What is a Projected Benefit Obligation (PBO)?
A projected benefit obligation (PBO) is an actuarial measurement of what a company will need at the present time to cover future pension liabilities. It is used to determine how much must be paid into a defined benefit pension plan to satisfy all pension entitlements that have been earned by employees up to that date, adjusted for expected future salary increase.
How a Projected Benefit Obligation (PBO) Works
Companies can provide employees with a number of benefits, including a salary when they are too old to work. The Financial Accounting Standards Board's (FASB) Statement of Financial Accounting Standards No. 87 states that companies must measure and disclose their pension obligations, together with the performance of their plans, at the end of each accounting period.
A projected benefit obligation (PBO) is one of three ways to calculate expenses or liabilities of traditional defined benefit pensions — plans that take into account employee years of service and salary to calculate retirement benefits.
PBO assumes that the pension plan will not terminate in the foreseeable future and is adjusted to reflect expected compensation in the years ahead. As a result, it takes into account a number of factors, including the following:
- The estimated remaining service life of employees
- Assumed salary rises
- A forecast of employee mortality rates
Actuaries are responsible for establishing whether pension plans are underfunded. These qualified professionals, who specialize in the measurement and management of risk and uncertainty, determine the benefits needed through a present value calculation.
Actuaries are responsible for comparing the pension plan’s liabilities to its assets. In general, they provide a breakdown of the following:
- Service costs: The increase in the present value of the defined benefit obligation, resulting from current employees getting another year's credit for their service.
- Interest costs: The annual interest accumulated on the unpaid balance of the PBO as an employee's service time increases.
- Actuarial gains or losses: The difference between the pension payments made by an employer and the anticipated amount. A gain occurs if the amount paid is less than expected. A loss occurs if the amount paid is higher than expected.
- Benefits paid: Obligations are reduced when benefits are paid out.
- A projected benefit obligation (PBO) is an actuarial measurement of what a company will need at the present time to cover future pension liabilities.
- PBO assumes that the plan will not terminate in the foreseeable future and is adjusted to reflect expected compensation in the years ahead.
- Actuaries are responsible for calculating whether pension plans are underfunded.
Establishing whether a company has an underfunded pension plan can be achieved by comparing pension plan assets, the investment fund referred to as the fair value of plan assets, to the PBO. If the fair value of the plan assets is less than the benefit obligation, there is a pension shortfall. The company is required to disclose this information in a footnote in its 10-K annual financial statement.
PBO is one of three approaches firms use to measure and disclose pension obligations. The other measures are:
- Accumulated benefit obligations (ABO): Unlike PBO, accumulated benefit obligations (ABO) refers to the present value of retirement benefits earned by employees using current compensation levels.
- Vested benefit obligations (VBO): The portion of the accumulated benefit obligation that employees will receive, irrespective of their continued participation in the company's pension plan.
Real World Example of Projected Benefit Obligations (PBO)
Let’s take a look at the funded status of the pension plans for automaking giants Ford Motor Company (F) and General Motors Co. (GM). As of December 2018, General Motors’ U.S. pension plan had a PBO of $61.2 billion, with fair value of plan assets at $56.1 billion. In other words, this means its plan was 92% funded.
Meanwhile, Ford's U.S. benefit obligation at that date was $42.3 billion, while its plan assets had a fair value of $39.8 billion. That means Ford's plan was 94% funded, which is slightly better than its peer.
As of Dec. 31, 2018, U.S. pension plan assets totaled $56.1 billion, while projected benefit obligations totaled $61.2 billion, giving an average funding ratio of 91.7%, up from 91.5% a year earlier.
Criticisms of Projected Benefit Obligations
Although a PBO is classified as a liability on the balance sheet, there is considerable criticism about whether it meets the predefined criteria to be defined as such. These criteria are the responsibility to surrender an asset from the result of the transactions taking place at a specified future date, the obligation for a company to surrender assets for the liability at some future point in time, and that the transaction resulting in the liability has already taken place.
Actuarial losses are treated differently by the Internal Revenue Service (IRS) and the FASB.