Projected benefit obligation and Total future liability

[johntavv]

Schweser says:
- Accumulated benefit obligation (ABO) = present value of liabilities earned
- Projected benefit obligation (PBO) = present value of liabilities earned + present value of liability from compensation increases.
- Total Future liability = present value of liabilities earned + present value of liability from comensation increases + present value of expected increase in benefit due from service until retirement.
So from this, Total future liability differs from PBO simply by adding present value of expected increase in benefit due from service until retirement. But doesn’t PBO already include the present value of expected increase in benefit due from service until retirement?

 

[Carlo]

Hi johntavv,
The distinction between these three measures of pension obligation, becomes relatively easy to grasp when the thought process starts by looking at the plan’s benefit formula.
Let’s assume that, under the terms of the DB plan, Company ABC has an obligation to pay its employees (when they retire) 1% of their final salary for each year of service.
Assume Company ABC has been in business for 10 years, has one employee who is currently on a GBP 1K monthly salary.
At the end of the year (its 10th in business) Company ABC is considering its obligation coming from the DB Plan.
They can think about it in three way:

1) ABO: “the actuarial present value of benefits attributed by the pension benefit formula to employee service rendered prior to that date and based on current and past compensation levels”. This definition is taken from the Statement of Financial Accounting Standards No. 87. The bit in bold is important because it says that this measure (ABO) assumes that a) the obligation is only for benefit accumulated to date (i.e. for the services this guy rendered in the past 10yrs) and b) that the employee final salary, whenever he decides to retire, will still be GBP 1K.

2) PBO: is the same as above with the difference that we now project a salary increase so that: a) as with ABO the obligation is only for benefit accumulated to date (i.e. for the past 10yrs) but b) differently from ABO the employee final salary, whenever he decides to retire, will be, say, GBP 2K.
Reason why PBO is used to calculate the funded status is that is more realistic than ABO given the assumption of salary increase and it is relatively easy to model.

It is useful to think that if the benefit formula is not based on final pay but, for instance, on a measure of profitability, then ABO=PBO.

3) Total Future Liability: the difference between this and PBO is that Company ABC no longer limits its projections to “benefits attributed by the pension benefit formula to employee service rendered prior to that date” but try and estimates also future services as well as salary increases. This is more woolly as assumptions become sort of prophecies.

All the best, Carlo