Projected Unit Credit Method: Calculation & Reporting

The Projected Unit Credit method is an actuarial valuation approach companies use to measure the obligation of a defined benefit pension plan. Its primary function is to calculate the present value of the pension benefits that employees have earned for their service to date. This method is a requirement for financial reporting under U.S. Generally Accepted Accounting Principles (GAAP) via ASC 715 and International Financial Reporting Standards (IFRS) via IAS 19.

Core Concepts of the Calculation

The Projected Unit Credit method is built on attributing a portion of the total projected pension benefit to each year of an employee’s service. This can be visualized as building a wall one brick at a time, where each year of work adds another “unit” of benefit to the employee’s total retirement package. This approach ensures that the cost of the pension is recognized over the employee’s entire service period rather than all at once at retirement.

A defining feature of this method is its use of projections. The calculation does not rely on an employee’s current salary but instead projects what their salary will be at their expected retirement date. This projected future salary is then used to determine the value of the benefit units earned.

Central to the calculation is the principle of present value. A promise to pay a pension benefit many years in the future is worth less in today’s dollars. The method uses a discount rate to translate future estimated payments back to their equivalent value on the current reporting date.

Key Actuarial Assumptions Required

To perform the calculation, actuaries must rely on several assumptions about future events. The selection of these assumptions has a significant impact on the final pension obligation figure.

One of the most influential inputs is the discount rate, used to calculate the present value of future benefit payments. Under ASC 715, this rate is determined by referencing market yields on high-quality corporate bonds with durations matching the expected pension payments. A higher discount rate results in a lower pension obligation, while a lower rate increases the liability.

Another assumption is the rate of future salary increases. This projects the annual growth in employee compensation until retirement, factoring in inflation, seniority, and promotions. A higher assumed salary growth rate leads to a larger projected final salary, which increases the pension benefit’s value.

Assumptions about employee demographics are also necessary for the calculation:

• The employee turnover rate estimates the percentage of employees who will leave the company before they become fully vested in the pension plan.
• The mortality rate, based on standard tables from actuarial bodies, predicts how long retirees will live and therefore how long pension benefits will need to be paid.
• The expected retirement age assumption estimates when employees will choose to stop working and begin receiving benefits.

The Calculation Process Step-by-Step

The calculation process for the Projected Unit Credit method follows a structured sequence to determine the pension obligation for an employee.

Project Salary at Retirement

The first step is to project an employee’s salary at retirement. This is done by taking the employee’s current salary and applying the assumed annual salary growth rate over the number of years remaining until their expected retirement. For instance, if an employee earns $80,000 today and is 20 years from retirement with an assumed 3% annual salary growth, their projected final salary would be calculated by compounding that growth over the 20-year period.

Calculate the Total Pension Payment

Next, the total annual pension payment the employee will receive upon retirement is calculated. This step uses the pension plan’s specific formula, which is often based on years of service and final salary, such as “1.5% multiplied by years of service, multiplied by final salary.”

Allocate the Benefit into Units

Once the total pension benefit is determined, it is allocated into equal units for each year of the employee’s service. If an employee is expected to work for 30 years, the total annual pension is divided by 30, which assigns a portion of the benefit to each year.

Calculate the Present Value of Earned Benefits

The final step is to calculate the present value of the benefit units earned to date. This involves discounting the value of the earned units back to the current date using the selected discount rate. The resulting figure is the Projected Benefit Obligation (PBO).

Financial Reporting Implications

The outputs from the Projected Unit Credit calculation directly impact a company’s financial statements. The Projected Benefit Obligation (PBO), valued using projected future salaries, is recorded as a long-term liability on the company’s balance sheet, reflecting the financial obligation for future pension payments.

Several components are reported as expenses on the income statement. The service cost is the present value of the benefit unit earned by all employees during the current year. The interest cost represents the increase in the PBO due to the passage of time and is calculated by multiplying the PBO at the beginning of the year by the discount rate.

Changes in the PBO from adjustments to actuarial assumptions are known as actuarial gains and losses. For example, if a company lowers its discount rate assumption, the PBO will increase, resulting in an actuarial loss. Under ASC 715, these gains and losses are not immediately run through the income statement.

Instead, they are recorded in a separate component of equity called Other Comprehensive Income (OCI), which reduces volatility in net income. These gains and losses stored in OCI are then amortized into the income statement over the average remaining service life of the employees, smoothing their impact on earnings.