Defined Benefit Plan and Pension Obligation
LEVEL II
Defined benefit plans promise a contractual regular amount that an employer pledges to provide to its employees post-retirement. The employer is responsible for making appropriate contributions and investment decisions to ensure there are sufficient pension assets to pay out the earned benefits when due. The estimated amount of these earned benefits, discounted to its present value, is known as the Pension Obligation.
Estimating Pension Obligation
Estimating the pension obligation involves a few key factors:
- The estimated remaining working years of the employee until retirement
- The estimated years the employee will live post-retirement
- The annual growth rate of the employee’s salary
- The discount rate
Using these estimates, the employer can calculate the present value (PV) of the future pension obligation. Let’s illustrate this with an example.
Example
A company has one employee, Jason, who earns a starting salary of $100,000 per year. Under the company’s defined benefit plan, Jason is promised an annual end-of-year payment of 1% of his final salary for each year of service until his death. The company estimates that Jason will work for another 15 years, live for 10 years post-retirement, his salary will grow by 3% each year, and the discount rate is 7% per year.
In his first year, Jason earns a retirement benefit of $1,558 for each year of his estimated 10-year retirement. The present value of these payments, discounted at the 7% rate for 10 years, is $10,943. However, since these funds will only be required in 15 years, the present value is further discounted back to $3,966. This is the Pension Benefit Obligation (PBO) for Jason’s first year of service.
In the second year, assuming no changes in assumptions or the plan, an additional $4,244 is added to the PBO. This addition is known as the Current Service Cost, the present value of benefits earned by the employee during the current period.
Another component added to the PBO is the Interest Cost, which is the increase in pension obligation due to the passage of time. It is calculated as the beginning PBO times the discount rate. In this case, the interest cost is added to the PBO, resulting in an ending PBO of $8,488 at the end of Jason’s second year of service.
Factors Affecting Pension Obligation
There are several factors that can significantly impact the pension obligation:
- Actuarial Gains and Losses: Changes in assumptions such as the employee’s post-retirement lifespan can result in actuarial gains or losses.
- Past Service Cost: If the terms of the pension plan change, such as an increase in the promised benefit percentage, this results in past service cost.
In reality, this process is extended to larger companies with a diverse workforce, and more complex actuarial assumptions are made.
Calculating Change in PBO
The change in PBO for the current period can be calculated with the following relationship:
Ending Pension Obligation = Beginning Obligation + Current Service Cost + Interest Cost ± Actuarial Gains and Losses + Past Service Cost – Actual Benefits Paid
Conclusion
Understanding and accurately estimating the pension obligation is essential for employers who offer defined benefit plans. It involves a series of calculations based on several assumptions and can be affected by changes in these assumptions or the terms of the pension plan. By monitoring these factors and adjusting accordingly, employers can ensure they meet their pension obligations and provide for their employees’ futures.
