vested or not vested, with no partial vesting.
29-6 Pension Plan Management
2. Three-to-seven-year rule. Under this rule, participants are partially
vested according to the number of years of service:
Years of Service Percent Vested
Of course, employers may offer plans that vest pension rights more quickly
than mandated by these two vesting rules.
Portable means ācapable of being carried,ā and a portable pension plan is
one that an employee can carry from one employer to another. Portability is
extremely important in occupations such as construction, where workers
move from one employer to another fairly frequently. A deļ¬ned contribu-
tion plan is always portable, because the planā™s assets are held in the
employeesā™ names. However, for a deļ¬ned beneļ¬t plan to be portable, both
the old employer and the new employer would have to be part of the same
planā”it would simply not be feasible for an IBM employee to leave IBM
and go to work for Delta Airlines and take along a share of the IBM plan.
(Note, however, that if the employeeā™s rights under the IBM plan were
vested, then he or she could receive payments from both Delta and IBM
upon retirement.) Where job changes are frequentā”as in trucking, con-
struction, and coal miningā”union-administered plans are used to make
Note that cash balance plans are completely portable. Indeed, this fact,
combined with the increasing mobility of the U.S. work force, is one reason
for the rapid growth of cash balance plans. By adding portability to the
advantages of a traditional deļ¬ned beneļ¬t plan, it can better serve the retire-
ment needs of employees of all ages.
Under deļ¬ned contribution, proļ¬t sharing, and cash balance plans, the com-
pany must make annual contributions. However, under a deļ¬ned beneļ¬t
plan the company promises to give employees pensions for some unknown
number of future years based on their unknown future salaries, and from
a fund whose future value is unknown, so its true costs are uncertain.
However, pension fund actuaries can estimate the present value of the
expected future beneļ¬ts under a deļ¬ned beneļ¬t plan, and this present value
constitutes a liability of the plan. The liability may be measured (1) by the
present value of all projected beneļ¬ts accrued by present workers, or (2) by
the present value of vested beneļ¬ts earned to date. The vested amount is
obviously smaller, and it represents the expected present value of the bene-
ļ¬ts that would be paid to workers if the ļ¬rm went out of business today or
if all workers resigned today. The value of the fundā™s assets is calculated as
their current market value. If the present value of all expected retirement
beneļ¬ts is equal to assets on hand, then the plan is said to be fully funded.
Key Terms and Concepts
If assets exceed the present value of beneļ¬ts, the plan is overfunded. If the
present value of beneļ¬ts exceeds assets, the plan is underfunded, and an
unfunded pension liability exists.
Actuarial Rate of Return
The discount rate used to determine the present value of future beneļ¬ts
under a deļ¬ned beneļ¬t plan is called the actuarial rate of return. Often, this
rate is the same as the assumed rate of return on the planā™s assets.
The actuarial rate of return is a critical element in pension plan manage-
ment. A higher assumed actuarial rate leads to lower current contribution
requirements because (1) the present value of beneļ¬ts will be lower and (2)
the planā™s assets will be assumed to earn more, hence to grow at a faster rate.
Since the actuarial rate is a forecast of the expected future rate of return on
the planā™s assets, there is a great deal of room for judgment. Some ļ¬rms base
their actuarial rate on recent plan performance, while others base the rate on
long-term historical returns on different asset classes and then apply these
historical returns to the planā™s current asset mix to get a weighted average.
If the estimates are unbiased, errors in actuarial rate assumptions should bal-
ance out over time. However, if a ļ¬rm purposely sets its actuarial rate too
high in order to hold down its contributions and thus raise its reported
income, its pension plan will build up a large unfunded deļ¬ciency.
The Employee Retirement Income Security Act of 1974 (ERISA) is the basic
federal law governing the structure and administration of corporate pension
plans. ERISA requires that companies fully fund their deļ¬ned beneļ¬t pen-
sion plans, although it gives them up to 30 years to make up for under-
funding of past service beneļ¬ts. For example, if a company agreed in 2003
to double payments to all employees who retire in the future, it would imme-
diately have a large unfunded liability. If the company had to come up with
the money to fully fund its plan, it would probably not be able to offer the
improved beneļ¬ts. The phased adjustment period is obviously important in
such a situation.
In addition, ERISA has several other provisions that affect the manage-
ment of deļ¬ned beneļ¬t plans. First, ERISA mandates that pension funds be
managed according to the āprudent manā rule, which focuses on diversiļ¬-
cation as the cornerstone of portfolio management. This has resulted in
pension funds diversifying into such investments as real estate, international
stocks and bonds, LBOs, and venture capital. Second, ERISA sets the manda-
tory vesting requirements discussed earlier to prevent situations whereby
long-term employees are ļ¬red or laid off just before their beneļ¬ts are vested.
Finally, ERISA established the Pension Beneļ¬t Guarantee Corporation
(PBGC), which we discuss next.
The Pension Beneļ¬t Guarantee Corporation (PBGC) was established by
ERISA to insure corporate deļ¬ned beneļ¬t pension funds. The PBGC, which
is an agency within the U.S. Department of Labor, steps in and takes over
payments to retirees of bankrupt companies with underfunded pension plans.
Currently, the PBGC is paying (or will pay when they retire) beneļ¬ts to some
624,000 retirees from 2,975 companies, including Pan American Airlines,
Eastern Airlines, Allis-Chalmers, Republic Steel, and LTV Corporation.
29-8 Pension Plan Management
Funds for the PBGC come from premiums paid by sponsors of deļ¬ned
beneļ¬t plans. Currently, the premium is $19 per participant per year, plus an
additional fee of $9 per $1,000 of unfunded liabilities. However, the ulti-
mate backers of the PBGC are the taxpayers. Just a few years ago, the PBGC
was grossly underfunded, with known obligations exceeding assets by some
$3 billion. At that time, pundits were predicting that the only thing that
would save the PBGC was a large government bailout. However, by 1997,
increased collections from sponsoring corporations, coupled with high
investment returns and a decline in large bankruptcies, resulted in a PBGC
surplus of about $900 million, its ļ¬rst ever.
To help control costs, the PBGC does not cover company-promised health
insurance for retirees. Further, PBGC payments to retirees are capped at
about $42,954 (in 2002 dollars) per year, which for some highly paid work-
ers is much less than their plan originally promised. Finally, the PBGC does
not guarantee pensions that are to be paid by annuities purchased by plans
from insurance companies. This feature is important, because in the 1980s,
many companies terminated overfunded deļ¬ned beneļ¬t plans, used a por-
tion of the planā™s assets to purchase insurance contracts to cover promised
beneļ¬t payments, and then recovered the excess assets for the stockholders.
Contributions to the Plan
Actuaries calculate annually how much a company must pay into its deļ¬ned
beneļ¬t fund in order to keep it fully funded (or to move it toward full fund-
ing). These contributions are a tax-deductible expense, just as are wages.
Obviously, if a company agrees to an increase in beneļ¬ts, this increases its
required contribution and consequently lowers its reported proļ¬ts and cash
ļ¬‚ow to stockholders. Also, if pension beneļ¬ts are tied to wages, then any
wage increase will also require an increase in payments to the pension plan.
Payments also depend on the investment performance of the pension fundā”
if the fundā™s managers do a good job of investing its assets, then required
annual contributions will be reduced, and vice versa if the fundā™s investment
performance is poor.
During the 1990s, as a result of the greatest bull market in history, many
corporationsā™ pension plans were overfunded to such an extent that they did
not have to make any annual contributions. Indeed, many ļ¬rms received
earnings credits. For example, in 1999 GE reported pension income of $1.38
billion, which was almost 5 percent of its operating income; its fund earned
that much more than the cost of the beneļ¬ts it provided to retirees during
the year and the cost of funding the additional future beneļ¬ts that it
promised during the year.3 However, since the tech crash and recession of
2001 and 2002, pension plans have faired less well. In 2001 GM lost $4.4
billion on its pension assets, and as a result of these losses and plan payouts,
its plan went from being overfunded by $1.7 billion in 2000 to being under-
funded by $9 billion at the end of 2001.
The Financial Accounting Standards Board (FASB), together with the SEC,
establishes the rules under which a ļ¬rm reports its ļ¬nancial condition to
stockholders. FASB Statement 87, āEmployersā™ Accounting for Pension
William Persek Jr., āHidden Asset: For Many Companies, Pension Plans Are Bolstering Proļ¬ts,ā Barronā™s, May 29,
Pension Fund Mathematics: Defined Benefit Plans
Plans,ā and Statement 35, āAccounting and Reporting by Deļ¬ned Beneļ¬t
Plans,ā provide guidance for reporting pension costs, assets, and liabilities.
The reporting of deļ¬ned contribution plans is relatively straightforwardā”
the annual contribution is shown on the income statement, and a note to the
ļ¬nancial statements explains the entry. However, reporting for deļ¬ned ben-
eļ¬t plans is much more complex. Basically, a ļ¬rm with a deļ¬ned beneļ¬t plan
must report in its annual report the planā™s overall funding status; the annual
pension expense; a full description of the pension plan, including the
employee groups covered, type of beneļ¬t formula, funding policy, and types
of assets held; the actuarial discount rate used, and any justiļ¬ed difference
between this rate and the rates used to project the beneļ¬t obligation or to
project the return on the planā™s assets; and the amounts and types of securi-
ties issued by the employer and/or related parties that are held by the plan.4
Define the following terms:
(1) Vested; nonvested; deferred vesting
(3) Fully funded; overfunded; underfunded
(4) Actuarial rate of return
(7) Plan contributions
Pension Fund Mathematics:
Defined Benefit Plans
It is clear that the calculation of the present value of expected future bene-
ļ¬ts is of primary importance for deļ¬ned beneļ¬t pension plans. This calcula-
tion determines both the required contribution to the fund for the year and
the reported unfunded liability or surplus. Thus, it is essential that ļ¬nan-
cial managers understand the basic mathematics that underly the beneļ¬ts
To illustrate the process, let us begin with the following assumptions:
1. A ļ¬rm has only one employee, age 40, who will retire 25 years from
now, at age 65, will die at age 80, and hence will live for 15 years after
retirement. There is no uncertainty about these facts.
2. The ļ¬rm has promised a beneļ¬t of $10,000 at the end of each year fol-
lowing retirement until death. For accounting purposes, 1/25 of this
$10,000 payment will be vested each year the employee works for the
3. No uncertainty regarding the contribution stream exists; that is, the
company will deļ¬nitely make the required payments, in equal annual
installments over the next 25 years, in order to build up the fund to the
level needed to make the payments of $10,000 per year during the
employeeā™s 15-year retirement life.
4. The pension fund will earn 8 percent on its assets; this rate is also
known with certainty.
FASB Statement 87 is very complex, hence we cannot discuss its provisions in detail in this text.
29-10 Pension Plan Management
The problem is to ļ¬nd (1) the present value of the future beneļ¬ts and
(2) the companyā™s required annual contributions. We ļ¬nd these values as
Step 1. Find the present value (at retirement) of a 15-year regular annuity
of $10,000 per year. Using a ļ¬nancial calculator, enter PMT
10000 [or 10000], n 15, and i 8; then solve for PV
Step 2. Find the set of equal annual cash contributions required to accu-
mulate $85,594.79 over 25 years. Using a ļ¬nancial calculator,
enter FV 85594.79 [or 85594.79], n 25, and i 8; then
solve for PMT $1,170.83. Thus, the company must contribute
$1,170.83 per year to satisfy its pension requirements. If it makes
these payments each year, it will be able to report a fully funded
A graphical representation of the contributions, beneļ¬ts, and fund value
is presented in Figure 29-1. The āValue of Fundā line is drawn continuously,
although in reality it would be a step function. Note also that setting up a
pension plan for this worker requires analysis over a 40-year horizon.
The rate of return assumed makes a substantial difference in the annual
contribution. If we had assumed a return of 9 percent rather than 8 percent,
the annual contributions would have dropped from $1,170.83 to $951.67.
Thus, annual contributions would have fallen by 18.7 percent from only a
one percentage point change in the assumed investment rate. Conversely, if
we had assumed a 7 percent return, the annual contributions would have
increased to $1,440.01, a 23 percent increase. Assumptions about how long
the worker will live, years before retirement, and, if the payment is based on
salary, annual raises will have similarly large effects on the required annual
Pension Fund Cash Flows and Value under Certainty
Value of Fund = Annual Contributions
+ Investment Returns
ā“ Benefit Payments