The Pension Obligation Now we consider more precisely what is meant by the pension obligation. Unfortunately, there's not just one definition, nor is there uniformity concerning which definition is most appropriate for pension accounting. Actually, three different ways to measure the pension obligation have meaning in pension accounting, as shown in Graphic 174. GRAPHIC 174 Ways to Measure the Pension Obligation   Q2,p.935

 1.   Accumulated benefit obligation (ABO) The actuary's estimate of the total retirement benefits (at their discounted present value) earned so far by employees, applying the pension formula using existing compensation levels.  2.   Vested benefit obligation (VBO) The portion of the accumulated benefit obligation that plan participants are entitled to receive regardless of their continued employment.  3.   Projected benefit obligation (PBO) The actuary's estimate of the total retirement benefits (at their discounted present value) earned so far by employees, applying the pension formula using estimated future compensation levels. (If the pension formula does not include future compensation levels, the PBO and the ABO are the same.) 

Later you will learn that the projected benefit obligation is the basis for some elements of the periodic pension expense. Remember, there is but one obligation; these are three ways to measure it. The relationship among the three is depicted in Graphic 175 on the next page. Now let's look closer at how the obligation is measured in each of these three ways. Keep in mind, though, that it's not the accountant's responsibility to actually derive the measurement; a professional actuary provides these numbers. However, for the accountant to effectively use the numbers provided, she or he must understand their derivation. Accumulated Benefit Obligation The accumulated benefit obligation (ABO) the discounted present value of estimated retirement benefits earned so far by employees, applying the plan's pension formula using existing compensation levels. is an estimate of the discounted present value of the retirement benefits earned so far by employees, applying the plan's pension formula using existing compensation levels. When we look at a detailed calculation of the projected benefit obligation later, keep in mind that simply substituting the employee's existing compensation in the pension formula for her projected salary at retirement would give us the accumulated benefit obligation.   The accumulated benefit obligation ignores possible pay increases in the future. 
Vested Benefit Obligation Suppose an employee leaves the company to take another job. Will she still get earned benefits at retirement? The answer depends on whether the benefits are vested under the terms of this particular pension plan. If benefits are fully vested—yes. Vested benefits benefits that employees have the right to receive even if their employment were to cease today. are those that employees have the right to receive even if their employment were to cease today.
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GRAPHIC 175 Alternative Measures of the Pension Obligation (K) Pension plans typically require some minimum period of employment before benefits vest. Before the Employee Retirement Income Security Act (ERISA) was passed in 1974, horror stories relating to lost benefits were commonplace. It was possible, for example, for an employee to be dismissed a week before retirement and be left with no pension benefits. Vesting requirements were tightened drastically to protect employees. These requirements have been changed periodically since then. Today, benefits must vest (a) fully within five years or (b) 20% within three years with another 20% vesting each subsequent year until fully vested after seven years. Fiveyear vesting is most common. ERISA also established the Pension Benefit Guaranty Corporation (PBGC) to impose liens on corporate assets for unfunded pension liabilities in certain instances and to administer terminated pension plans. The PBGC provides a form of insurance for employees similar to the role of the FDIC for bank accounts and is financed by premiums from employers equal to specified amounts for each covered employee. It makes retirement payments for terminated plans and guarantees basic vested benefits when pension liabilities exceed assets. The vested benefit obligation is actually a subset of the ABO, the portion attributable to benefits that have vested. Projected Benefit Obligation As described earlier, when the ABO is estimated, the most recent salary is included in the pension formula to estimate future benefits, even if the pension formula specifies the final year's salary. No attempt is made to forecast what that salary would be the year before retirement. Of course, the most recent salary certainly offers an objective number to measure the obligation, but is it realistic? Since it's unlikely that there will be no salary increases between now and retirement, a more meaningful measurement should include a projection of what the salary might be at retirement.^{5} Measured this way, the liability is referred to as the projected benefit obligation (PBO) the discounted present value of estimated retirement benefits earned so far by employees, applying the plan's pension formula using projected future compensation levels.. The PBO measurement may be less reliable than the ABO but is more relevant and representationally faithful. To understand the concepts involved, it's helpful to look at a numerical example. We'll simplify the example (Illustration 171) by looking at how pension amounts would be determined for a single employee. Keep in mind though, that in actuality, calculations would be made (by the actuary) for the entire employee pool rather than on an individualbyindividual basis.   The benefits of most pension plans vest after five years.
The PBO estimates retirement benefits by applying the pension formula using projected future compensation levels. 
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ILLUSTRATION 171 Projected Benefit Obligation 
The actual includes projected salaries in the pension formula. The projected benefit obligation is the present value of those benefits. (K)Using Excel, enter: =PV(.06,20,60000) Output: 688195 (K)Using a calculator: (K)  Jessica Farrow was hired by Global Communications in 2000. The company has a defined benefit pension plan that specifies annual retirement benefits equal to: Farrow is expected to retire in 2039 after 40 years service. Her retirement period is expected to be 20 years. At the end of 2009, 10 years after being hired, her salary is $100,000. The interest rate is 6%. The company's actuary projects Farrow's salary to be $400,000 at retirement.^{*} What is the company's projected benefit obligation with respect to Jessica Farrow? Steps to calculate the projected benefit obligation:1.   Use the pension formula (including a projection of future salary levels) to determine the retirement benefits earned to date.  2.   Find the present value of the retirement benefits as of the retirement date.  3.   Find the present value of retirement benefits as of the current date. 
(K) ^{*}This salary reflects an estimated compound rate of increase of about 5% and should take into account expectations concerning inflation, promotions, productivity gains, and other factors that might influence salary levels. 

If the actuary's estimate of the final salary hasn't changed, the PBO a year later at the end of 2010 would be $139,715 as demonstrated in Illustration 171A.
ILLUSTRATION 171A PBO in 2010 
In 2010 the pension formula includes one more service year. Also, 2010 is one year closer to the retirement date for the purpose of calculating the present value.  
CHANGES IN THE PBO. Notice that the PBO increased during 2010 (Illustration 171A) from $119,822 to $139,715 for two reasons:  1.   One more service year is included in the pension formula calculation (service cost).   2.   The employee is one year closer to retirement, causing the present value of benefits to increase due to the time value of future benefits (interest cost). 
These represent two of the events that might possibly cause the balance of the PBO to change. Let's elaborate on these and the three other events that might change the balance of the PBO. The five events are (1) service cost, (2) interest cost, (3) prior service cost, (4) gains and losses, and (5) payments to retired employees.
p. 944 1. Service cost. As we just witnessed in the illustration, the PBO increases each year by the amount of that year's service cost increase in the projected benefit obligation attributable to employee service performed during the period.. This represents the increase in the projected benefit obligation attributable to employee service performed during the period. As we explain later, it also is the primary component of the annual pension expense. 2. Interest cost. The second reason the PBO increases is called the interest cost interest accrued on the projected benefit obligation calculated as the discount rate multiplied by the projected benefit obligation at the beginning of the year.. Even though the projected benefit obligation is not formally recognized as a liability in the company's balance sheet, it is a liability nevertheless. And, as with other liabilities, interest accrues on its balance as time passes. The amount can be calculated directly as the assumed discount rate multiplied by the projected benefit obligation at the beginning of the year.^{6}   Each year’s service adds to the obligation to pay benefits. Interest accrues on the PBO each year. 
 We can verify the increase in the PBO as being caused by the service cost and interest cost as follows: (K)  

3. Prior service cost. Another reason the PBO might change is when the pension plan itself is amended to revise the way benefits are determined. For example, Global Communications in our illustration might choose to revise the pension formula by which benefits are calculated. Let's back up and assume the formula's salary percentage is increased in 2010 from 1.5% to 1.7%: Obviously, the annual service cost from this date forward will be higher than it would have been without the amendment. This will cause a more rapid future expansion of the PBO. But it also might cause an immediate increase in the PBO as well. Here's why. Suppose the amendment becomes effective for future years' service only, without consideration of employee service to date. As you might imagine, the morale and dedication of longtime employees of the company could be expected to suffer. So, for economic as well as ethical reasons, most companies choose to make amendments retroactive to prior years. In other words, the more beneficial terms of the revised pension formula are not applied just to future service years, but benefits attributable to all prior service years also are recomputed under the more favorable terms. Obviously, this decision is not without cost to the company. Making the amendment retroactive to prior years adds an extra layer of retirement benefits, increasing the company's benefit obligation. The increase in the PBO attributable to making a plan amendment retroactive is referred to as prior service cost the cost of credit given for an amendment to a pension plan to employee service rendered in prior years..^{7} For instance, Graphic 176 presents an excerpt from an annual report of Ecolab, Inc. describing the increase in its PBO as a result of making an amendment retroactive:   When a pension plan is amended, credit often is given for employee service rendered in prior years. The cost of doing so is called prior service cost. 
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GRAPHIC 176 Prior Service Cost—Ecolab, Inc. Real World Financials  Note 1: Retirement Plans (in part)
… The Company amended its U.S. pension plan to change the formula for pension benefits and to provide a more rapid vesting schedule. The plan amendments resulted in a $6 million increase in the projected benefits obligation. 
Let's put prior service cost in the context of our illustration. At the end of 2009, and therefore the beginning of 2010, the PBO is $119,822. If the plan is amended on January 3, 2010, the PBO could be recomputed as: (K) The $15,976 increase in the PBO attributable to applying the more generous terms of the amendment to prior service years is the prior service cost. And, because we assumed the amendment occurred at the beginning of 2010, both the 2010 service cost and the 2010 interest cost would change as a result of the prior service cost. This is how: (K)  
Retroactive benefits from an amendment add additional costs, increasing the company's PBO. This increase is the prior service cost.
Prior service cost increased the PBO at the beginning of the year. The pension formula reflects the plan amendment. 
 We can verify the PBO balance by calculating it directly: ^{*}Adjusted by $2 to compensate for the rounding of present value factors.  

p. 946 The plan amendment would affect not only the year in which it occurs, but also each subsequent year because the revised pension formula determines each year's service cost. Continuing our illustration to 2011 demonstrates this:   During 2011, the PBO increased as a result of service cost and interest cost. 
(K) 4. Gain or loss on the PBO. We mentioned earlier that a number of estimates are necessary to derive the PBO. When one or more of these estimates requires revision, the estimate of the PBO also will require revision. The resulting decrease or increase in the PBO is referred to as a gain or loss, respectively. Let's modify our illustration to imitate the effect of revising one of the several possible estimates involved. Suppose, for instance, that new information at the end of 2011 about inflation and compensation trends suggests that the estimate of Farrow's final salary should be increased by 5% to $420,000. This would affect the estimate of the PBO as follows:   Decreases and increases in estimates of the PBO because of periodic reevaluation of uncertainties are called gains and losses. 
(K) The difference of $9,155 represents a loss on the PBO because the obligation turned out to be higher than previously expected. Now there would be three elements of the increase in the PBO during 2011.^{8}   Changing the final salary estimate changes the PBO. 
(K) If a revised estimate causes the PBO to be lower than previously expected, a gain would be indicated. Consider how a few of the other possible estimate changes would affect the PBO:   The revised estimate caused the PBO to increase. 
•   A change in life expectancies might cause the retirement period to be estimated as 21 years rather than 20 years. Calculation of the present value of the retirement annuity would use n = 21, rather than n = 20. The estimate of the PBO would increase.  •   The expectation that retirement will occur two years earlier than previously thought would cause the retirement period to be estimated as 22 years rather than 20 years and the service period to be estimated as 28 years rather than 30 years. The new expectation would probably also cause the final salary estimate to change. The net effect on the PBO would depend on the circumstances.  •   A change in the assumed discount rate would affect the present value calculations. A lower rate would increase the estimate of the PBO. A higher rate would decrease the estimate of the PBO. 
p. 947 5. Payment of retirement benefits.
We've seen how the PBO will change due to the accumulation of service cost from year to year, the accrual of interest as time passes, making plan amendments retroactive to prior years, and periodic adjustments when estimates change. Another change in the PBO occurs when the obligation is reduced as benefits actually are paid to retired employees.   Payment of retirement benefits reduces the PBO. 
The payment of such benefits is not applicable in our present illustration because we've limited the situation to calculations concerning an individual employee who is several years from retirement. Remember, though, in reality the actuary would make these calculations for the entire pool of employees covered by the pension plan. But the concepts involved would be the same. Graphic 177 summarizes the five ways the PBO can change.
GRAPHIC 177 Components of Change in the PBO (K)Illustration Expanded to Consider the Entire Employee Pool For our single employee, the PBO at the end of 2011 is $192,254. Let's say now that Global Communications has 2,000 active employees covered by the pension plan and 100 retired employees receiving retirement benefits. Illustration 172 expands the numbers to represent all covered employees.   The PBO is not formally recognized in the balance sheet. 
ILLUSTRATION 172 The PBO Expanded to Include All Employees 
 The changes in the PBO for Global Communications during 2011 were as follows: (K) ^{*}Of course, these expanded amounts are not simply the amounts for Jessica Farrow multiplied by 2,000 employees because her years of service, expected retirement date, and salary are not necessarily representative of other employees. Also, the expanded amounts take into account expected employee turnover and current retirees. ^{†}Includes the prior service cost that increased the PBO when the plan was amended in 2010. 

