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On the left, we show the fair value of the plan assets. This is the investment fund.
During the year, wise investments will hopefully increase the size of the fund. This is
the "return on plan assets." Also, employer contributions, cash the company simply
gives from its own bank account, will increase the fund. Finally, benefits paid (or
disbursements) to current retirees will reduce the plan assets.



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On the right, we show the basic calculation of the projected benefit obligation (PBO),
which is an estimate of the future stream of benefit obligations discounted to the
present value into a single number. For clarity's sake, we omitted a few items.

In the annual report, you will see two other measures of estimated future
obligations: the vested benefit obligation (VBO) and the accumulated benefit
obligation (ABO). You do not need either of these for the purposes we discuss here,
but ABO is less than PBO because it assumes that salaries will not rise into the
future, while PBO assumes salary increases. VBO is less than ABO because it counts
only service already performed, but PBO counts the future service (minus turnover
assumptions). PBO is the number that matters because it's the best guess as to the
present value of the discounted liabilities assuming the employees keep working and
salaries keep rising.

By subtracting the PBO from the fair value of the plan assets, you get the funded
status of the plan. This is an important number that will be buried somewhere in the
footnotes, but it must be disclosed.

Breaking Down the Funded Status of the Plan
Let's look at an actual example. We will use data from the annual report 10-K for
PepsiCo (ticker: PEP) for the year ended December 31, 2003. Although its pension
plan happened to be under-funded at that time, it can be considered relatively
healthy--especially compared to other companies. We picked PepsiCo because the
company's plan is well-disclosed and its 10-K contains helpful commentary.

Below is the part of the footnote that calculates the fair value of the plan assets. You
can see that the pension fund produced an actual return of 7.9% in the year 2003
($281 / $3,537). Other than the investment returns, the largest changes are due to
employer contributions and benefit payouts:




Now take a look at the calculation of the PBO (see below). Whereas the fair value of


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plan assets (how much the fund was worth) is a somewhat objective measure, the
PBO requires several assumptions which make it more subjective:




You can see that PepsiCo started 2003 with an estimated liability of $4,324, but the
liability is increased by service and interest cost. Service cost is the additional
liability created because another year has elapsed, for which all current employees
get another year's credit for their service. Interest cost is the additional liability
created because these employees are one year nearer to their benefit payouts.

The reason for and effect of the additional interest cost is easier to understand with
an example. Let's assume that today is 2005 and the company owes $100 in five
years, in the year 2010. If the discount rate is 10%, then the present value of this
obligation is $62 ($100 · 1.1^5 = $62). (For a review of this calculation, see
"Understanding the Time Value of Money.") Now let one year elapse. Because at the
start of 2006 the funds now have four years instead of five years to earn interest
before 2010, the present value of the obligation as of 2006 increases to $68.3 ($100



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· 1.1^4 = $68.3). You can see how interest cost depends on the discount rate
assumption.

Now, let's continue with PepsiCo's footnote above. Plan amendments refer to
changes to the pension plan, and they could have a positive or negative impact on
cost. "Experience loss" is more commonly labeled "actuarial loss/gain," and it too can
be positive or negative. It refers to additional costs created because of the actuarial
estimates changes made during the year. For example, we don't know exactly the
cause in PepsiCo's case, but perhaps it increased its estimate of the average rate of
future salary increases or the average age of retirement. Either of these changes
would increase the PBO and the additional cost would show up as an "actuarial loss."

We see that PepsiCo's liability at the end of the year 2003 was $5,214. That is the
PBO. We also see a lesser amount "for service to date." That is the VBO and we can
ignore it.

The fair value of the plan assets ($4,245) subtracted by the PBO ($5,214) results in
the funded status at the end of 2003 of -$969 million. The bottom line: PespiCo's
pension plan at that time was under-funded by almost one billion dollars.

Pension Plans and the Balance Sheet
Now remember we said that pension plans are off-balance-sheet financing, and in
PepsiCo's case, the $4.245 billion in assets and $5.214 billion in liabilities are not
recognized on the balance sheet. Therefore, typical debt ratios like long-term debt to
equity probably do not count the pension liability of $5+ billion. But it's even worse
than that. You might think the net "deficit" of -$969 million would be carried as a
liability, but it is not. Again, from the footnotes:




Due to the smoothing rules of pension plan accounting, PepsiCo carried $1,288 in
pension plan assets on the balance sheet, at the end of 2003. You can see how the


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two "unrecognized" lines on the footnote above boost the negative into a positive:
the losses for the current year--and prior years, for that matter--are not recognized
in full; they are amortized or deferred into the future. Although the current position
is negative almost one billion, smoothing captures only part of the loss in the current
year--it's not hard to see why smoothing is controversial.

Cash Contributed to the Pension Is Not Pension Cost
Now we have enough understanding to take a look at why cash contributed to the
pension plan bears little--if any--resemblance to the pension expense (also known as
"pension cost") that is reported on the income statement and reduces reported
earnings. We can find actual cash contributed in the statement of cash flows:




Now compare these cash contributions to the pension expense. In each of the three
years reported, cash spent was significantly higher than pension expense:




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The first two components of pension expense--service and interest cost--are identical
to those found in the calculation of PBO. The next component is "expected return on
plan assets." Recall that the "fair value of plan assets" includes actual return on plan
assets. Expected return on plan assets is similar, except the company gets to
substitute an estimate of the future return on plan assets. It is important to keep in
mind that this estimate is an assumption the company can tweak to change the
pension expense. Finally, the two "amortization" items are again due to the effects of
smoothing. Some people have gone so far as to say the pension expense is a bogus
number due to the assumptions and smoothing.

Critical Questions
We have just scratched the surface of pension plan accounting, but we have
reviewed enough to identify the four or five critical questions you need to ask when
evaluating a company's pension fund.

We have two primary concerns in regard to analysis of the pension fund:

• What is the economic status of the liability? A dramatically under-funded plan
will require increased cash contributions in the future and foreshadows future
increases in income statement expenses.

• How aggressive/conservative is the pension expense? An aggressive
accounting policy is a "red flag" because it will usually have to be unraveled
by the company in future periods. Conservative policies contribute to earnings
that are higher in quality.




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Take a look at key assumptions disclosed by PepsiCo:




In regard to our first concern--the economic status of the liability--we want to look at
the funded status that equals the fair value of plan assets minus the PBO. The two
key assumptions that impact the PBO are the discount rate and projected rate of
salary increases. A company can decrease its PBO (and therefore, increase its funded
status) by either increasing the discount rate or lowering the projected rate of salary
increases. You can see that PepsiCo's rate of salary increase is fairly stable at 4.4%
but the discount rate dropped to 6.1%. This steady drop in the discount rate
contributes significantly to the increased PBO and the resultant under-funded status.




In regard to our second concern--the quality of the pension expense--there are three
key assumptions:




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The discount rate is a little bit mixed because it has opposite effects on the service
and interest cost, but in most cases, it behaves as before: a lower discount rate
implies a decrease in pension expense. Regarding expected return on plan assets,
notice that PepsiCo's assumption here has steadily decreased over the two years to
finish at 8.2%. Soft equity markets are a double-whammy for pension funds: they
not only lower the discount rate (which increases the PBO) but they lower the
expected return on the plan assets!

So we can now summarize the effect of accounting practices:

• Aggressive (dubious) accounting includes one or more of the following: a high
discount rate, an expected return on plan assets that is overly optimistic by
being quite higher than the discount rate, and a low rate of salary increase.

• Conservative (good) accounting includes all of the following: low discount
rate, an expected return on plan assets that is near the discount rate, and a
high rate of salary increase

Finally, companies are now required to disclose how the pension plan is invested. For
example, PepsiCo's footnote explains the target asset allocation of its pension (60%
stock and 40% bonds) and then breaks down its actual allocation. Furthermore, you
can check to see how much of the pension fund is invested in the company stock.

You should definitely look at these allocations if you have a view about the equity or
bond markets. There has been much academic discussion about companies'
allocation mismatching: the argument goes that they are funding liabilities with too




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much equity when liabilities should be funded with bonds (of course, companies fund
with equities to boost their actual and expected returns).

Conclusion
For evaluating stocks that have a pension plan, you can do the following:

1. Locate the funded status (fair value of plan assets minus projected benefit
obligation).

2. Check the trend and level of the following key assumptions:

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