A defined benefit plan defines the benefits that the employee will receive at the time of retirement.

• The employer is committed to specified retirement benefits.
• The trust accumulates assets, and employer is the trust-beneficiary. That is, the employer assumes the risk of the investment. As long as the plan continues, the employer is responsible for the payment of the defined benefits without regard to what happens in the trust.
• Retiree benefits are a fixed amount. Any shortfall in the accumulated assets held in the trust must be made up by the employer, and any excess accumulated in the trust can be recaptured by the employer.

The employer needs to determine what the contribution should be today to meet the pension benefit commitments that will arise at retirement. It is at risk because it must be sure to make enough contributions. The liability is often controversial because its measurement and recognition relate to unknown future variables.

The plan's return objective is to meet the actuarial rate of return which is the discount rate used to find the present value of the plan's future obligations and therefore determines the size of the firm's annual contribution to the pension plan. The actuarial rate of return is set by actuaries who estimate future pension obligations based on assumptions regarding future salaries (and increases), retirement patterns, age of worker, worker life expectancies and the firm's benefit formula.

The principal elements of a defined benefit plan are (1) the obligation for benefits to be paid to retirees, and (2) the plan assets that will be used to meet that obligation. The funded status of a plan is often referred to as the "pension plan's economic position".

• If a plan has insufficient funds to meet the retirement needs of its employees the fund plan is considered to be underfunded. Many analysts watch the liability of a large firm and the extent to which a firm may have inadequate funds in its retirement accounts.
• On the other hand, overfunded plans (in which the present value of the pension liabilities is less than the plan's assets) enable the fund's portfolio managers to invest funds in a more aggressive investment strategy.

Pension Plan Assets

What Are Pension Benefit Obligations?

The pension obligation is the actuarial present value of forecasted benefits to be paid to retirees.

• The vested benefit obligation (VBO) is the amount of the benefit obligation that does NOT depend on future employee service. It is based on vested benefits.
  Most companies have a vesting requirement, which means that the participant has to work for the company for some period of time to be entitled to full pension benefits. The VBO will be a percentage of the ABO.

• The accumulated benefit obligation (ABO) reflects the present value of pension benefits earned at the balance sheet date based on compensation to date. It is based on current salary levels. It is useful if the company is expected to settle the liability on a currently basis such as through a plan settlement.

• The projected benefit obligation (PBO) is the actuarial present value of the benefits attributed to employee service rendered to date, as measured by the benefit formula. Its computation includes projected salary increases. The GAAP calculations of obligations are based largely on PBO. PBO is the actuarial present value of the benefits the employer expects to pay retired employees. It assumes that the employee will continue working for the company until retirement and that the company is a going concern.
  Basically, the ABO is the recalculation of the PBO without taking into account projected salary increases.

Interaction among the terms:

• The PBO is the projected pension but it is based only on the years of service earned to date.
• The ABO recalculates PBO under the implicit assumption that the participant will leave the company at the end of the year, so future salary increases and pension increases due to additional years of service are not considered.
• For non-pay-related pensions, ABO will be the same as PBO, but for pay-related plans, ABO will be smaller than PBO.
• Future projected compensation increases are used to compute PBO, but not ABO or VBO.

Two critical assumptions to estimate future benefits are:

• Discount rate. It is used to compute the actuarial present value of benefits, the pension expense, and the obligation of the employer under the plan. It determines the amount of employee benefits payable, if all employee obligations were hypothetically settled today. The discount rate must approximate the market interest rate.
  The higher the discount rate, the lower the PBO, ABO and VBO, and vice versa. Because a higher discount rate does not impact assets in the plan, a higher discount rate will result in a lower net pension liability.

• The rate of compensation increase. It must be economically consistent with other assumptions used.
  The higher the expected rate of compensation growth, the higher the PBO. However, the ABO and VBO are not affected by this rate since they are based on the current salary level.

Example

An employee begins at a salary of $50,000 per year. The company's defined benefit plan provides for an annual pension benefit of 3% per year of service, applied to the final salary. The employee is expected to have annual salary increase of 2%, will retire in 10 years and will have a life expectancy of 10 years post-retirement. The discount rate is 5%.

In Year 1, the pension obligation is calculated as follows:
PBO:
Annual salary: $50,000.
Years to retirement: 9 (at the end of Year 1).
Expected final salary: $59,755 (increases at 2% annually for 9 years)
Projected pension: $1,793 (rounded).

If the employee works for the full 10 years, the project pension would be 3% x 10 years, or 30% of final salary, or $17,926 per year.

Just for Year 1, the present value of 10 payments of $1,793 discounted to the beginning of the payout period (beginning in Year 10) at the rate of 5% is $14,537. Discounting this amount back to the end of Year 1 results in a present value of $9,371, which represents the PBO as of the end of the Year 1.

The ABO for Year 1 takes into account only the actual pension benefit earned. In this case, the pension would be $50,000 x 0.03 = $1,500. The present value of 10 payments of $1,500, discounted to the beginning of the payout period at the rate of 5% is $12,162. Discounting this amount back to the end of Year 1 results in a present value of $7,840. This is the ABO for Year 1.

If the company has a 5-year vesting schedule so that the participant vests in 20% of the ABO each year for the first 5 years, then the VBC is $7,840 x 0.20 = $1,568.

In Year 2, the pension obligation is calculated as follows:
PBO:
Annual salary - $50,000 x 1.02 = $51,000.
Years to retirement: 8 (at the end of Year 2).
Expected final salary: $59,755 (increases at 2% annually for 9 years)
Projected annual pension: $59,755 x 3% x 2 = $3,585.
PV of 10-year annuity $3,585 = $29,067
PBO (PV of the annuity for 8 years at 5%): $19,674.

Since year 1 PBO was $9,371, the Year 2 pension liability is $19,674.