Pension Plan Management

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Chapter 30

• Pension Plan Management

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Topics in Chapter

• Pension plan terminology
• Defined benefit versus defined contribution plans
• Pension fund investment tactics
• Retiree health benefits

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How important are pension funds?

• They constitute the largest class of investors.
• They hold about 33 of all U. S. stocks.

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Pension Plan Terminology

• 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.

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• Profit sharing plan Employer payments vary with
  the firms profits. (Defined contribution, but as
  a percentage of profits).
• Cash balance plan Employer promises to put a
  specified percentage of the employees salary
  into the plan, and to pay a specified return on
  the plans assets.

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• 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.

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• 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.

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• The actuarial rate of return is the rate of
  return
• used to find the PV of expected benefits
  (discount rate).
• at which the funds assets are assumed to be
  invested.

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• Employee Retirement Income Security Act (ERISA)
  The federal law governing the administration and
  structure of corporate pension plans.

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• 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.

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Pension Funds and Financial Reporting

• 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.

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• Defined Contribution Plan
• The annual contribution is shown as a cost on the
  income statement.
• A note explains the entry.
• Defined Benefit Plan
• The plans funding status must be reported
  directly on the balance sheet.

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• The annual pension contribution (expense) is
  shown on the income statement.
• Details regarding the annual expense, along with
  the composition of the funds assets, are
  reported in the notes section.
• The annual pension contribution is tied to the
  assumed actuarial rate of return the greater
  the assumed return, the smaller the contribution.

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Annual Contributions for Full Funding

• 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 plans actuarial rate of return is 10.

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1. Required amount in plan at retirement date
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Annual Contribution During Employment Years
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Graph of Pension Fund Assets
152 0
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Additional Real World Complexities.

• Dont know how long the employee will work for
  the firm (the 40 years).
• Dont know what the annual pension payment will
  be (the 20,000).
• Dont 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.

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Risks Borne by Plan Sponsor and Plan
Beneficiaries

• Defined benefit plan Most risk falls on the
  company, because it guarantees to pay a specific
  retirement benefit regardless of the firms
  profitability or the return on the plans assets.

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• Defined contribution plan Places more risk on
  employees, because benefits depend on the return
  performance of each employees chosen investment
  fund.
• Profit sharing Most risk to employee, least to
  employer. Company doesnt pay into fund unless
  it has earnings, and employees bear investment
  risk.

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• Cash balance Middle of the road in terms of
  risk for both employer and employee. Employers
  payment obligations are fixed and known, while
  employees are guaranteed a specified return.

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What type of companies tend to have each type of
plan?

• Large, more mature companies (and governments)
  tend to use defined benefit plans.
• New, start-up companies tend to use profit
  sharing plans.
• Many older companies are shifting to defined
  contribution and cash balance plans.

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How are assets administered in defined
contribution plans?

• 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.

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Pension Plans and the Possibility of Age
Discrimination?

• 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.

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Pension Plans and the Possibility of Gender
Discrimination?

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

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Pension Plans and EmployeeTraining 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.

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Pension Plans and Union Conflicts at Financially
Distressed Firms

• Benefits paid under defined benefit plans are
  usually tied to the number of years worked and
  the final (or last few) years salary.
  Therefore, unions are more likely to work with a
  firm to ensure its survival under a defined
  benefit plan.

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Two Components of a Plans Funding Strategy

• How fast should any unfunded liability be
  reduced?
• What rate of return should be assumed in the
  actuarial calculations?

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What is the primary goal of aplans investment
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.

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Judging the Performance of Pension Plan Managers

• Alpha analysis Compare the realized return on
  the portfolio with the required return on the
  portfolio.
• Comparative analysis Compare the managers
  historical returns with other managers having the
  same investment objective (same risk profile).

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Whats meant by tappingpension fund assets?

• 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.

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Why is tapping controversial?

• 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.

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Rising Costs of Retiree Health Benefits

• 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.

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How are retiree health benefitsreported to
shareholders?

• Before 1990, firms used pay-as-you-go procedures
  which concealed the true liability.
• Now companies must set up reserves for retiree
  medical benefits.
• Firms must report current expenses to account for
  vested future medical benefits.
• The 1990 rule has forced companies to assess
  their retiree health care liability. Many are
  now cutting benefits.