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Annual Contributions

5 10 15 20 25 30 35 40 Years

Annual Benefits
Risks Inherent in Pension Plans

Draw a sketch that summarizes the mathematics of pension funding.
Self-Test Questions
How can discounted cash flow (DCF) concepts be used to estimate the annual
funding requirement?

Risks Inherent in Pension Plans
Different types of plans differ with regard to the certainty of cash contribu-
tions, investment earnings, and promised bene¬ts at retirement. In a de¬ned
contribution or cash balance plan, the corporation, or plan sponsor, con-
tributes a guaranteed amount that will be invested for eventual payments to
the bene¬ciaries. No guarantee, however, is made about either the rate of
return earned on the funds contributed or the ¬nal payments. Thus, the ben-
e¬ciaries assume the risk of ¬‚uctuations in the rate of return on the invested
money, so they must bear a risk regarding the level of their retirement
A pro¬t sharing plan is similar to a de¬ned contribution plan, except that
the sponsor™s cash contributions are also uncertain. This uncertainty regard-
ing contributions on top of the uncertainty about the fund™s earned rate of
return increases the risk to the bene¬ciaries. The value of the fund at retire-
ment, hence retirees™ incomes, could be quite large or quite small, depending
on (1) how pro¬table the corporation is and (2) how well the plan™s assets
are managed.
Finally, under a de¬ned bene¬t plan, the corporate sponsor guarantees to
pay a stated amount from retirement to death, hence the sponsor bears all
risks of unexpected variations in rates of return on investment. Note too that
the required level of the fund, and the resulting annual contributions, could
vary if the de¬ned bene¬ts are based on some average of the ¬nal years™
salaries, for salaries can grow at a rate different from the assumed rate.
Thus, the corporation™s future cash payment requirements are relatively
uncertain. Further, these payments cannot be reduced even if the corpora-
tion™s pro¬ts fall, as they would be under a pro¬t sharing plan.
For all these reasons, a de¬ned bene¬t plan is by far the riskiest from the
standpoint of the sponsoring corporation, but the least risky from the stand-
point of the employees.
Large corporations traditionally used de¬ned bene¬t plans, while smaller
ones typically used pro¬t sharing and/or de¬ned contribution plans. As a
result, approximately 91 percent of private pension plans are de¬ned con-
tribution or pro¬t sharing plans, but they include only 66 percent of the
total number of employees participating in pension plans. The reason for
this situation lies in the relative ability to bear risk. Large ¬rms such as GM,
GE, and IBM can assume the risks inherent in de¬ned bene¬t plans better
than their employees. In contrast, many small ¬rms simply do not have the
stability required to assume such long-term risks, and consequently both
they and their employees are better off under a de¬ned contribution and/or
pro¬t sharing plan. However, the high and volatile in¬‚ation of the 1970s and
early 1980s has motivated even some very large companies to terminate
their de¬ned bene¬t plans in favor of de¬ned contribution and cash balance
plans. So, with new companies opting for de¬ned contribution and/or pro¬t
sharing, and older companies switching to such plans, there is a strong trend
away from de¬ned bene¬t plans.
29-12 Pension Plan Management
Chapter 29

Risks to the Corporation
The allocation of risks inherent in pension plan operations depends on how
the plans are structured. Under a de¬ned bene¬t plan, the risks fall primar-
ily on the corporation. If the plan calls for de¬ned contributions, then risks
are shared. Under a profit sharing plan, almost all the risk falls on the
bene¬ciaries. Risk to the corporation under a de¬ned bene¬t plan can be fur-
ther subdivided into (1) uncertainty about the annual cash contribution and
(2) uncertainty about the ¬rm™s obligations in the event it goes bankrupt.
Risks of Annual Cash Contributions The minimum annual cash con-
tribution is the sum of (1) the amount needed to fund projected future bene-
¬t payments that were accrued during the current period, (2) the amount
(which could be zero) that must be contributed to make up for not having
funded all bene¬ts for service that occurred prior to the current period, and
(3) an additional amount (which could be zero or negative) required to offset
unexpected deviations from the plan™s actuarial assumptions, especially devi-
ations in the earned rate of return and in employee turnover and wage rates.
In our Figure 29-1 illustration of pension fund cash ¬‚ows, the annual cash
contributions were known with certainty. In actual plans, there are three key
types of actuarial assumptions that re¬‚ect real-world risks: (1) personnel
assumptions, which allow the actuary to adjust annually for the probability
that any employee will leave the company (that is, terminate employment,
become disabled, retire, or die); (2) future salary assumptions, which take
into account expected future average wage increases, which will, of course,
affect the ¬nal salary and hence de¬ned bene¬t payments based on the ¬nal
salary; and (3) discount rate assumptions, which explicitly forecast the port-
folio™s expected future rate of return, which is used both to compound the
fund™s growth from investment and to discount and thus ¬nd the present
value of future bene¬ts.
At the end of each year, the assumptions are examined and modi¬ed if
necessary, and actuaries determine the present value of expected future ben-
e¬ts. Then the deviation between this value and the actual value of the
fund™s assets is calculated, and it becomes part of an account called “total
cumulative actuarial gains and losses.” Then the annual cash contribution is
adjusted by an amount suf¬cient to amortize this cumulative amount over a
15-year period. For example, suppose a fund were set up on January 1,
2004, and money were deposited based on a set of actuarial assumptions.
Then, at the end of the year, the actual actuarial conditions were examined
and compared with the assumed conditions, and the actual value of the fund
was compared with the money that would be needed for full funding under
the revised actuarial assumptions. Any difference between the actual and
required fund balance would be added to the cumulative gains and losses
account, and the required annual contribution would be increased or
decreased by an amount suf¬cient to amortize this account™s balance over a
15-year period. The same method would be used at the end of 2005; the
cumulative gains and losses account would be adjusted, and a new 15-year
amortization payment for actuarial gains and losses would be determined.
All of this is designed to build the fund up to its required level but, at the
same time, to smooth out the required annual cash contribution and thus
smooth out the ¬rm™s reported pro¬ts and cash ¬‚ows.
Bankruptcy Liens Prior to ERISA, employees had no claim against a cor-
poration™s assets in the event of bankruptcy. Of course, if a de¬ned bene¬t
Risks Inherent in Pension Plans

plan were fully funded, bankruptcy would present no problem for employees,
but bankruptcies did impose serious hardships on members of plans that
were not fully funded. Congress changed the bankruptcy statutes to raise the
priority of unfunded vested pension liabilities, and today unfunded vested
liabilities have a lien with the same priority as federal taxes on up to 30 per-
cent of the stockholders™ equity. Thus, the pension fund ranks above the
unsecured creditors for up to 30 percent of common and preferred equity,
and any unsatis¬ed pension claims rank on a par with those of the general
If one of the subsidiaries of a holding company had been operating at a
loss, and consequently had a low net worth, and if the subsidiary also had
an unfunded pension liability that was greater than its net worth, then the
parent company would be better off without the subsidiary than with it.
This situation has led companies to spin off or otherwise dispose of sub-
sidiaries. Such spin-offs have a detrimental effect on the PBGC, which in fact
sued International Harvester (now Navistar) for selling its Wisconsin Steel
subsidiary three years before the subsidiary went bankrupt. The PBGC
claimed that the purpose of the divestiture was to rid International Harvester
of its subsidiary™s underfunded pension liability.
Effects of Pension Plans on Stock Prices The value of a ¬rm™s stock
is obviously affected by its pension plan, but because of the uncertainties
inherent in pension plan calculations, devising reasonable accounting proce-
dures for reporting both the annual pension expense and the corporation™s
pension liabilities has proved to be quite dif¬cult. FASB Statement 87 was
designed both to increase the disclosure of information about a pension
fund™s condition and to mandate more uniformity in choosing the actuarial
rate of return used to calculate the present value of bene¬ts. However,
because of the variety of funding techniques and the great dif¬culty involved
in forecasting future pension liabilities, reported pension plan data must still
be viewed with a certain amount of skepticism.6
Can investors make sense of pension fund accounting data? To help
answer this question, researchers have examined the relationship between
corporations™ market values and their pension fund liabilities, and they con-
cluded that investors recognize the existence of unfunded pension liabilities
and lower the ¬rm™s value accordingly.7 This and other evidence indicates
that investors are well aware of the condition of companies™ pension funds,
and that unfunded pension liabilities do reduce corporate value.

Risks to Beneficiaries
Although the preceding section might suggest that most of the risks inherent
in de¬ned bene¬t pension plans are borne by the PBGC or the corporate
sponsor, this is not entirely true. For example, suppose that in 2003 a corpo-
ration went bankrupt and its employees were laid off. It is true that the PBGC
will provide the promised retirement payments when the employees actually
retire. But suppose an employee is 50 years old now, his or her bene¬ts are

Note that if a company has been suffering losses prior to bankruptcy, which is generally the case, its equity will be
low, and 30 percent of a low number is lower yet. Nevertheless, PBGC must still make full payments as speci¬ed in the
company™s plan to all vested pension holders, subject to the limits noted previously.
FASB Statement 87 was passed by a 4“3 vote, which re¬‚ects the lack of consensus regarding the proper accounting
treatment for pension plans.
For example, see Martin Feldstein and Randall Morck, “Pension Funds and the Value of Equities,” Financial Analysts
Journal, September“October 1983, 29“39.
29-14 Pension Plan Management
Chapter 29

$10,000 per year, and retirement, as de¬ned by the plan, is 15 years away.
If the ¬rm is in an industry where employment is declining, such as steel or
textiles, the worker will have a hard time ¬nding a new job offering compa-
rable wages. Moreover, even if the worker could get another job that pro-
vides the same salary and an equivalent pension plan, his or her bene¬ts will
still be adversely affected. The bene¬ts under the bankrupt company™s plan
will be frozen”the past bene¬ts from the now-bankrupt ¬rm will not be
increased as a result of pay increases over the worker™s remaining employ-
ment life, as they probably would have been had the original employer not
gone bankrupt. The worker™s bene¬ts under his or her new plan, assuming
he or she does get a new job, would rise with in¬‚ation, but the worker™s
retirement income will be the sum of payments under the old frozen plan and
the new one, hence will almost certainly be lower than they would have been
had no bankruptcy occurred. To illustrate, if his or her plan were terminated,
a 50-year-old manager with a $100,000 annual salary might rate a yearly
pension of $36,000 when he or she reaches age 65, based on a payout of
36 percent of the ¬nal year™s salary. However, if the manager had been able
to continue working at the company, and if salaries had increased by 5 per-
cent annually, then the pension bene¬t would have come to about $75,000 a
year, without even increasing the payout percentage. Thus, bankruptcy de¬-
nitely imposes hardships on workers, and a realization of this fact has been
a major factor in unions™ acceptance of reduced wages and bene¬ts in situa-
tions where bankruptcy and resulting layoffs would otherwise have occurred.
It should also be recognized that (1) prior to the 1930s most people had
to depend on personal savings (and their children) to support them in their
old age, (2) Social Security was put into effect in 1933 to help provide a for-
malized retirement system for workers, (3) corporate pension plans did not
really “take off” until after World War II, and (4) even today many work-
ers, especially those employed by smaller ¬rms, have no formal retirement
plan other than Social Security. Also, when the Social Security Act was
passed in 1933, it was supposed to be based on insurance principles in the
sense that each person would pay into the system and then receive bene¬ts
which, actuarially, were equivalent to what he or she had paid in. Thus,
Social Security was designed to help workers provide for their own future.
Today, Social Security has become an income transfer mechanism in that
workers with high salaries get less out of the system than they pay in, while
low-salaried workers get more out than they pay in. In a sense, the Social
Security system, including Medicare, has become a “safety net” for all older
Americans, irrespective of their payments into the system. Even so, few people
want to be totally dependent on the income provided by Social Security, so
private pension plans are a vital part of the American economic scene.

Consider the four types of pension plans: (1) defined benefit, (2) defined con-
Self-Test Question
tribution, (3) profit sharing, and (4) cash balance. Describe each plan with
respect to the risks borne by the corporation and the beneficiaries.

Illustration of a Defined Benefit versus
a Defined Contribution Plan
Some corporations and governmental units give their employees a choice
between a de¬ned bene¬t plan and a de¬ned contribution plan. The impli-
cations of these plans ought to be understood both by employees and by the
Illustration of a Defined Benefit versus a Defined Contribution Plan

agencies responsible for paying the prescribed bene¬ts. Although pension
plan status would rarely be the primary factor when choosing a job, it still
should be given at least some consideration. Our example does not corre-
spond (to our knowledge) exactly with the plan of any company, but many
companies do have plans that are similar to our hypothetical Company DB
(for de¬ned bene¬t), while other companies have plans similar to our hypo-
thetical Company DC (for de¬ned contribution).
Here are the assumptions used in the illustration:
1. It is now 2004.
2. The employee is 30 years old, earns $30,000 per year, and plans to
retire in 35 years, at age 65.
3. Both companies provide for immediate vesting. (This is not always the
case, especially for de¬ned bene¬t plans.)
4. The rate of in¬‚ation is expected to be 6 percent per year. Salaries will
also increase at this same rate.
5. Pension fund assets are expected to earn a return of 10 percent.
6. The employee is expected to live for 15 years past retirement at age 65,
or to age 80.

Company DB: Defined Benefit
This ¬rm has a de¬ned bene¬t plan that offers 2 percent of the average
salary paid during the last year the employee works for the company for
each year of service at the company. Thus, if the employee worked for one
year and then resigned, we would have the following situation:


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( 7 .)