FM11 Ch 29 Pension Plan Management

Pension plan terminologyDefined benefit versus defined contribution plans Pension fund investment tactics Retiree health benefits CHAPTER 29 Pension Plan Management... Defined contr

Pension plan terminology

Defined benefit versus defined contribution plans

Pension fund investment tactics

Retiree health benefits

CHAPTER 29

Pension Plan Management

They constitute the largest class of investors.

They hold about 33% of all U S

stocks.

How important are pension funds?

Defined benefit plan: Employer agrees

to give retirees a specific benefit,

generally a percentage of final salary.

Defined contribution plan: Employer

agrees to make specific payments into

a retirement fund, frequently a mutual fund Retirees’ benefits depend on the investment performance of their own

fund 401(k) is the most common type.

(More )

Profit sharing plan: Employer

payments vary with the firm’s profits (Defined contribution, but as a

percentage of profits).

Cash balance plan: Employer

promises to put a specified

percentage of the employee’s salary into the plan, and to pay a specified

return on the plan’s assets.

(More )

Vesting: Gives the employee the

right to receive pension benefits at

retirement even if he/she leaves the company before retirement.

Deferred vesting: Pension rights are not vested for the first few years.

Portability: A “portable” pension

plan can be moved to another

employer if the employee changes

jobs.

(More )

Fully funded: Value of plan assets

equals the present value of expected

retirement benefits.

Underfunded: Plan assets are less than the PV of the benefits An “unfunded

liability” is said to exist.

Overfunded: The reverse of

underfunded.

(More )

used to find the PV of expected

benefits (discount rate).

at which the fund’s assets are

assumed to be invested.

Employee Retirement Income

Security Act (ERISA): The federal law

governing the administration and

structure of corporate pension plans.

(More )

Pension Benefit Guarantee Corporation (PBGC):

A government agency created by

ERISA to ensure that employees of

firms which go bankrupt before their defined benefit plans are fully funded will receive some minimum level of

benefits.

However, for high income employees (i.e., airline pilots), PBGC pension

payments are often less than those

promised by the company.

Financial Accounting Standards

Board (FASB), together with the SEC, establishes rules for reporting

pension information.

Pension costs are huge, and

assumptions have major effect on

reported profits.

Who establishes guidelines for

reporting pension fund information on

corporate financial statements?

Defined Contribution Plan :

The annual contribution is shown

as a cost on the income statement.

A note explains the entry.

Defined Benefit Plan :

The plan’s funding status must be reported directly on the balance

sheet

How are pension fund data reported

in a firm’s financial statements?

(More )

The annual pension contribution

(expense) is shown on the income

The annual pension contribution is

tied to the assumed actuarial rate of return: the greater the assumed

return, the smaller the contribution.

Data/Assumptions :

Employee begins work at 25 , will work

40 years until 65 , and then retire.

Employee will live another 15 years , to

age 80 , and will draw a pension of

$20,000 per year.

The plan’s actuarial rate of return is 10% .

Given the following data, how much must the firm contribute annually (at year-end) over the employee’s working life to fully

fund the plan by retirement age?

Step 1 Determine the amount the firm must have in the plan

at the time the employee retires It is $152,122.

15 10 20,000 0 Compute PV = $152,121.59

N I PV PMT FV Input 15 10 20000 0

Output 152,122

N I PV PMT FV Input 40 10 0 152122

Output 343.71

Step 2: Determine the annual contri- bution during the employment

years With $152,122 to be accumulated, the answer is

$343.71.

0 40 55 Years Dollars

($000)

Don’t know how long the employee will work for the firm (the 40 years).

Don’t know what the annual pension

payment will be (the $20,000).

Don’t know what rate of return the

pension fund will earn (the 10%).

A large number of employees creates complexities, but it also reduces the

aggregate actuarial uncertainty.

Pension fund management is much

more complex than this illustration.

Defined benefit plan: Most risk falls

on the company, because it

guarantees to pay a specific

retirement benefit regardless of the

firm’s profitability or the return on

the plan’s assets.

sponsor and plan beneficiaries under

the four types of pension plans?

(More )

Defined contribution plan: Places

more risk on employees, because

benefits depend on the return

performance of each employee’s

chosen investment fund.

Profit sharing: Most risk to

employee, least to employer

Company doesn’t pay into fund

unless it has earnings, and

employees bear investment risk.

(More )

Cash balance: “Middle of the road”

in terms of risk for both employer

and employee Employer’s payment obligations are fixed and known,

while employees are guaranteed a

specified return.

Large, more mature companies (and governments) tend to use defined

What type of companies tend to

have each type of plan?

Usually set up as a 401(k) plan.

Employees make tax-deductible

contributions into one or more

investment vehicles (often mutual

funds) established by the company.

Company may make independent or matching contributions.

contribution or a profit sharing plan, how are the assets administered?

Defined benefit plans are more costly to firms when older workers are hired The firm has a shorter time to accumulate

the needed funds, hence must make

larger annual contributions.

Does the type of pension plan influence the possibility of age

discrimination?

Since women live longer than men, female employees are more costly under defined benefit plans.

influence the possibility of sex

discrimination?

How does the type of pension

plan influence employee

training costs?

Defined benefit plans encourage

employees to stay with a single

company, hence they reduce

training costs.

Vesting and portability facilitate job shifts, hence increase training

costs.

Benefits paid under defined benefit

plans are usually tied to the number of years worked and the final (or last few) year’s salary Therefore, unions are

more likely to work with a firm to

ensure its survival under a defined

benefit plan.

influence the militancy of unions when

a company faces financial adversity?

How fast should any unfunded liability be reduced?

What rate of return should be

assumed in the actuarial

calculations?

What are the two components of a

plan’s funding strategy?

To structure the portfolio to minimize the risk of not achieving the

assumed actuarial rate of return.

A low risk portfolio will mean low

expected returns, which will mean

larger annual contributions, which

hurt profits.

plan’s investment strategy?

Alpha analysis : Compare the

realized return on the portfolio with the required return on the portfolio.

Comparative analysis: Compare the manager’s historical returns with

other managers having the same

investment objective (same risk

profile).

How can a company judge the mance of its pension plan managers?

perfor-This occurs when a company terminates

an overfunded defined benefit plan ,

uses a portion of the funds to purchase annuities which provide the promised

pensions to employees, and then

recovers the excess for use by the firm.

First used by corporate raiders after

takeovers, with proceeds used to pay

down takeover debt.

pension fund assets?

Some people believe that pension fund assets belong to employees, hence

tapping “robs” employees (Excess

funds make it easier to bargain for

higher benefits.)

Courts have ruled that defined benefit plan assets belong to the firm, so firms can recover these assets as long as

this action does not jeopardize current employees’ contractual benefits.

Why is “tapping” controversial?

Because of the increased number of retirees, longer life expectancies,

and the dramatic escalation in health care costs over the last ten years,

many firms are forecasting that

retiree health care costs will be as

high, or higher, than pension costs retiree health benefits over the

last decade?

 Before 1990, firms used pay-as-you-go

procedures which concealed the true

liability.

retiree medical benefits.

account for vested future medical benefits.

assess their retiree health care liability

Many are now cutting benefits.

How are retiree health benefits

reported to shareholders?