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The term vested benefit obligation is used to signify the actuarial present value of a retirement plan. The retirement or pension plan in question is the one earned by employees, and may also commonly be used as one of the measures of the pension fund liability of a company.
The term vested benefit obligation (VBO) is used to signify the actuarial present value of a retirement plan.
VBO only covers the amount that the employee is entitled to, regardless of whether or not they continue to participate in the pension plan of the company.
There are three approaches used for pension planning, namely accumulated benefit obligation, projected benefit obligation, and vested benefit obligation.
Measuring Pension Obligations
According to the Financial Accounting Standards Board (FASB), a company can measure its financial obligations pertaining to pension planning using either of three approaches. The approaches include Accumulated Benefit Obligation (ABO) and Projected Benefit Obligation (PBO), in addition to the VBO. The standards also need to be adhered to while disclosing the year-end financial conditions of the pension fund, and the performance of the plans in it. It is required of all companies under FASB Statement of Financial Accounting Standards No. 87.
The ABO represents a company’s pension plan liability at any given time. It is an approximation, which is calculated such that it does not consider any future salary increases. Thus, it assumes that the plan is going to be terminated immediately.
A PBO, on the other hand, considers all pension entitlements that an employee may be eligible to receive. It means that the projection accounts for future salary increases as well. Thus, it provides an actuarial measurement of the funds needed by the company at present in order to meet future liabilities related to the pension plan of employees.
The VBO is only a portion of the total accumulated benefit obligation that an employee may be eligible to receive. It only covers the amount that the employee is entitled to, regardless of whether or not they continue to participate in the pension plan of the company. Thus, it represents only that portion of the benefit that’s vested.
According to the Employee Retirement Income Security Act (ERISA), which came into effect in 1974, companies are required to vest benefits in either of two ways. According to the first approach, pension benefits are to be fully vested within five years.
Alternatively, for up to three years of services, the company can vest 20% of the total benefit. Then, it must vest 20% per year until the completion of seven years of service. It means that the employee is vested completely into the program.
Usually, minimum vesting requirements are pinned at five years. Due to such a fact, one can assume that there WILL hardly be any difference in the values of the ABO and the VBO in most pension plans. In situations where the values of the two are almost the same, companies are permitted to show only the ABO value in their financial statements. The company may state here that the VBO and ABO values are not different materially.
Example of a Vested Benefit Obligation
Consider a situation where an employer offers a dollar-for-dollar annual matching contribution of up to 5% to the pension account of the employee, X. During their tenure at the company, X contributes the full 5%, but leaves after just two years. The total account balance at the time of termination of employment is $10,000. ($5,000 contributed by X, and $5,000 contributed by the employer).
Assuming that X’s plan vests on a five-year graded schedule, which means they receive 20% ownership per year and 100% ownership only after five years.
After two years, X’s benefits will only be 40% vested, which means out of their $5,000 contribution, they are only eligible to receive $2,000. They will need to wait another three years in order to receive the remaining $3,000. Here, it makes sense for X to leave the company, given that the tradeoff in terms of time is too significant.
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