Chapter 29
Pension Plan Management
ANSWERS TO END-OF-CHAPTER QUESTIONS
29-1a.Under a defined benefit plan, the employer agrees to give retirees a specifically defined benefits package. The payments could be set in final form as of the retirement date, or they could be indexed to increase with the cost of living.
b.Under a defined contribution plan, companies can agree to make specific payments into a retirement fund, and then have retirees receive benefits from the plan depending on the investment success of the plan.
c.Under a profit-sharing plan, the employer makes payments into a retirement fund, but the payments vary with the level of corporate profits.
d.The cash balance plan is a new type of retirement plan developed in the late 1990s. It is like a defined benefit plan in some respects and like a defined contribution plan in others. Cash balance plans work like this: An account is created for each employee. The company promises to put a specified percentage of the employee's monthly salary into the plan, and to pay a specified return on the plan's assets, often the T-bill rate.
e.An employee's pension rights are said to be vested if they provide a claim on pension fund assets, even if the employee leaves the company prior to retirement.
f.Portability refers to a pension plan that an employee can carry from one employer to another.
g.A pension plan is fully funded when the present value of expected retirement benefits is equal to the fund's assets on hand. If assets on hand exceed the present value of expected benefits, then the plan is said to be overfunded. If present value of benefits exceeds assets, then the fund is underfunded.
h.The actuarial rate of return is the discount rate used to determine the present value of future benefits under the plan. It is also the rate of return at which the fund's assets are assumed to be invested.
i.The Employee Retirement Income Security Act (ERISA) of 1974 is the basic federal law governing the administration and structure of corporate pension plans.
j.The Pension Benefit Guarantee Corporation (PBGC) is a government run insurance system created by the ERISA to ensure that employees of companies which go bankrupt before their plans are fully funded will receive benefits.
Answers and Solutions: 29 - 1
k.Federal Accounting Standards Board (FASB) Statement 87, "Employers Accounting for Pension Plans," and FASB Statement 35, "Accounting and Reporting by Defined Benefit Plans," provide firms with current guidance for reporting pension costs, assets, and liabilities. For defined contribution plans, FASB rules require the annual contribution to be shown on the income statement, with a note to the financial statements explaining the entry. Conversely, the rules for defined benefit plans require far more complex reporting procedures. In this case, the fund's overall funding status must be reported directly on the balance sheet if the plan is underfunded, and the annual pension expense must be shown on the income statement. In addition, the firm must provide information concerning the breakdown of the fund's annual pension expense and the composition of the fund's assets in the notes section of the annual report.
l.Funding strategy for a pension fund involves two decisions: (1) how fast should any unfunded liability be reduced, and (2) what rate of return should be assumed in the actuarial calculations?
m.The investment strategy for a pension plan deals with the question: Given the assumed actuarial rate of return, how should the portfolio be structured?
n.Asset allocation models are used by pension fund managers to help plan funding and investment strategies. These models examine the risk/return relationships of portfolios with various mixes of assets under different economic scenarios.
o.The Jensen alpha is a numerical measure of a portfolio's performance as compared to a "market" portfolio, such as the S&P 500. The alpha measures the vertical distance of a portfolio's return above or below the Security Market Line. It represents the extra return (positive or negative) after adjustment for the portfolio's market risk.
p.Tapping fund assets refers to usage of pension fund assets for a corporation's own benefit. Given that corporate sponsors administer defined benefit plans which have assets running into the hundreds of billions of dollars, to what extent should a corporation be able to tap its pension fund? Should companies be able to use funds to fight off takeovers? There are no easy answers to these questions.
q.Health care benefits are offered by most companies as part of their retirement packages, usually until the retirees reach age 65 and become eligible for Medicare. With the population aging and Health care costs surging, the present liability of estimated future costs of retiree health care represents a large portion of many companies' net worth. Also, a 1990 FASB rule requires companies to accrue, or set up a reserve for, future medical benefits of retirees. These factors have resulted in many companies either scrapping or significantly reducing coverage of their retiree health benefits.
Answers and Solutions: 29 - 1
29-2Ideally, the employee will choose the plan that provides the incremental cash flows (both costs and benefits) that maximize the employee's expected utility of consumption. However, there are many economic variables involved which have profound effects on the expected value of the plans. These include employee's expected work life, potential number of employers, vesting provisions of funds, risks of adequate funding of pension funds, expected inflation, and the likelihood of unexpected inflation. Because these factors can vary so much between individual employees and employers, no meaningful generalizations about these variables' specific effects on pension funds can be made.
29-3From an employer's standpoint, the defined benefit plan's major advantage is promotion of low employee turnover. The economic consequences of job-changing are not desirable under a defined benefit plan, since benefits are frozen at the time of separation, instead of adjusted for inflation over time. Thus, defined benefit plans provide incentive to stay with the firm for a long period.
However, there are several disadvantages associated with defined benefit plans. First, the plan puts greater risk on employers, since it guarantees to pay employees a fixed retirement benefit regardless of the firm's ability to fully fund the plan. Second, the employer's future cash contributions to the plan are uncertain, thus hampering financial planning efforts. This is particularly true if retirement benefits are based on final years' salaries, which can grow at different rates than inflation and other assumed levels. Finally, because of FASB Statement 87, there are greater financial reporting requirements associated with defined benefit plans.
Defined contribution plans avoid many of the problems of defined benefit plans, since future payments are based on the rate of return on the pension plan's portfolio. Furthermore, since employee retirement benefits are not fixed, defined contribution plans are exempt from the reporting requirement of FASB Statement 87. However, since retirement benefits are based on the portfolio's return, the defined contribution plan provides no strong incentives for employees to remain with the firm, as do defined benefit plans.
The greater risks involved with a defined benefit plan are a major reason why, in general, only large corporations, such as IBM and GM, can afford to offer them to employees.
29-4Pension fund data are found in the annual report section entitled "Notes to Consolidated Financial Statements." For example, the 1991 IBM Annual Report indicated a present value of pension benefits of $16.2 billion for its U. S. plan and a plan asset value of $25.2 billion. IBM's pension fund information covers about 1.5 pages in its report, because its defined benefit plan requires more disclosure than a company having a defined contribution plan like Rubbermaid, with a few paragraphs in its 1991 Annual Report devoted to pension plans and other employee benefits. In accordance with FASB Statement 87, firms with underfunded or overfunded plans must incorporate the shortage or excess directly into the firm's balance sheet. Thus, firm's having underfunded plans with large liabilities and significant current contributions will report lower profits and a weaker financial condition than firms that have their plans fully funded or overfunded.
Answers and Solutions: 29 - 1
29-5If the returns on these assets are less than perfectly positively correlated with the fund's other assets, then the addition of such investments as foreign stocks and precious metals would lower the overall risk of the portfolio. In other words, if these assets have a lower beta than the fund's portfolio, then adding them will lower the beta of the fund. However, the returns on foreign stocks and precious metals are typically quite volatile, and such assets are generally not suitable for meeting current payment obligations.
29-6a.Defined benefit plans carry with them economic incentive to discriminate against older workers in hiring, while defined contribution plans and cash balance plans are neutral in this regard.
b.There is an economic incentive for employers to discriminate against women in their hiring practices if they use defined benefit plans, since women tend to live longer than men.
c.Defined benefit plans contribute to lower employee turnover that would reduce training costs.
d.Pension benefits in a defined benefit plan are usually based on number of years worked and either the final, or the last several years' salary. This means that unions are more likely to work with a firm to ensure its survival, and thus ensure the survival of the pension plan, if it has a defined benefit plan. However, the level of benefits and the details of their calculation may be the subject of intense negotiation by the union. On the other hand, the ultimate benefits under a defined contribution plan depend on the actuarial return on the assets invested in the plan, with few details to be negotiated except the annual contribution that the firm makes. Under such a plan, a union has little pension-induced incentive to be "flexible" with the company (although it certainly may be flexible to keep the company solvent and keep jobs for its workers!), and the primary negotiation point with respect to the plan is the level of contributions. Note that with a cash balance plan, the union may also want to negotiate the guaranteed rate of return on the plan's assets.
29-7Most economists would argue that insurance premiums of any type should reflect the relative risk to the insurer. Thus, corporate liability insurance is higher for drug manufacturers than for greeting card makers, and life insurance is higher for smokers than for nonsmokers. Following this line of reasoning, PBGC insurance premiums should be higher for those firms whose pension plans are more likely to require a PBGC bailout.
Answers and Solutions: 29 - 1
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
29-1a.His wage in the final year of working is $179,700:
$20,000(1.05)45 = $20,000(8.9850) = $179,700.
Thus, his annual retirement benefit is $80,865:
$179,700(0.01)(45) = $80,865.
b.Assuming an actuarial rate of 10 percent, CC must accumulate $615,066 by the time of Mr. Jones's retirement:
PV = $80,865(PVIFA10%,15) = $615,066.
CC must contribute $856 per year over Mr. Jones's 45year working life to accumulate $615,066.
$615,066 = PMT(FVIFA10%,45)
PMT = $856.
c.Final year wage = $20,000(1.05)20 = $53,066.
Annual retirement benefit = $53,066(0.01)(20) = $10,613.
Lump sum required = $10,613(PVIFA10%,15) = $80,723.
Annual contribution = $1,409:
$80,723 = PMT(FVIFA10%,20)
PMT = $1,409.
We see that the older worker requires $1,409 $856 = $553 more in annual pension fund contributions. Thus, from a pension funding standpoint alone, CC would favor a younger worker.
d.Ms. Brown would receive the same retirement benefit as computed for Mr. Jones in Part a, $80,865 per year. However, Ms. Brown would receive the benefit for 25 years rather than 15 years. Thus, her annual pension cost would be $1,021:
PV = $80,865(PVIFA10%,25) = $734,015.
$734,015 = PMT(FVIFA10%,45)
PMT = $1,021.
Thus, the company is actually "paying" Ms. Brown more than they are paying Mr. Jones. Whether this is equitable or not is a matter of debate.
Answers and Solutions: 29 - 1
29-2a.Required return = r = rRF + (rM rRF)b = 10% + (6%)1.2 = 17.2%.
Realized return = = 18.0%.
Alpha = r = 18.0% 17.2% = 0.8 percentage points.
b.If the portfolio return was net of all transactions costs and management fees, then the portfolio manager "outperformed the market" on a riskadjusted basis. This may be due to his extraordinary ability to identify undervalued stocks or, more commonly, shear luck.
c.It would be impossible to predict next year's performance based on one year's historical performance.
29-3a.Find the present value (today's value) of the firm's obligations.
To simplify calculations, find the value of each 5-year period's payment as of the beginning of the period. For example, the value at Time 10 of the payments for Years 11-15 is:
101112131415
| | | | | |
2,500,0002,500,0002,500,0002,500,0002,500,000
N = 5, I = 10, PMT = -2500000, and FV = 0. Solve for PV = $9,476,967 = Value at Year 10.
01015 20 25 30
| | | | | |
9,476,9677,581,5745,686,180 3,790,787 1,895,393
$3,653,781
1,814,969
845,214
349,874
108,622
$6,772,460
b.Since the assets are less than the PV of benefits, the plan is underfunded.
Answers and Solutions: 29 - 1
MINI CASE
Southeast Tile Distributors Inc. is a building tile wholesaler that originated in Atlanta but is now considering expansion throughout the region to take advantage of continued strong population growth. The company has been a "mom and pop" operation supplemented by part-time workers, so it currently has no corporate retirement plan. However, the firm's owner, Andy Johnson, believes that it will be necessary to start a corporate pension plan to attract the quality employees needed to make the expansion succeed. Andy has asked you, a recent business school graduate who has just joined the firm, to learn all that you can about pension funds, and then prepare a briefing paper on the subject. To help you get started, he sketched out the following questions:
a.How important are pension funds to the U. S. Economy?
Answer:Pension funds constitute the largest class of investors. In 2001, the funds had assets of over $11 trillion and they owned more than 33 percent of all U. S. Stocks. Thus, pension funds are a major force in the financial markets.
b.Define the following pension fund terms:
1.Defined benefit plan
2.Defined contribution plan
3.Profit sharing plan
4.Cash balance plan
5.Vesting
6.Portability
7.Fully funded; overfunded; underfunded
8.Actuarial rate of return
9.Employee Retirement Income Security Act (ERISA)
10.Pension Benefit Guarantee Corporation (PBGC)
Answer:1.Under a defined benefit plan, the employer agrees to give retirees a specific defined benefit, such as $500 per month, 80 percent of his or her average salary over the 5 years preceding retirement, or 2.5 percent of his or her highest salary for each year of employment.
Mini Case: 29 - 1
2.In a defined contribution plan, companies agree to make specific payments into a retirement fund, and then the retirees receive benefits from the plan depending on the investment success of the plan.
3.Under a profit sharing plan, the employer makes payments into the retirement fund that vary with the level of corporate profits.
4.The cash balance plan is a new type of retirement plan developed in the late 1990s. It is like a defined benefit plan in some respects and like a defined contribution plan in others. Cash balance plans work like this: an account is created for each employee. The company promises to put a specified percentage of the employee's monthly salary into the plan, and to pay a specified return on the plan's assets, often the t-bill rate.
5.An employee is vested if he or she has the right to receive pension benefits even if they leave the company prior to retirement. If the employee loses his or her pension rights upon leaving the company prior to retirement, the rights are said to be nonvested. Most plans today have deferred vesting, in which pension rights are nonvested for the first few years, say 5, and then become fully vested at that point.
6.A portable pension plan is one that an employee can carry from one employer to another. Portability is especially important in industries where job changes are frequent--as in trucking and construction--and union-administered plans are typically used to make portability possible.
7.If the present value of expected retirement benefits is equal to plan assets on hand, the plan is said to be fully funded. If assets exceed the present value of benefits, then the plan is overfunded, while the plan is underfunded if the present value of benefits exceeds assets. If the plan is underfunded, an unfunded pension liability is said to exist.
8.The discount rate used to determine the present value of future benefits is called the actuarial rate of return. This rate is also the rate of return at which the fund's assets are assumed to be invested.
Mini Case: 29 - 1
9.The Employee Retirement Income Security Act Of 1974 (ERISA) is the basic federal law governing the administration and structure of corporate pension plans.
10.The Pension Benefit Guarantee Corporation (PBGC) is a government-run insurance company created by the ERISA to ensure that employees of companies which go bankrupt before their plans are fully funded will receive benefits.
c.What two organizations provide guidelines for reporting pension fund activities to stockholders? Describe briefly how pension fund data are reported in a firm's financial statements. (hint: consider both defined contribution and defined benefit plans.)
Answer:The Financial Accounting Standards Board (FASB), together with the SEC, establishes the rules under which a firm reports its financial results, including its income and asset positions, to stockholders. The reporting of defined contribution plans is relatively simple: the annual contribution is shown on the firm's income statement and a note explains the entry. However, the reporting of defined benefit plans is more complex. In this case, the fund's overall funding status must be reported directly on the balance sheet if the plan is underfunded, and the annual pension expense must be shown on the income statement. In addition, the firm must provide information concerning the breakdown of the fund's annual pension expense and the composition of the fund's assets in the notes section of the annual report.