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Service cost is is one of the five components of pension expense. The other components are interest cost, expected return on plan assets, amortized gains or losses, and amortized prior service costs.

A simple way to think of service cost is the additional pension benefits earned by employees the prior year of having worked. It is this additional prior year of work that results in additional pension benefits that in turn, result in service cost. Service cost is usually provided by the actuaries to the accountants of the company recording pension expense. The time value of money is used to discount the future payouts.

The service cost is the actuarial present value of benefits that the pension benefit formula attributes to employee services rendered during the period. The service cost component is developed using actuarial assumptions that reflect:

  • The time value of money (the discount or interest rate)
  • assumptions regarding uncertainties that reflect the probability of payment such as:
    1. mortality
    2. turnover
    3. attrition
    4. retirement ages
    5. and, lump sum vs. annuity elections

Computation of service cost involves a complex set of actuarial calculations. As a result, accountants work with actuaries to develop this component. Employers will use qualified actuaries to assist in the computations but the responsibility for reporting the information remains that of management. Management is also responsible for understanding the key inputs and the actuarial process and for having appropriate internal controls over the process.

Service cost recognized in an accounting period is the employer’s cost of the increase in future benefits to be received by employees as a result of services rendered during that accounting period.

Service cost is a component of net periodic pension cost. As a component of net periodic pension cost, service cost is based on the projected benefit obligation (PBO), which reflects future compensation levels to the extent that the pension benefit formula defines benefits as a function of future compensation levels.

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