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.

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.

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.

The accounting for pension plans requires providers to estimate the expected return on plan assets. Whenever there are discrepancies, and there often are, between actual and expected returns, 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.

(For related reading, see "Explaining Amortization in the Balance Sheet.")