The pension obligation is measured as the present value of future benefits that employees earn for services provided under both IFRS and US GAAP. It is denoted as the present value of defined benefit obligation (PVDBO) under IFRS and projected benefit obligation (PBO) under US GAAP.
Here are the three ways of measuring pension obligation:
PBO is the actuarial present value at the assumed discount rate of all future pension benefits earned to date, based on expected future salary increases. It measures the obligation of the company on a going concern assumption.
ABO is the actuarial present value of benefits (whether vested or non-vested) earned to date based on current salary levels, ignoring future salary increases. The accumulated benefit obligation differs from the projected benefit obligation in that it makes no assumption about future salary levels.
VBO is the actuarial present value of vested benefits.
We can link those three measures mathematically as:
We use the following formula:
PBO at the beginning of the year is the closing obligation at the end of the previous year or the present value of benefits earned in prior years. Mathematically,
Current service cost refers to the increase in the present value of a defined benefit obligation as a result of employee service in the current period.
Interest cost is the increase in the present value of the defined benefit obligation due to the passage of time:
Vesting is a provision in pension plans where an employee gains rights to future benefits only after meeting specific criteria, such as a pre-specified number of years of service. Fluctuations of estimates and assumptions about future salary increases, the discount rate, and the expected change in vesting cause changes in the present value of the defined benefit obligation. If the change in the pension obligation is positive, it is an actuarial loss, and an adverse change in the pension obligation is an actuarial gain.
ABC Company sets up a DB pension plan. A newly employed personnel has a salary of £90,000 in the coming year. Let’s assume that he has 10 years of service before retiring. The assumed discount rate is 10%, and the assumed compensation increase is 6% per annum.
For simplicity in this calculation, we make further assumptions:
What is the closing benefit obligation in Year 1?
The steps for calculation of closing the defined benefit pension obligation for this employee for the first year are as follows:
Breaking down the information given, we have:
Assume that ABC Company pays the benefit as a lump sum upon retirement. In that case, a lump sum pension benefit is equal to 4%, i.e. (10%-6%) of the employee’s final salary for each year of service after the commencement date.
The lump sum payable on retirement is given by: