Vested Benefit Obligation (VBO)

What is Vested Benefit Obligation (VBO)?

Vesting means you have acquired adequate service credit and are eligible for a pension once you attain the minimum age as per your retirement plan. Unlike other office procedures, vesting does not require writing emails, signing documents, or handling paperwork. It is automatic.

Vested Benefits include all benefits accumulated before T-Day (plus all investment returns on those accumulated benefits, up to retirement date) for members below the age of 55 on T-Day.

In the case of members above the age of 55, it consists of all benefits accumulated before T-Day, and contributions made to that same fund after T-Day, including returns on investment in the benefits and contributions accumulated till the retirement date.

It is different from non-vested benefits. In vested benefits, the employer and employees contribute to the fund; in non-vested benefits, the employer does not contribute to the plan.

In the case of members below the age of 55 on T-Day, all contributions in the provident fund after T-Day, including returns on investment in the benefits and contributions accumulated till the retirement date, will also constitute non-vested benefits.

Contributions are net of fees, charges, or risk premiums which will be distributed among the members 'Vested Benefits' or 'Non-Vested Benefits.'

Now, let's understand benefit obligations. Benefit Obligations mean all obligations that provide benefits as compensation for services rendered to present or former directors, employees, or agents.

Vested Benefit Obligation (VBO) refers to the actuarial present value of the payment that an entity expects to pay under the retirement benefit plan. It is calculated using current salary levels of vested benefits only.

It is the calculation of a company’s payment obligation that it has to pay to its retired employees subsequently. It is widely used as one of the indicators of a company’s pension liability.

To ensure a fair payment system, vested benefit obligation should be directly proportional to seniority, i.e., more senior employees will have a more significant vested benefit obligation than a company with newer employees.

VBO ensures this as it is typically associated with multi-year cliff vesting. Multi-year cliff vesting means workers can get ownership of shares after a decided period instead of receiving them partly.

For instance, if the vesting is for 3 years, the worker will get total ownership of shares at the end of the 3rd year. Hence instead of getting ownership year after year, workers get full at the end of 3rd year. VBO covers part of the amount the employee is eligible to receive today, i.e., to date.

Understanding Vested Benefit Obligation

When discussing a pension plan, we can never conclude whether it will return a good amount. It's like figuring out if a fresher who has started investing in stocks will become Warren Buffet someday.

Pensions include contributions from both employees and employers. The accumulated funds are then used to generate more money. Eventually, the pension plan starts remitting as people retire. The remittance supports the employees in their old age.

There are two sides to a coin (heads and tails in general language), carrying their respective intricacies. On one side of the coin, you have the amount of money the pension will have; on the other, you have an estimate of what the plan pays out in the form of benefits.

The two sides of the coin can also be described in another way. One side of the coin represents the plan's future assets, while the other represents the pension plan's liabilities. The vested benefit obligation refers to money the company owes.

Vested Benefit Obligation Example

To further understand, let us take an example: suppose you are an investment banking analyst. You are a part of the investment banking community. Your annual salary is $82,000 a year.

At 20 years as a full-time investment banking analyst, you are entitled to a pension of half your annual salary ($41,000 a year).

You will be getting the pension at age 65, and it will last till the day you die. At 30 years as an investment banker, you qualify for a 3/4 pension, or $61,500 a year.

You've been on the job for 27 years. You're bored with this job and want to become a content creator. So you quit.

You've crossed the age of 20, enabling you to get 50% of your pension. However, you are still in your 20s’ and haven't touched the age of 30, forbidding you 75% of the pension (loss of 25%).

So, they would use the $41,000-a-year measure for the Vested Benefit Obligation calculation. It kicks in when you turn 65.

Based on life expectancy charts, they estimate you'll receive a pension for 20 years. The pension plan, therefore, needs $820,000 ($41,000 * 20) for your benefits.

VBO Measurement Approach & Requirement

There are a few methods people use to calculate pension plan payout. These approaches are required to trail the plan's financial health. They help measure how balanced it is financially.

FASB Statement of Financial Accounting Standards No. 87 requires firms to measure and disclose pension obligations and the overall financial health of their plans at the end of each accounting period.

FASB Standard 87 states that the firm should measure pension cost periodically and then allocate it over the period the employee will serve, taking an approximate period based on the firm’s judgment.

Standard 87 also mandates the firm to recognize a liability and provide disclosures. The standard believes it will be easier to understand and compare pensions by allocating pensions calculated periodically over the service period of the worker.

Firms use three approaches to measure obligations, namely: 

• Vested benefit obligation (VBO)
• Accumulated benefit obligation (ABO) 
• Projected benefit obligation (PBO)

The Employee Retirement Income Security Act (ERISA) of 1974 requires companies to vest benefits using either of the following two approaches:

• Employee’s pension benefits must be completely vested in a maximum of five years, 
• For the first 20% of the employee's pension benefits, a company can choose to vest it in three years or less, and the rest 80% by vesting 20% per year after seven years of service. 

Since minimum vesting requirements are generally five years, the values of the vested and accumulated benefit obligations are veritably near in almost all pension plans.

Vested benefit obligation refers to the benefit that has been vested, i.e., the company owes the amount to the employee (the amount is due now). Accumulated benefit obligation, on the other hand, refers to the present value of benefits due or not.

Generally, the accumulated benefit obligation (ABO) and VBO values must be bared at financial year-end. In cases where the values are nearly analogous, companies' fiscal statements show the ABO value only. They do so by stating that the difference between VBO and ABO values is immaterial.

VBO for a Benefit Pension Plan

Sometimes, the actuarial present value of benefits that an employee will get at the end of their service period may be less than the actual value of benefits that the employee will get when he quits before his withdrawal date.

This happens under some defined benefit pension plans (generally foreign plans).

a. Illustration 1

The provisions of the Italian severance pay enactment state that the accumulated employees’ benefit for service given till the date of termination is outstanding on the date of termination.

The value of that benefit's outstanding presently, not the actuarial present value, would exceed the present value of future contingent cash flows of that benefit if payment is made on the anticipated withdrawal date.

b. Illustration 2

In the United Kingdom, legislation states that deferred vested benefits of terminated employees be lawfully revalued from the date of separation to the normal retirement age.

If this is followed, VBO could exceed the accumulated benefit obligation (ABO), provided that obligation is measured considering a legal revaluation only after the employee's expected termination date.

The issue is whether:

• The VBO is the actuarial present value of the vested benefits to which the worker is entitled if the worker separates instantly (Approach 1) or 
• The actuarial present value of the vested benefits to which the employee is presently entitled but based on the worker’s anticipated date of separation or retirement (Approach 2).  

Let us have a discussion on the Emerging Issues Task Force (EITF):The Task Force concluded that both approaches are acceptable for situations not specifically addressed by Statement 87. The SEC Observer noted that the method used should be bared.

A FASB staff representative indicated that the FASB staff had acknowledged technical queries by stating that Approach 1 should be used to determine the VBO. This is because it is not subjected to future service.

Several Task Force members indicated that Approach 2 is more consistent with their view of the intent of Statement 87, which bases the measurement of pension obligations on actuarial expectations.

And what is the current status? No conversations or meetings of ETIF are planned for the future.

VBO Vs. ABO Vs. PBO

PBO calculates the total amount the company needs to meet future liabilities. It provides the present value of payments that will be made in the future as part of employees' pension plans.

The PBO approach This means that it will include all the expected payments the employee will receive. Here, in the PBO approach, payments refer to salaries. This is because the pension is calculated based on current and foreseeable salaries.

Actuaries are accountable for using the projected benefit obligation (PBO) to calculate whether or not pension plans are uneconomic and unprofitable.

ABO estimates a pension plan liability at any given time in the company. If the accumulated benefit obligation (ABO) is above the pension plan's assets, the plan is underfunded; if it is below the pension plan's assets, the plan is overfunded.

Uneconomic/unprofitable or overly profitable(providing more than required) status can be altered by the discount rate used and the expected return on the assets the plan money is put into.

VBO, PBO, and ABO are not shown directly in the balance sheet. These are shown as footnotes.

To summarize, VBO is the amount due at the time of retirement. The main difference between ABO and PBO is that, unlike ABO, PBO is not calculated on the current salary. ABO does not include foreseeable increments in salary.

Researched and authored by Shambhavi Himatsingka | LinkedIn

Reviewed and edited by Parul Gupta | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Earned Income
• Gross Pay
• Honorarium
• Phantom Stock Plan
• Vesting Benefit