Brigham & Ehrhardt: Financial Management: Theory and Practice 14e

Brigham & Ehrhardt
Financial Management:
Theory and Practice 14e
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
1
Chapter 29
Pension Plan Management
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
2
Topics in Chapter
 Pension plan terminology
 Defined benefit versus defined
contribution plans
 Pension fund investment tactics
 Retiree health benefits
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 3
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.
(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. (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. (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.
(More...)
 The actuarial rate of return is the rate
of return 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...)
 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.
(More...)
Reporting
 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...)
Reporting
 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.
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%;
the rate used to discount benefits also is
10%.
1. Required amount in plan at
retirement date
Input 15 10 20,000 0
N I PV PMT FV
Output 152,122
Annual Contribution During
Employment Years
Input 40 10 0 152122
N I PV PMT FV
Output 343.71
Graph of Pension Fund Assets
Dollars
($000)
152
0 40 55 Years
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.
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...)
Plan Beneficiaries
 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...)
Plan Beneficiaries
 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.
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.
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 contributions.
Pension Plans and 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.
Pension Plans and the Possibility
of Gender Discrimination?
 Since women live longer than men,
female employees are more costly
under defined benefit plans.
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.
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.
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?
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.
Judging the Performance of
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).
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.
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.
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 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.

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