What it means
A defined benefit pension promises a retirement income based on a formula, typically a percentage of salary for each year of service. Because those payments happen decades in the future, the promise has to be converted into a single present value figure before it can sit on a balance sheet.
The ABO does that conversion using current salaries only. Its sibling measure, the projected benefit obligation, does the same sum but assumes salaries keep rising until retirement, which is why the projected figure is almost always the larger of the two.
The gap between them is not academic. If a company freezes its plan so no further benefits build up, the projected obligation collapses towards the ABO, which is exactly why acquirers, trustees and regulators look at the ABO when they want a floor on what the plan owes.
Calculating it involves three steps: work out the annual pension each member has already earned using today's salary, value that stream of future payments as at the retirement date, then discount it back to today at the plan's chosen discount rate. Actuaries add mortality assumptions, early retirement patterns and vesting rules, but the skeleton of the calculation is that simple.
The number moves a lot when the discount rate moves, which catches people out. A one percentage point rise in the discount rate can cut a long-dated pension obligation by roughly a tenth, so a plan can look dramatically better funded without a single thing changing about the promises themselves.
In practice
Real-world examples.
Example
A manufacturer decides to close its defined benefit plan to future accrual. Its actuary explains that once the freeze takes effect the projected obligation and the ABO become the same number, because there are no future salary increases left to project into the benefit formula.
Example
A private equity buyer running due diligence on a family engineering group finds an ABO of $46 million against plan assets of $41 million. The $5 million shortfall becomes a direct deduction from the price offered, because the buyer treats it as debt that comes with the business.
Example
A pension committee is told that a rise in the discount rate from 4.5% to 5.5% has cut the reported obligation from $210 million to $189 million, a 10% fall. The chair reminds the board that the members are owed exactly the same pensions as before, so the improvement is a measurement effect rather than a real gain.
Formula
Calculation
ABO = present value of (benefit percentage x years of service to date x current salary), discounted from the expected payment dates back to today
Consider an employee earning $80,000 today, in a plan that pays 1.5% of salary for each year of service, who has completed 20 years and will retire in 10 years' time. Assume the pension is paid for 20 years after retirement and the discount rate is 5%.
Annual pension earned to date = 1.5% x 20 x $80,000 = $24,000 a year
Annuity factor for 20 years at 5% = (1 - 1.05 to the power -20) / 0.05 = 12.4622
Value of the pension at the retirement date = $24,000 x 12.4622 = $299,093
Discount back 10 years: 1.05 to the power 10 = 1.6289
ABO today = $299,093 / 1.6289 = $183,617
So this single member contributes about $183,617 to the plan's accumulated benefit obligation. Add every member together and you have the plan total.Case study
Seen in the real world.
Harlow Pressings is an illustrative and entirely invented metal components business with an old defined benefit scheme covering 400 former and current staff. Its most recent actuarial report showed an ABO of $58 million, a projected benefit obligation of $71 million, and plan assets of $52 million.
The board had been focusing on the projected figure, which implied a $19 million hole and made every discussion feel hopeless. The scheme actuary pointed out that the $13 million difference between the two measures existed only because the plan assumed decades of future pay rises for members still accruing benefits.
Harlow chose to close the scheme to future accrual and give affected staff a defined contribution arrangement instead. The measured shortfall fell towards the $6 million ABO gap, the annual deficit contributions became affordable, and the company could finally set a recovery plan the bank was willing to lend against.
Watch out
Common mistakes.
- Assuming the ABO is the amount the company must pay into the plan this year. It is a present value of promises already earned, not a cash contribution schedule, and the two are set by completely different rules.
- Comparing one company's ABO with another's without checking the discount rate. Two identical plans can report obligations tens of percentage points apart purely because of different assumptions.
- Treating the ABO as the full cost of a plan that is still open. As long as members keep working and earning pay rises, the projected benefit obligation is the more realistic measure of where the liability is heading.
Questions
People also ask.
Is the ABO the same as the wind-up or buyout cost?
No, a buyout price charged by an insurer is usually higher because it includes a margin for risk and profit that the accounting measure does not carry.
Why does the ABO exclude future salary increases?
Because it is designed to measure only what has already been earned under the benefit formula, which makes it a cleaner floor for the liability.
Does the ABO apply to defined contribution plans?
No, in a defined contribution plan the account balance is the liability, so there is nothing to project or discount.
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