I’ve never seen a question asking you to calculate PBO using a timeline, e.g. 2% final salary, retire in 20 years, then find the PBO.
The LOS is pretty ambiguous about this. I’ve only seen this once in blue box examples.
Did anyone see questions asking you to calculate PBO using this method?
A timeline is not a method. It is a tool to visualize valuation methods, be it bond, equity, private equity, swap or any other valuation.
Calculating PBO is out of scope of the exam, but you need to understand the inputs used to calculate PBO (just like the components of the BS model).
I just couldn’t think of another better way to describe this method.
Are you sure calculating PBO is out of scope? Because in LOS 19b. It says “explain and calculate measures of a defined benefit pension obligation (i.e. present value of the defined benefit obligation and projected benefit obligation) and net pension liability (or asset)”.
I really don’t understand the scope of “calculate” this LOS covers. It seems like it means we need to calculate PBO using the timeline method?
Take my word and bet your house on it.
It’s not out of scope of exam, in CFAI Mock you are required to calculate PBO at the end of second year.
IMO, this is ordinary finance maths from L1.
Is there a simple way to memorise all the steps required to find the PBO? It seems like a bloody long process.
It’s not. Practice 10 times (est. no longer than 10 minutes) until you find you are able to solve it in-the fly…
I have not come across a question that asks you to calculate it, but even if it does, its just a multistage TVM problem.
There was a practice topic portal question last year that required a calculation of a closing obligation using the projected unit credit method over a couple of years. I know because I created a note sheet based on it. It was pretty simple though, where the only costs were current service and interest costs and it was a new plan so the opening PBO was zero. The key to these is using the correct number of years to retirement to calculate estimated final salary (assuming it’s a factor in the benefit formula), the annual unit credit and number of years used to discount the annual unit credit to determine the current service cost.
I’m doubtful something like this would make it to the exam, but I would say it’s still fair game. One of the LOS bullets for the reading refers to calculating a projected benefit obligation.
Tried to do it in the mock exam, had no idea how to do it even though I’ve practised with the textbook example. A lot of tricks in that question in the mock exam, why did they give you the estimated final salary, and current salary with annual wage increase %? Then how do you know which one to use?
Funny, I haven’t done the mock yet, but I just pulled it up and it’s the same as the sample I have from last year’s topic tests that I mentioned above. I don’t know why they give both the current salary and the salary growth rate when they already give the estimated final salary. It might be distractor information to trip you up. The bottom line is, you only need the estimated final salary for this problem. If it was not given, it could be calculated as $60,000x(1+0.035)^5.
Here are the important details:
Smith just started, so the terms of the new collective bargaining agreement apply to him. Years until retirement = 6, Estimated Final Salary (given) = $71,261, Estimated years in retirement = 25
From here your goal is to get to the Annual Unit Credit, which is found by applying the benefit formula to find the annual payment in retirement, find the PV of those payments, then divide that by the years until retirement.
Benefit formula = 1.75% x Final Salary x # of years of service under the plan = 1.75% x $71,261 x 6 = $7,482.41
PV of future payments (N =25, I = 7.5%, PMT = $7,482.41, CPT PV) = $83,405.96.
Annual unit credit = PV of future payments / # of years of service under the plan = $83,405.96 / 6 = $13,900.99. This is the undiscounted Current Service cost that applies to each individual year of service. To calculate the actual Current Service cost you find the PV of the annual unit credit.
For year 1 (2014) the opening obligation starts at 0, so there are no interest costs, only the current service cost. The PV of the annual unit credit for 2014 is $13,900.99/(1+0.075)^5 = $9,692.85. You use 5 here because you are discounting back to the END of Year 1 to find the ending obligation. $9,682.85 is the opening obligation for Year 2, so this amount incurs an interest cost of 7.5% (given discount rate). $9,682.85 x .075 = $726.21. Then we need to add our Current Service cost for Year 2. $13,900.99/(1+0.075)^4 = $10,409.07.
Opening Obligation + Current Service Cost + Interest Cost = Ending Obligation.
$9,682.85 + $10,409.07 + $726.21 = $20,818.13 at the end of Year 2.
Hello- I feel like the above answer and method of calculating is very different from the way PBO is calculated in the Schweser book p 38. Schweser doesn’t multiply the initial annual payment by 6 but rather by 1 for the first year and 2 for the second year. Why are we multiplying here by 6 and not by 1? 1.75% x $71,261 x 6 = $7,482.41?