Risk mismatch b/w pension assets & liabilities is a significant problem.. Risk mismatch is of greatest concern if: Ratio of pension assets to the market cap of equity is high.. ACCOUNTI
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2013, Study Session # 5, Reading # 17
1 THE APPARENT ISSUEFUNDING SHORTFALL
Funding shortfall is a primary focus of the analysts, rating agencies & regulators
Risk mismatch b/w pension assets & liabilities is a significant problem
Balance sheet numbers are usually static & give no indication of risk
Risk mismatch is of greatest concern if:
Ratio of pension assets to the market cap of equity is high
Greater allocation to equities A&L = Assets & Liabilities
2 ACCOUNTING FOR VALUE MISMATCH AND RISK
Share prices reflect the value of pension surpluses or shortfalls
Companies with larger pension deficits appear to trade at lower P/E & P/B ratio
Stock markets pick up the difference in risk
Equity heavy pension plans seemed to show up in more volatile stock prices
Calculating the WACC (assumptions):
Project in question has roughly the same operating risk
Project has same leverage ratio
Pension risk should be incorporated into WACC
Companies distort operating risk measures by failing to incorporate pension A&L:
Leverage ratio is understated
Overstate WACC for an operating project
If a pension-adjusted leverage ratio is used, the unleveraged operating β for most companies would fall
3 STRATEGIC ANALYSIS AND POLICY DEVELOPMENT
Integrated enterprise-wide approach ⇒ views pension A&L as part of the firm’s comprehensive economic & risk balance sheet
Risk budget ⇒ by risks in the pension fund, the firm is able to take more risk in its operating businesses
Conventional analysis ⇒ major shift of pension assets from stocks to bonds would reduce reporting earnings
Economic analysis ⇒ equity risk & the risk of overall firm ∆ when a firm alters the mix of its pension assets b/w F.I & equities
Effects of Pension Change on Optimal Capital Structure
As pension asset allocation is changed, the capital structure is affected
To the risk of total assets, we have to leverage (keep of equity unchanged)
If a firm shifts its pension assets from stocks to bonds, the amount of equity capital needed to maintain equity risk would fall
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2013, Study Session # 5, Reading # 17
5 MOVING FROM A DB TO A DC PLAN
Problem with DC ⇒ inexperience employees with complex investment decisions
Solution ⇒ design a product that works institutionally for a DC Plan but has an output that looks more likely as a DB plan
4 IMPLEMENTATION
Several actions:
Issue debt to fund the plan
Fund the plan while making a change in the asset mix of the pension
Derivatives & other asset classes for pension asset exposure
Decision ⇒ whether to take risk with the surplus & type of risk
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