Defined Benefit Pension Accounting for Bankers

Introduction

Defined benefit pensions are a promise to pay retirees a specified income for life, funded by a trust that the company must keep topped up. The accounting has to measure an obligation that stretches decades into the future and plan assets that move with markets, and then decide how much of the change belongs in each year's earnings. For bankers, pensions matter because a large deficit is a debt-like claim on the business, and because the expense is easy to misread.

At the end of 2025, Lockheed Martin's qualified pension plans held $22.85 billion of assets against obligations of $26.74 billion, leaving a deficit of about $3.9 billion on its balance sheet. Its plans for salaried employees have been frozen since 2020, so employees earn almost no new benefits: the year's service cost was just $50 million. Yet its pension expense for 2025 was $924 million, driven by the amortization of past losses, interest cost that the assumed return on assets no longer fully offset, and a $479 million charge for transferring obligations to insurers. A quarter-point fall in the discount rate during the year added about $700 million to the obligation.

A defined contribution plan, such as a 401(k), is simple to account for: the company's contribution is the expense, and nothing remains on the balance sheet. A defined benefit plan promises a benefit, usually based on salary and years of service, and leaves the company with the investment and longevity risk of delivering it.

Projected benefit obligation

The present value, under Accounting Standards Codification (ASC) 715, of the pension benefits employees have earned to date, including the effect of expected future salary increases where the benefit formula depends on pay. It is measured with actuarial assumptions about discount rates, mortality and retirement, and compared with plan assets to determine a plan's funded status.

The difference between plan assets at fair value and the projected benefit obligation is the plan's funded status, recognized on the balance sheet as an asset if the plan is overfunded or a liability if it is underfunded. Three assumptions drive the obligation. The discount rate is based on yields on high-quality corporate bonds matching the timing of benefit payments; Lockheed used 5.375% at the end of 2025, down from 5.625%. Mortality assumptions decide how long benefits will be paid. And, for plans that are not frozen, assumed salary growth decides how large final benefits will be.

Sensitivity to Interest Rates

Because the obligation is long-dated, it is highly sensitive to the discount rate. Lockheed disclosed that a 25 basis point change would move its obligation by about $700 million, and its after-tax equity by about $550 million. Rising interest rates since 2022 have shrunk many companies' obligations and improved their funded status, even where asset returns were weak.

Pension expense, called net periodic benefit cost, is built from several components that behave very differently. Lockheed's 2025 annual report shows them for its qualified plans:

Service cost is the value of benefits earned by employees during the year, a true operating cost. Interest cost is the unwinding of the discount on the obligation. The expected return on plan assets is an assumed long-run return, 6.50% for Lockheed, applied to the fair value of the assets or to a smoothed market-related value (Lockheed's choice), not the actual return. And amortization spreads earlier gains and losses into earnings slowly.

Since Accounting Standards Update (ASU) 2017-07, only service cost may be presented within operating income, alongside other compensation; the other components sit below operating income, often in a line such as non-service pension income or expense, and only service cost can be capitalized into inventory or other assets. For a company with a frozen plan, that means almost the entire pension cost, or income, now sits outside operating profit, as Lockheed's does.

Gains and Losses in Other Comprehensive Income

Each year, the obligation and the assets are remeasured. Differences between what was assumed and what happened, a change in the discount rate, actual asset returns above or below the expected return, or experience on mortality, are actuarial gains and losses, recognized first in other comprehensive income. They reach earnings only gradually, through the corridor approach.

Corridor approach

The US GAAP method, under ASC 715, of amortizing accumulated actuarial gains and losses into pension expense only to the extent they exceed 10% of the greater of the projected benefit obligation and the market-related value of plan assets. The excess is spread over the average remaining service period of active participants, or their remaining life expectancy if most are inactive.

The corridor means small swings in assumptions never reach earnings, while large accumulated losses bleed into expense for years. Lockheed carried $9.5 billion of pre-tax actuarial losses in accumulated other comprehensive income at the end of 2025, the source of its $313 million amortization charge; the treatment of that account is covered in other comprehensive income.

The corridor sets only the minimum amortization. ASC 715 allows any faster systematic method, and some companies elect to recognize all actuarial gains and losses in earnings immediately, typically at the annual remeasurement in the fourth quarter. This mark-to-market approach makes reported earnings far more volatile but removes the lag.

The cash a company puts into its plan follows minimum funding rules under the Employee Retirement Income Security Act (ERISA), not the accounting expense. Contributions are an operating cash outflow and are generally tax-deductible when paid, while the expense is non-cash, so a company can report pension income while contributing cash, or the reverse. Lockheed contributed $860 million in 2025 and, as a government contractor, recovered $1.6 billion of pension costs through its contract prices under the government's Cost Accounting Standards, a separate measure from the GAAP expense.

Companies with frozen plans increasingly buy group annuity contracts from insurers, using plan assets, and transfer the obligations to them. When the year's settlements exceed the plan's service cost plus interest cost, ASC 715 requires the company to recognize at once a share of the losses accumulated in other comprehensive income equal to the percentage of the obligation settled, as a non-cash settlement charge; below that threshold, immediate recognition is an accounting policy choice. Lockheed's December 2025 transfer of $943 million of obligations produced its $479 million charge. The transfer shrinks the plan and its risk; the charge is a one-off that bankers remove from adjusted earnings, alongside the other items covered in one-time items: restructuring, impairments and gains.

In valuation, an underfunded pension is usually treated as a debt-like item: the deficit, net of the tax deduction the company will receive when it funds it, is subtracted in the bridge from enterprise value to equity value, as explained in pensions and other off-balance-sheet liabilities. If the deficit is treated as debt, the non-service components of pension cost, which are effectively financing costs on that debt, should be excluded from earnings before interest, taxes, depreciation and amortization (EBITDA) and from the forecast, so the obligation is not counted twice. Service cost stays in EBITDA as an operating cost. The usual treatment of each pension item is:

For credit analysis, rating agencies typically add underfunded pension obligations to debt, and the required contribution schedule competes with debt service for cash. In M&A, a target's pension plan comes with the deal: its deficit, its sensitivity to rates and its funding requirements all affect the price, and the buyer's view of the assumptions may differ from the seller's.

Pension accounting smooths volatile markets into steadier earnings, at the price of making the expense hard to interpret. The balance sheet shows the economic position, the funded status; the income statement shows a blend of operating cost, financing cost and amortized history. Bankers keep the first, separate the second and set aside the third.