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   Pension Plan Management

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
They hold about 33% of all U. S.
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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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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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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
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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

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Actuarial rate of return: The rate of
  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.
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Pension Benefit Guarantee Corporation
  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
  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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   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.
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 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...)
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The annual pension contribution
 (expense) is shown on the income
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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 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?
 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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               Determine the amount the
Step 1.        firm must have in the plan
               at the time the employee
               retires. It is $152,122.

Input     15
          15    10
                10         20,000
                           20000    0
          N      I    PV    PMT     FV
     Compute PV = $152,121.59
Output          152,122
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              Determine the annual contri-
Step 2:       bution during the employment
              years. With $152,122 to be
              accumulated, the answer is

Input     40     10     0            152122
          N       I    PV    PMT       FV
Output                      343.71
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  Graph of Pension Fund Assets



  0             40    55    Years
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  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.
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  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.
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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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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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   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.
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 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.
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     Does the type of pension plan
    influence 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.
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 Does the type of pension plan
influence the possibility of sex

Since women live longer than men,
female employees are more costly
under defined benefit plans.
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    How does the type of pension
      plan influence 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
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     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.
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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
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    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.
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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
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       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.
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    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.
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What has happened to the cost of
 retiree health benefits over the
           last 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.
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     How are retiree health benefits
       reported to shareholders?
 Before 1990, firms used pay-as-you-go
  procedures which concealed the true
 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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