributions | – | 90,000 | 90,000 |
| Benefits paid | (60,000) | (60,000) | – |
| Actuarial (loss) / gain | 45,000 | 10,000 | (35,000) |
| Closing balance | 1,306,000 | 1,173,000 | (133,000) |
| Opening net deficit | (100,000) |
| Current service cost (P&L) | (85,000) |
| Net interest cost (P&L) | (3,000) |
| Employer contributions paid | 90,000 |
| Remeasurement loss (OCI) | (35,000) |
| Closing net deficit | (133,000) |
| Account | Dr | Cr |
|---|---|---|
| Staff costs – current service cost (P&L) | 85,000 | |
| Net pension liability | 85,000 |
Recognise current service cost for benefits earned during the year.
| Account | Dr | Cr |
|---|---|---|
| Finance costs – net interest cost (P&L) | 3,000 | |
| Net pension liability | 3,000 |
Net interest cost of £3,000 (£36,000 interest on obligation less £33,000 interest income on assets).
| Account | Dr | Cr |
|---|---|---|
| Net pension liability | 90,000 | |
| Bank | 90,000 |
Employer contributions paid into the scheme, reducing the net deficit.
| Account | Dr | Cr |
|---|---|---|
| OCI – remeasurement of net defined benefit liability | 35,000 | |
| Net pension liability | 35,000 |
Net actuarial loss (£45,000 loss on obligation less £10,000 gain on assets) recognised in other comprehensive income, not profit.
The remeasurement loss never touches your profit and loss account, which can lull directors into thinking the scheme is ‘not affecting performance’. It still reduces reserves and increases the balance sheet liability, which is exactly what lending covenants, net asset tests and distributable reserves calculations look at. Always check loan agreements for how they define liabilities before assuming a DB deficit is accounting noise.
IAS 19 vs FRS 102 Section 28: what is actually different
If you report under UK GAAP (FRS 102) rather than full IFRS, the good news is that Section 28 was deliberately aligned with IAS 19’s core approach, so the mechanics above apply either way. The differences are mostly around disclosure depth and some practical shortcuts available to smaller reporters.
| Area | IAS 19 | FRS 102 Section 28 |
|---|---|---|
| Measurement method | Projected unit credit method required | Same method required, but annual comprehensive valuations by an actuary are not mandatory (roll-forwards permitted) |
| Discount rate | High quality corporate bond yields matched to benefit duration | Same principle, often using published UK actuarial indices |
| Multi-employer schemes with no scheme-level data | Treated as DC if data unavailable, but agreed deficit recovery plans require a liability | Same approach: treated as DC, but liability required for agreed deficit recovery plans |
| Disclosure requirements | Extensive, including sensitivity analysis and asset-class breakdowns | Reduced disclosure, particularly for qualifying entities within a group |
| Use by smaller UK companies | Rare, unless part of an international group | Standard route for most UK SMEs with a DB obligation |
In practice, a significant FRS 102 relief for SMEs relates to multi-employer schemes, such as certain industry pension schemes where you pay into a shared pot alongside many other employers. If the scheme administrator cannot give you your own slice of the assets and liabilities, both standards allow you to account for your participation as if it were a defined contribution scheme, expensing regular ongoing contributions. However, under FRS 102 paragraph 28.11A (and IAS 19 paragraph 37), if you have entered into an agreement to fund a deficit (such as a recovery plan), you must recognise a balance sheet liability for the present value of those agreed deficit payments. DC accounting does not eliminate liabilities if a deficit recovery agreement exists.
What this means for your business
- Identify, in writing, which scheme type each employee group belongs to. If you only operate auto-enrolment DC schemes, your pension accounting is genuinely simple – do not let advisers over-engineer it.
- If you sponsor any legacy or inherited DB scheme, ensure the liability is updated each year (using actuarial roll-forwards or full valuations) and expect two separate effects: a modest, fairly predictable P&L charge (service cost and net interest), and a potentially volatile OCI movement that changes reserves without touching reported profit.
- Before your DB actuarial valuation is finalised each year, check how your bank or investor agreements define liabilities and net assets, so a larger-than-expected deficit does not trigger an unwelcome covenant conversation at the last minute.
- Where you participate in a multi-employer or industry DB scheme and cannot get scheme-specific figures, confirm with your accountant that DC treatment is appropriate, ensure any contractual deficit funding plan is recognised as a balance sheet liability, and keep a file note explaining why – auditors will ask for it.
Need clarity on your pension accounting before year end?
Whether you are confirming a simple DC contribution charge or untangling a legacy DB deficit for the first time, getting the treatment right under IAS 19 or FRS 102 protects your profit figures, your covenants and your audit sign-off.
