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Pension Plan Management


Chapter 30 Pension Plan Management – PowerPoint PPT presentation

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Title: Pension Plan Management

Chapter 30
  • Pension Plan Management

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

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

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.

  • 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.

  • 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

  • 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
  • Overfunded The reverse of underfunded.

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

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

  • 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.

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.

  • 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.

  • 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.

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.

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

Risks Borne by Plan Sponsor and Plan
  • 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.

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

  • 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.

What type of companies tend to have each type of
  • 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.

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

Pension Plans and the Possibility of Age
  • 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.

Pension Plans and the Possibility of Gender
  • Since women live longer than men, female
    employees are more costly under defined benefit

Pension Plans and EmployeeTraining Costs?
  • Defined benefit plans encourage employees to stay
    with a single company, hence they reduce training
  • Vesting and portability facilitate job shifts,
    hence increase training costs.

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.

Two Components of a Plans Funding Strategy
  • How fast should any unfunded liability be
  • What rate of return should be assumed in the
    actuarial calculations?

What is the primary goal of aplans investment
  • To structure the portfolio to minimize the risk
    of not achieving the assumed actuarial rate of
  • A low risk portfolio will mean low expected
    returns, which will mean larger annual
    contributions, which hurt profits.

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

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.

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

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.

How are retiree health benefitsreported to
  • 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.
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