Lecture Managerial finance - Chapter 29: Pension plan management
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Chapter 29
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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(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.
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(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. 6
(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.
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(More...)
Employee Retirement Income Security
Act (ERISA): The federal law governing
the administration and structure of
corporate pension plans.
(More...)
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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.
(More...)
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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 plan’s funding status must be reported
directly on the balance sheet.
(More...)
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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 fund’s
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 plan’s actuarial rate of return is 10%.
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Additional Real World
Complexities.
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.
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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 firm’s profitability or
the return on the plan’s assets.
(More...)
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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.
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(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.
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Pension Plans and 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.
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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)
year’s salary. Therefore, unions are
more likely to work with a firm to ensure
its survival under a defined benefit plan.
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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 benefits
reported to shareholders?
Before 1990, firms used payasyougo
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.
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