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On the right, we show the basic calculation of the projected benefit obligation (PBO), which is an estimate of the future stream of benefit obligations discounted to the present value into a single number. For clarity's sake, we omitted a few items.
In the annual report, you will see two other measures of estimated future obligations: the vested benefit obligation (VBO) and the accumulated benefit obligation (ABO). You do not need either of these for the purposes we discuss here, but ABO is less than PBO because it assumes that salaries will not rise into the future, while PBO assumes salary increases. VBO is less than ABO because it counts only service already performed, but PBO counts the future service (minus turnover assumptions). PBO is the number that matters because it's the best guess as to the present value of the discounted liabilities assuming the employees keep working and salaries keep rising.
By subtracting the PBO from the fair value of the plan assets, you get the funded status of the plan. This is an important number that will be buried somewhere in the footnotes, but it must be disclosed.
Breaking Down the Funded Status of the Plan
Let's look at an actual example. We will use data from the annual report 10-K for PepsiCo (ticker: PEP) for the year ended December 31, 2003. Although its pension plan happened to be under-funded at that time, it can be considered relatively healthy--especially compared to other companies. We picked PepsiCo because the company's plan is well-disclosed and its 10-K contains helpful commentary.
Below is the part of the footnote that calculates the fair value of the plan assets. You can see that the pension fund produced an actual return of 7.9% in the year 2003 ($281 / $3,537). Other than the investment returns, the largest changes are due to employer contributions and benefit payouts:
Now take a look at the calculation of the PBO (see below). Whereas the fair value of
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