the number of retirees was small compared with active workers, health care
costs were affordable, and many companies didnā™t even have an idea of the
potential liability created by such beneļ¬ts.
However, with the population aging and health care costs soaring, at
many companies the liability of estimated future costs represents 20 to 40
percent of the ļ¬rmā™s net worth, and for some smokestack companies, it
exceeds net worth. For low-income retirees, health care beneļ¬ts can cost cor-
porations two to three times more than pension beneļ¬ts. Now that they real-
ize what is happening, many companies are trying to reduce retiree health
Although the Grumman pension fund eventually made a $13.2 million proļ¬t on the Grumman stock it purchased, a
lawsuit brought against the planā™s trustees resulted in a ruling that held that trustees are liable for actions in using the
fund to counter takeover attempts. This ruling sends a clear signal that plan assets must be managed, according to
ERISA, for the āsole and exclusive beneļ¬tā of beneļ¬ciaries.
care beneļ¬ts. Thus far, most of the reductions have been minor, such as man-
dating second opinions and increasing co-payments. However, corporate
planners and consultants say that changes are likely to become more preva-
lent and more profound. Possibilities range from cutting back beneļ¬ts for
retirees, forcing them into managed care plans, or even eliminating retiree
health care altogether.
Perhaps the most important factor forcing companies to consider health
care beneļ¬ts is the Financial Accounting Standards Board (FASB) rule that
requires companies to set up a reserve for future medical beneļ¬ts of retirees.
Prior to FASB Statement 106, companies merely deducted retiree medical
payments from income in the year that they were paid. Now ļ¬rms must take
current write-offs to account for vested future medical beneļ¬ts, which
impacts both the income statement and the balance sheet. The new rule was
implemented in 1993, and companies could either take a one-time charge or
amortize the write-off over 20 years. Some strong companies, such as
General Electric, took the write-off. Its liability totaled $1.8 billion in 1993,
but GE had more than $20 billion of book equity to absorb the charge. Other
companies, however, found it impossible to take the one-time charge option.
For example, General Motors had a $24 billion liability but only $28 billion
in book equity, so a one-time charge would have almost wiped out its net
worth. Thus, GM had to amortize its current liability. The rationale behind
Statement 106 is clear: retiree health care costs should be reported just like
pension costsā”at the time the beneļ¬ts are earned by workers.
Do retiree health care benefits pose a significant problem for corporations?
What impact has FASB Statement 106 had on the reporting of retiree health
This chapter provides an introduction to pension fund management. The key con-
cepts covered are listed below:
ā¢ Most companies, and almost all governmental units, have some type of
employee pension plan. The management of these plans is important to employ-
ees, who use pensions to provide post-retirement income, and to stockholders,
who bear the costs of pension plans.
ā¢ Pension funds are big business, totaling almost $11 trillion in assets.
ā¢ There are four basic types of pension plans: (1) deļ¬ned contribution plans, (2)
deļ¬ned beneļ¬t plans, (3) proļ¬t sharing plans, and (4) cash balance plans.
ā¢ Under a deļ¬ned contribution plan, companies agree to make speciļ¬c payments
into a retirement fund, perhaps 10 percent of an employeeā™s salary, and then
retirees receive beneļ¬ts based on the total amount contributed and the invest-
ment performance of the fund.
ā¢ Under a deļ¬ned beneļ¬t plan, the employer agrees to give retirees a speciļ¬cally
deļ¬ned beneļ¬t, such as $500 per month or 50 percent of their ļ¬nal yearā™s
ā¢ In a proļ¬t sharing plan, companies make contributions into an employee-owned
account, but the size of the payments depends on corporate proļ¬ts.
ā¢ A cash balance plan is a deļ¬ned beneļ¬t plan that has some of the popular fea-
tures of a deļ¬ned contribution plan. Employees accrue speciļ¬c, observable
amounts in their accounts, and they can move these accounts if they leave the
29-26 Pension Plan Management
If an employee has the right to receive pension beneļ¬ts even if he or she leaves
the company, the beneļ¬ts are said to be vested. Congress has set limits on the
amount of time it takes employees to become vested.
A portable pension plan can be carried from one employer to another. Deļ¬ned
contribution plans are portable because the contributions and fund earnings
effectively belong to the employee. Also, unions manage the pension funds in
some industries, enabling employees with deļ¬ned beneļ¬t plans to move among
ļ¬rms in that industry without losing beneļ¬ts.
Under deļ¬ned contribution or proļ¬t sharing plans, the ļ¬rmā™s obligations are sat-
isļ¬ed when the required contributions are made. However, under a deļ¬ned bene-
ļ¬t plan companies must cover all promised beneļ¬ts. If the present value of
expected retirement beneļ¬ts equals the assets in the fund, the plan is said to be
fully funded. If fund assets exceed the present value of expected beneļ¬ts, the
fund is overfunded. If assets are less than the present value of expected beneļ¬ts,
the plan is underfunded.
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. This rate is also the
expected rate of return on the fundā™s assets.
The Employee Retirement Income Security Act of 1974 (ERISA) is the basic fed-
eral law governing the structure and administration of corporate pension plans.
The Pension Beneļ¬t Guarantee Corporation (PBGC) was established by ERISA
to insure corporate deļ¬ned beneļ¬t pension funds. Funds used by the PBGC
come from fund sponsors, and these funds are used to make payments to retirees
whose ļ¬rms have gone bankrupt with underfunded pension funds. However,
taxpayers will have to pay if the PBGC does not have sufļ¬cient funds to cover
its payments to bankrupt ļ¬rmsā™ retirees.
The different types of pension plans have different risks to both ļ¬rms and
employees. In general, a deļ¬ned beneļ¬t plan is the riskiest for the sponsoring
organization but the least risky from the standpoint of employees.
Assuming a company has a deļ¬ned beneļ¬t plan, it must develop the fundā™s fund-
ing strategy: (1) How fast should any unfunded liability be reduced, and (2) what
actuarial rate of return should be assumed?
A deļ¬ned beneļ¬t planā™s investment strategy must answer this question: Given the
assumed actuarial rate of return, how should the portfolio be structured so as to
minimize the risk of not achieving the target return?
The performance of pension fund managers can be assessed in two ways: (1) The
fundā™s beta can be estimated, and the return can be plotted on the Security
Market Line (SML). (2) The fundā™s historical performance can be compared with
the performance of other funds with similar investment objectives.
Pension fund managers use asset allocation models to help evaluate funding and
During the major bull market of recent years, many deļ¬ned beneļ¬t plans have
become overfunded. Some corporate sponsors have terminated their overfunded
plans, used some of the proceeds to buy annuities to cover the planā™s liabilities,
and then reclaimed the remainder.
Retiree health beneļ¬ts have become a major problem for employers for two rea-
sons: (1) these costs are escalating faster than inļ¬‚ation, and (2) a recent
Financial Accounting Standards Board (FASB) ruling forced companies to accrue
the retiree health care liability rather than merely expense the cash ļ¬‚ows as they
(29-1) Deļ¬ne each of the following terms:
a. Deļ¬ned beneļ¬t plan
b. Deļ¬ned contribution plan
c. Proļ¬t sharing plan
d. Cash balance plan
g. Fully funded; overfunded; underfunded
h. Actuarial rate of return
i. Employee Retirement Income Security Act (ERISA)
j. Pension Beneļ¬t Guarantee Corporation (PBGC)
k. FASB reporting requirements
l. Funding strategy
m. Investment strategy
n. Asset allocation models
o. Jensen alpha
p. āTappingā fund assets
q. Retiree health beneļ¬ts
(29-2) Suppose you just started employment at a large ļ¬rm that offers a deļ¬ned beneļ¬t
plan, a cash balance plan, and a deļ¬ned contribution plan. What are some of the
factors that you should consider in choosing among the plans?
(29-3) Suppose you formed your own company several years ago and now intend to offer
your employees a pension plan. What are the advantages and disadvantages to the
ļ¬rm of both a deļ¬ned beneļ¬t plan and a deļ¬ned contribution plan?
(29-4) Examine the annual report of any large U.S. corporation. Where are the pension
fund data located? What effect does this information have on the ļ¬rmā™s ļ¬nancial
(29-5) A ļ¬rmā™s pension fund assets are currently invested only in domestic stocks and
bonds. The outside manager recommends that āhard assetsā such as precious met-
als and real estate, and foreign ļ¬nancial assets, be added to the fund. What effect
would the addition of these assets have on the fundā™s risk/return trade-off?
(29-6) How does the type of pension fund a company uses inļ¬‚uence each of the follow-
a. The likelihood of age discrimination in hiring?
b. The likelihood of sex discrimination in hiring?
c. Employee training costs?
d. The likelihood that union leaders will be āļ¬‚exibleā if a company faces a
changed economic environment such as those faced by the airline, steel, and
auto industries in recent years?
(29-7) Should employers be required to pay the same āhead taxā to the PBGC irrespec-
tive of the ļ¬nancial condition of their plans?
(29-1) The Certainty Company (CC) operates in a world of certainty. It has just hired
Benefits and Mr. Jones, age 20, who will retire at age 65, draw retirement beneļ¬ts for 15 years,
Contributions and die at age 80. Mr. Jonesā™s salary is $20,000 per year, but wages are expected
to increase at the 5 percent annual rate of inļ¬‚ation. CC has a deļ¬ned beneļ¬t plan
in which workers receive 1 percent of the ļ¬nal yearā™s wage for each year
employed. The retirement beneļ¬t, once started, does not have a cost-of-living
adjustment. CC earns 10 percent annually on its pension fund assets. Assume that
pension contribution and beneļ¬t cash ļ¬‚ows occur at year-end.
a. How much will Mr. Jones receive in annual retirement beneļ¬ts?
b. What is CCā™s required annual contribution to fully fund Mr. Jonesā™s retirement
29-28 Pension Plan Management
c. Assume now that CC hires Mr. Smith at the same $20,000 salary as Mr. Jones.
However, Mr. Smith is 45 years old. Repeat the analysis in parts a and b under
the same assumptions used for Mr. Jones. What do the results imply about the
costs of hiring older versus younger workers?
d. Now assume that CC hires Ms. Brown, age 20, at the same time that it hires
Mr. Smith. Ms. Brown is expected to retire at age 65 and to live to age 90.
What is CCā™s annual pension cost for Ms. Brown? If Mr. Smith and Ms.
Brown are doing the same work, are they truly doing it for the same pay?
Would it be āreasonableā for CC to lower Ms. Brownā™s annual retirement
beneļ¬t to a level that would mean that she received the same present value as
(29-2) Houston Metals Inc. has a small pension fund that is managed by a professional
portfolio manager. All of the fundā™s assets are invested in corporate equities. Last
year, the portfolio manager realized a rate of return of 18 percent. The risk-free
rate was 10 percent and the market risk premium was 6 percent. The portfolioā™s
beta was 1.2.
a. Compute the portfolioā™s alpha.
b. What does the portfolio alpha imply about the managerā™s performance last year?
c. What can the ļ¬rmā™s ļ¬nancial manager conclude about the portfolio managerā™s
performance next year?
(29-3) Consolidated Industries is planning to operate for 10 more years and then cease
operations. At that time (in 10 years), it expects to have the following pension
Years Annual Total Payment
The current value of the ļ¬rmā™s pension fund is $6 million. Assume that all cash
ļ¬‚ows occur at year-end.
a. Consolidatedā™s actuarial rate of return is 10 percent. What is the present value
of the ļ¬rmā™s pension fund beneļ¬ts?
b. Is the plan underfunded or overfunded?
Please go to our web site, http://brigham.swlearning.com, to access the
With your Xtra! CD-ROM, access the Thomson Analytics Problems and use the
Thomson Analytics Academic online database to work this chapterā™s problems.
Selected Additional References
Southeast Tile Distributors Inc. is a building tile wholesaler d. Assume that an employee joins the ļ¬rm at age 25, works
that originated in Atlanta but is now considering expansion for 40 years to age 65, and then retires. The employee
throughout the region to take advantage of continued strong lives another 15 years, to age 80, and during retirement