Pension plan terminology Defined benefit versus defined contribution plans

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

2. How important are pension funds? • They constitute the largest class of investors. • They hold about 33% of all U. S. stocks.

3. 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. (More...)

4. 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...)

5. 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...)

6. 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...)

7. Actuarial rate of return:The rate of return: • 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...)

8. 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.

9. Who establishes guidelines for reporting pension fund information on corporate financial statements? • 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.

10. How are pension fund data reported in a firm’s 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. (More...)

11. 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.

12. 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? • 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%.

13. Determine the amount the firm must have in the plan at the time the employee retires. It is $152,122. Step 1. 15 10 20,000 0 Input 15 10 20000 0 N I PV PMT FV Compute PV = $152,121.59 Output 152,122

14. Determine the annual contri-bution during the employment years. With $152,122 to be accumulated, the answer is $343.71. Step 2: Input 40 10 0 152122 N I PV PMT FV Output 343.71

15. Graph of Pension Fund Assets Dollars ($000) 152 0 Years 40 55

16. Pension fund management is much more complex than this illustration. • 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.

17. What risks are borne by the plan sponsor and plan beneficiaries under the four types of pension plans? • 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...)

18. 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...)

19. 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.

20. 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.

21. If a company uses either a defined contribution or a profit sharing plan, how are the assets administered? • 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.

22. Does the type of pension plan influence 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.

23. Does the type of pension plan influence the possibility of sex discrimination? Since women live longer than men, female employees are more costly under defined benefit plans.

24. How does the type of pension plan influence 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.

25. Does the type of pension plan influence the militancy of unions when a company faces financial adversity? 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.

26. What are the two components of a plan’s funding strategy? • How fast should any unfunded liability be reduced? • What rate of return should be assumed in the actuarial calculations?

27. What is the primary goal of a plan’s 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.

28. How can a company judge the perfor-mance of its pension plan managers? • 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).

29. What’s meant by “tapping” pension 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.

30. 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.

31. What has happened to the cost ofretiree health benefits over thelast decade? 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.

32. How are retiree health benefits reported 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.