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Chapter 29
Pension Plan Management1




P ension plans are an important component of the U.S. financial system:
(1) At the end of 2001, the U.S. retirement market held assets with an
aggregate market value of almost $11 trillion and owned 33 percent of all
mutual fund assets. (2) Pension plans provide workers with the majority of their
retirement income. (3) Contributions to pension plans are an important compo-
nent of most compensation plans, and they affect morale, labor productivity, and
economic stability. (4) The rate of return on pension plan assets can have a major
effect on corporate earnings, employees™ retirement incomes, or both. (5) Because
pension plans are large owners of corporate stocks, their managers play an
important role in the direction and control of corporate policy.
In this chapter, we discuss the different types of pension plans, their manage-
ment and regulation, and their effects on both individuals and firms.


The Role and Scope of
Pension Plan Management
Most companies”and practically all government units”have some type of
employee pension plan. Typically, the chief ¬nancial of¬cer (CFO) adminis-
ters the plan, and he or she has these three speci¬c responsibilities: (1) decid-
ing on the general nature of the plan, (2) determining the required annual
payments into the plan, and (3) managing the plan™s assets. Obviously, the
company does not have total control over these decisions”employees,
often through their unions, have a major say about the plan™s structure, and
the federal government imposes strict rules on certain aspects of all plans.
Still, companies have considerable latitude regarding several key decisions,
and these decisions can materially affect the ¬rm™s pro¬tability and its
employees™ welfare.
Although a few ¬rms have provided pensions since the turn of the cen-
tury, the real start of large-scale pension plans began in 1949, when the
United Steelworkers negotiated a comprehensive retirement plan in their
contract with the steel companies. Other industries followed, and the move-
ment grew rapidly thereafter. Under a typical pension plan, the company (or
governmental unit) agrees to provide retirement payments to employees.
These promised payments constitute a liability, and the employer is required

1
This chapter was coauthored by Professor Jim Bicksler of Rutgers University. Professor Russ Fogler of the University
of Florida also provided important contributions.
29-2 Pension Plan Management
Chapter 29


to establish, under the pension plan, a pension fund and place money in it
each year in order to have suf¬cient assets to meet pension payments as they
come due.
Pension plan assets represent a large fraction of total assets for many ¬rms.
For example, GM has about $324 billion in assets, while the market value of
its pension fund assets is $67 billion. If the pension fund is managed well and
produces relatively high returns, the ¬rm™s required annual additions can be
minimized. However, if the fund does not perform well, then the ¬rm will
have to increase contributions to the fund, which will lower earnings.
Pension fund management is an important but complex job. Indeed, pen-
sion fund administration requires so much specialized technical knowledge
that companies typically hire specialized consulting ¬rms to help design,
modify, and administer their plans. Still, because the plans are under the gen-
eral supervision of the ¬nancial staff, and because they have such signi¬cant
implications for the ¬rm as a whole, it is important that ¬nancial managers
understand the basics of pension plan management.

Why is pension fund management important to most firms?
Self-Test Question


Four Types of Pension Plans
There are four principal types of pension plans: (1) de¬ned contribution
plans, (2) de¬ned bene¬t plans, (3) pro¬t sharing plans, and (4) cash balance
plans. The key features of these plans are discussed in this section.

Defined Contribution Plan
Under all pension plans, the employer agrees to do something to help
employees when they retire. Rather than specifying exactly how much each
retiree will receive, companies can agree to make speci¬c payments into a
retirement fund and then have retirees receive bene¬ts that depend on the
plan™s investment success. This type of plan is called a de¬ned contribution
plan. For example, a trucking ¬rm might agree to make payments equal to
15 percent of all union members™ wages each year into a pension fund
administered by the Teamsters™ Union, and the fund would then dispense
bene¬ts to retirees. Such plans do not have to be administered by unions”
indeed, today the most common procedure is for the monthly payment
applicable to each employee to be turned over to a mutual fund of the
employee™s choice and credited to the employee™s account. Thus, a de¬ned
contribution plan is, in effect, a savings plan that is funded by employers,
although many plans also permit additional contributions by employees.
The ¬rm is obligated, in bad times as well as in good, to make the speci¬ed
contributions.
There are a number of different types of de¬ned contribution plans,
including 401(k) plans and Employee Stock Ownership Plans (ESOPs).2
De¬ned contribution plans are not subject to the rules of the Employee
Retirement Income Security Act of 1974 (discussed later). Additionally,

2
Section 401(k) is part of the federal law which authorized the most widely used de¬ned contribution plan, hence the
name “401(k) plan.” An ESOP invests in the ¬rm™s common stock. In a KASOP, which is a variation of the ESOP, the
¬rm™s contribution consists of shares of its common stock, but employee contributions can be invested in other alter-
natives.
29-3
Four Types of Pension Plans


these plans are portable (also discussed later) in that the assets belong to the
employee and can be carried forward whenever he or she changes jobs. Since
the sponsoring ¬rm does not guarantee any speci¬c dollar payments to par-
ticipants upon retirement, participants in a de¬ned contribution plan bear
all of the investment risk associated with poor portfolio performance.
However, most de¬ned contribution plans allow participants to choose
among several investment alternatives, so each individual can accommodate
his or her own risk preference.
To illustrate a de¬ned contribution plan, consider the one offered by
Merck. Employees can contribute up to 15 percent of their pre-tax salaries
into the plan, which is deductible from the employees™ taxable income.
Further, the company will match an employee™s contribution by 50 cents on
each dollar up to 5 percent of salary. For example, if an employee making
$50,000 per year contributes the maximum 0.15($50,000) $7,500,
Merck will chip in an additional $2,500 for a total contribution of $10,000.
In the Merck plan, all contributions from the employee are deducted from
the employee™s salary before income taxes are paid. This means that the
employee does not pay tax on the income that is contributed to the pension
plan at the time the contribution is made, nor does the employee pay taxes
when any income or capital gains are generated by the retirement account.
However, retirees must pay income taxes when they receive retirement ben-
e¬ts, and since contributions to the plan were deducted from taxable
income, all bene¬ts received from the plan are fully taxed.
Upon retirement, employees have several options. Although most begin
receiving bene¬ts immediately upon retirement, some might choose to leave
the funds in the retirement account and perhaps take a job with another
company, especially if they are reasonably young. Note that this defers the
payment of income taxes. However, they may not leave the funds in the
retirement account inde¬nitely. IRS regulations require that they begin with-
drawing funds when they reach 70.5 years of age. When retirees do begin
receiving bene¬ts, they can choose a lump-sum disbursement, but this would
result in a huge tax liability. Most retirees choose to “roll over” the retire-
ment account by purchasing an annuity, often sold by an insurance com-
pany. A typical lifetime annuity guarantees a monthly payment for as long
as the retiree lives. The amount of the payment depends on the amount that
was in the retirement account and the age of the retiree. There are many
other features available on annuities, such as a surviving spouse option (in
which the spouse of the retiree continues to receive payments after the death
of the retiree), ¬xed-term annuities, in¬‚ation-linked payments, and an
option that guarantees a minimum number of payments to the retiree™s heirs
should the retiree die soon after the annuity™s ¬rst payment.

Defined Benefit Plan
Under a de¬ned bene¬t plan, the employer agrees to give retirees a speci¬-
cally de¬ned bene¬t, such as $500 per month, 50 percent of his or her last
salary, or 2.5 percent of his or her highest annual salary for each year of
employment. The payments could be ¬xed as of the retirement date, or they
could be indexed to increase as the cost of living increases. The key, though,
is that payments to retirees, not contributions by the company, are speci¬ed
(de¬ned).
De¬ned bene¬t plans differ in several important respects from de¬ned
contribution plans. Most important, the sponsoring ¬rm, not the participants,
29-4 Pension Plan Management
Chapter 29


bears the risk of poor portfolio performance. The company has a ¬rm obli-
gation to its retirees that must be met regardless of how well or poorly the
pension plan™s investments perform. Note, though, that de¬ned bene¬t par-
ticipants generally bear purchasing-power risk”that is, the risk that in¬‚a-
tion will eat away at the purchasing power of a ¬xed pension payment.
Sometimes, though, the payments are indexed to rise with in¬‚ation.
To illustrate a de¬ned bene¬t plan, consider the plan offered by Eastman
Kodak. Assuming an employee had 30 years of service and a ¬nal annual
income of $50,000, Kodak™s plan promises to pay $19,700 per year at age
65. This is 1.31 percent of the ¬nal salary for each year of service. Thus, an
employee who started with Kodak at age 21 could quit work at age 51 and
begin to collect his or her pension at age 65. Alternatively, full bene¬ts could
be collected when the employee™s years of service plus age equals 85, so an
employee could begin with Kodak at age 25, work to age 55, and collect full
bene¬ts. If a vested employee does not meet one of these guidelines for full
bene¬ts, he or she can still receive retirement bene¬ts, but at less than the
full amount.

Profit Sharing Plan
A third type of plan calls for the employer to make payments into the retire-
ment fund, but with the payments varying with the level of corporate prof-
its; this is a pro¬t sharing plan. For example, a computer manufacturer
might agree to pay 10 percent of its pre-tax pro¬ts into a fund that would
then invest the proceeds and pay bene¬ts to employees upon their retire-
ment. These plans are operated like de¬ned contribution plans in the sense
that each employee™s funds are maintained in a separate account, and bene-
¬ts depend on the plan™s performance. However, payments to the plan rise
or fall depending on the level of the ¬rm™s pro¬ts. Pro¬t sharing plans can
be operated separately or used in conjunction with de¬ned bene¬t or de¬ned
contribution plans. For example, Schering-Plough does not match employee
401(k) contributions, but it funds a separate pro¬t sharing plan with con-
tributions up to 15 percent of each participant™s annual salary. As noted
above, under most pro¬t sharing plans, a separate account is maintained for
each employee, and each employee gets a share of the contribution each year
based upon his or her salary. The employee™s account builds up over time
just as if the employee were putting money into a mutual fund, which may
in fact be the case.

Cash Balance Plan
In the late 1990s, a new type of plan called a cash balance plan was devel-
oped. This new plan is a type of de¬ned bene¬t plan where the bene¬t is
de¬ned in terms of a cash balance, rather than a monthly retirement salary.
Employees like the certainty inherent in a de¬ned bene¬t plan, but also like
receiving a monthly statement showing how their retirement assets have
grown under a de¬ned contribution or a pro¬t sharing plan. Cash balance
plans combine these two features, and they work like this: (1) A hypotheti-
cal account is created for each employee. (2) The company promises to
increase the amount in this account by a certain percentage of the employee™s
monthly salary (known as a pay credit), and to pay a speci¬ed return on the
plan™s total balance, often the T-bill rate (known as an interest credit).
Employees can then watch the balance in this account grow, with the growth
rate assured. At retirement the account balance is converted into an annuity
29-5
Key Terms and Concepts


or a lump sum payment. According to pension authorities, people ¬nd it easier
to interpret a total dollar amount in an account than a hard-to-understand
statement showing that at some future date, if you stay with the company,
you will receive payments based on some relatively complex formula. In
addition, cash balance plans often allow vested employees to take a lump
sum payout if they terminate employment prior to retirement.
Even though it looks to the employee like a de¬ned contribution plan, a
cash balance plan is really a de¬ned bene¬t plan, and employers like de¬ned
bene¬t plans for two reasons. First, because money is not actually deposited
to an employee™s account, the employer has greater ¬‚exibility in funding the
plan when business is down and cash is tight. With a cash balance plan,
bene¬ts can continue to accrue to employees even if the company cuts back
or even curtails its cash retirement contributions. Second, the interest rate
credited to the accounts is often substantially less than the rate of return
earned on the assets backing the plan, so companies can make smaller con-
tributions and save money as compared with a de¬ned contribution plan.
So, large companies including Xerox, Bell Atlantic, and AT&T are adopting
cash balance plans at a rapid rate, and some experts predict that 80 percent
of all companies with more than 5,000 employees will have such plans
within the next ten years.

Name and define the four principal types of pension plans.
Self-Test Questions
Which type plan is most risky from the standpoint of sponsoring corporations?
From the standpoint of beneficiaries?


Key Terms and Concepts
Certain terms and concepts are used frequently in discussions of pension
plans, and it is useful to de¬ne them at this point.

Vesting
If employees have a right to receive pension bene¬ts even if they leave the
company prior to retirement, then their pension rights are said to be vested.
If the employee loses his or her pension rights by leaving the company prior
to retirement, the rights are said to be nonvested. De¬ned contribution and
pro¬t sharing plans generally provide immediate vesting (as soon as the
employee is eligible to participate in the plan). However, most de¬ned bene-
¬t plans have deferred vesting, which means that pension rights are non-
vested for the ¬rst few years, but become fully vested if the employee
remains with the company for a prescribed period, say, ¬ve years. The costs
to the company are clearly lower for plans with deferred vesting, because
such plans do not cover employees who leave prior to vesting. Moreover,
deferred vesting tends to reduce turnover, which, in turn, lowers training
costs. However, it is much easier to recruit employees if the plan offers early
vesting. Also, many argue that vesting is socially desirable, and as a result
there has been a tendency over time for Congress to require vesting for more
and more employees and within a shorter and shorter period of time.
Currently, companies with de¬ned bene¬t plans are required to vest partic-
ipants at least as fast as either the ¬ve-year rule or the three-to-seven-year rule:
1. Five-year rule. Under this rule, participants must be fully vested after

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