FinQuiz smart summary, allicatiing sharholder capital to pension plan

2013, Study Session # 5, Reading # 17

“ALLOCATING SHAREHOLDER CAPITAL TO PENSION PLANS”
A&L = Assets & Liabilities

1. THE APPARENT ISSUEFUNDING 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

2. ACCOUNTING FOR VALUE MISMATCH AND RISK

Value Mismatch

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.

Risk Mismatch

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

4. IMPLEMENTATION

Underfunding

Overfunding

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.

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.

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