Can someone explain pension accounting -- PBO, plan assets, and funded status?
Pension accounting for CFA Level II is incredibly dense. I need help understanding the projected benefit obligation (PBO), how plan assets work, what the funded status represents, and how pension expense flows through the income statement.
Pension accounting is one of the most complex FRA topics at Level II. Let's break it down systematically.
Key Components:
PBO Changes During the Year:
| Component | Effect on PBO |
|---|---|
| Service cost | Increases PBO (new benefits earned) |
| Interest cost | Increases PBO (discount rate x beginning PBO) |
| Actuarial losses | Increases PBO (assumption changes) |
| Actuarial gains | Decreases PBO |
| Benefits paid | Decreases PBO |
| Past service cost | Increases PBO (retroactive benefit changes) |
Plan Asset Changes:
| Component | Effect on Plan Assets |
|---|---|
| Actual return on assets | Increases (if positive) |
| Employer contributions | Increases |
| Benefits paid | Decreases |
Pension Expense (Income Statement):
Under both IFRS and US GAAP, the total periodic pension cost has three components, but they are reported differently:
US GAAP:
| Component | Where Reported |
|---|---|
| Service cost | Operating income |
| Interest cost | Below operating (or footnote) |
| Expected return on plan assets | Below operating (credit) |
| Amortization of prior service cost | Below operating |
| Amortization of net actuarial loss | Below operating |
IFRS (IAS 19R):
| Component | Where Reported |
|---|---|
| Service cost | Income statement (P&L) |
| Net interest cost (PBO - Plan Assets) x rate | Income statement (P&L) |
| Remeasurements (actuarial gains/losses) | OCI (never recycled) |
Worked Example -- Stonebridge Pension Plan:
Beginning of year: PBO = $800M, Plan Assets = $700M
Discount rate: 5%, Expected return on assets: 6%
| Item | Amount |
|---|---|
| Service cost | $25M |
| Interest cost (5% x $800M) | $40M |
| Expected return (6% x $700M) | ($42M) |
| Actual return | $50M |
| Contributions | $30M |
| Benefits paid | $35M |
US GAAP Pension Expense:
$25M + $40M - $42M = $23M (excluding amortizations)
Ending PBO: $800M + $25M + $40M - $35M = $830M
Ending Plan Assets: $700M + $50M + $30M - $35M = $745M
Funded Status: $745M - $830M = ($85M) (underfunded)
The actuarial gain = Actual return ($50M) - Expected return ($42M) = $8M, reported in OCI under US GAAP.
Exam Tip: Be prepared to reconcile PBO and plan assets from beginning to ending balances, calculate pension expense, and determine the funded status on the balance sheet.
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