Linking Pension Liabilities to Assets (#16) Future Wages

Totally confused about future wages.

Schweser book 2, page 56, 5th pargraph down, “The second component of future benefits is from future services rendered.”

They’ve already described the first component of future benefits as being from wages to be earned in the future.

How are these two components any different? The curicullum, btw, is just as confusing!

wages -> paid by the hour / salary…This has a component of inflation required -since wages must increase over time in order to cover the cost of living increases…There .is also a growth component - person being paid a wage - the company becomes profitable - pays the person more…

services - they talk of it - in the curriculum - it looks and feels like someone being paid a % of their wage for a specific task.


Just like the volatility of future wage benefits, the volatility of future service benefits is linked to wage growth. As wages grow, the service accruals granted will be based on higher wages, and thus the corresponding benefit payment will be higher. But in reality this portion of the liability is often not included in the fund- ing target and relatively uncertain. Hence, it should be excluded from the invest- ment benchmark.(page/492).

Given a specific number cannot be assigned to this component - it is left out of the lnvestable benchmark.

My thought was that services was similar to years worked, while wages referred to the final salary that the individual recieved in their last year of service. So, the pension is both a function of # of future years worked and the wages to be paid.

that would not make sense. From what I think - there is a component of the # of years worked - which is required for the Wage component too. So if Services were actually years worked - then how come that becomes “uncertain” if the wage component has the same component present and can be estimated actuarially?

After my original post I think I figured it out.

One of those wage increases is embedded in the PBO. As we all know from Level II, the PBO includes past service costs as adjusted for expected wage increases in the future (as contrasted with the ABO, which does not include those wage increases).

So I think one of those future wage items is actual future services, while the other is future wage rates for past services.

btw - CFAI explanation is on page 490 - 492 in Book 2.

Don’t think about this from the perspective of an individual recieving a pension payment (like we were taught to calculate in level 2), think about it from the perspective of the pension plan managers.

Wage related growth has to do with increases in wages. I think the calculation here is looking at each persons current years of service, estimating the # of years they have left, growing wage benefits but not giving them credit for those additional years worked. Someone who worked 15 years with a 100k salary would have a smaller pension than someone who worked 25 yrs with a 100k salary. So taking into account wage growth, but only looking at current benefits earned.

t’s unpredictable how many years a person will actually work. Each additional year worked increases the pension payout due to them (see page 492). That future service calc would try to predict how many total years the employee would work and the wage they would earn the last year. Instead of just increasing the liability due to them for each additional year worked.

This was my understanding too.

I agree with ftwcfa, but I look at future service from an aggregate of the firm and not an estimate of how long an employee will work.

For future service, in relation to the pension it doesn’t matter how long a person will work in the future because if they quit, they still need to be replaced with another worker. having one worker with 25 years service, is equivalent to two workers, one with 10 years, and another with 15 (assuming each year of service gets an equal increase in benefits). The issue is more in the expansion or contraction of the firm, if the firm does well in the future the plan will accrue more service cost in the aggregate because it will need more workers. the opposite is true for a firm that needs to contract. Since there are many reasons why a firm may expand or contract (cost cutting, market cycles, products coming into or out of favor) these service costs are extremely volatile and not able to be estimated for long periods in the future.

So future services rendered = years of service of all employees

Can anyone confirm?

I would take it take it from the start & see what i have understood

Decomposing the pension obligation

1) Inactive. Two parts here. a) Retirees - retired & currently receiving benefits b) Deferreds - Not retired, but not working in the company anymore. Company is owing their future benefits. Benefits are fixed then nominal bond portfolio.

2) Active - working with the company. Obligation can be decomposed into two parts. a) For past services. Known so Part B (deffereds) + this part = Accrued benefits. Accrued but not yet started paying off.

b) Future services (this is where the problem of understanding is) - are the benefits attributed to (i) future wages to be earned, (ii) future services to be rendered, and (iii) future entrants into the plan.

(i) Futures wages to be earned - this is current wages plus _ X% growth. _ If X% is known (assumed-provided by actuary) future benefits could be ascertained. PV of this future wage liability + Accrued benefits = Projected benefit Obligations (PBO)

(ii) Future entrants into the plan - Not known hence not modeled

(iii) Future services to be rendered - number of years in futures current - active employees will continue to work. IMO, here the company would pay benefits to these employes when they retire based on two things - a)length of service b) salary history at the time retirement. Say the formula company adopted is

  • X % multiplied to No of years of services of their avg of final last 3 year’s salary
  • Say 2% X 10 years x Average pay = 20% of the final salary as benefit every year

Since we neither know with certainity the year of services nor the final pay withdrawn by these employee, its difficult to model them. Also future services of future entrants is not known.

Rahuls with all do respect I think your post is a little over-involved and doesn’t really answer the question…