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report. Companies were able to overlook retiree health care costs because
the number of retirees was small compared with active workers, health care
costs were affordable, and many companies didn™t even have an idea of the
potential liability created by such bene¬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 ¬rm™s net worth, and for some smokestack companies, it
exceeds net worth. For low-income retirees, health care bene¬ts can cost cor-
porations two to three times more than pension bene¬ts. Now that they real-
ize what is happening, many companies are trying to reduce retiree health
15
Although the Grumman pension fund eventually made a $13.2 million pro¬t on the Grumman stock it purchased, a
lawsuit brought against the plan™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 “sole and exclusive bene¬t” of bene¬ciaries.
29-25
Summary


care bene¬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 bene¬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 bene¬ts is the Financial Accounting Standards Board (FASB) rule that
requires companies to set up a reserve for future medical bene¬ts of retirees.
Prior to FASB Statement 106, companies merely deducted retiree medical
payments from income in the year that they were paid. Now ¬rms must take
current write-offs to account for vested future medical bene¬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 costs”at the time the bene¬ts are earned by workers.

Do retiree health care benefits pose a significant problem for corporations?
Self-Test Questions
Explain.
What impact has FASB Statement 106 had on the reporting of retiree health
benefits?



Summary
This chapter provides an introduction to pension fund management. The key con-
cepts covered are listed below:
• 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.
• Pension funds are big business, totaling almost $11 trillion in assets.
• There are four basic 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.
• Under a de¬ned contribution plan, companies agree to make speci¬c payments
into a retirement fund, perhaps 10 percent of an employee™s salary, and then
retirees receive bene¬ts based on the total amount contributed and the invest-
ment performance of the fund.
• 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 or 50 percent of their ¬nal year™s
salary.
• In a pro¬t sharing plan, companies make contributions into an employee-owned
account, but the size of the payments depends on corporate pro¬ts.
• A cash balance plan is a de¬ned bene¬t plan that has some of the popular fea-
tures of a de¬ned contribution plan. Employees accrue speci¬c, observable
amounts in their accounts, and they can move these accounts if they leave the
company.
29-26 Pension Plan Management
Chapter 29


If an employee has the right to receive pension bene¬ts even if he or she leaves

the company, the bene¬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. De¬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 de¬ned bene¬t plans to move among
¬rms in that industry without losing bene¬ts.
Under de¬ned contribution or pro¬t sharing plans, the ¬rm™s obligations are sat-

is¬ed when the required contributions are made. However, under a de¬ned bene-
¬t plan companies must cover all promised bene¬ts. If the present value of
expected retirement bene¬ts equals the assets in the fund, the plan is said to be
fully funded. If fund assets exceed the present value of expected bene¬ts, the
fund is overfunded. If assets are less than the present value of expected bene¬ts,
the plan is underfunded.
The discount rate used to determine the present value of future bene¬ts under a

de¬ned bene¬t plan is called the actuarial rate of return. This rate is also the
expected rate of return on the fund™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 Bene¬t Guarantee Corporation (PBGC) was established by ERISA

to insure corporate de¬ned bene¬t pension funds. Funds used by the PBGC
come from fund sponsors, and these funds are used to make payments to retirees
whose ¬rms have gone bankrupt with underfunded pension funds. However,
taxpayers will have to pay if the PBGC does not have suf¬cient funds to cover
its payments to bankrupt ¬rms™ retirees.
The different types of pension plans have different risks to both ¬rms and

employees. In general, a de¬ned bene¬t plan is the riskiest for the sponsoring
organization but the least risky from the standpoint of employees.
Assuming a company has a de¬ned bene¬t plan, it must develop the fund™s fund-

ing strategy: (1) How fast should any unfunded liability be reduced, and (2) what
actuarial rate of return should be assumed?
A de¬ned bene¬t plan™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

fund™s beta can be estimated, and the return can be plotted on the Security
Market Line (SML). (2) The fund™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

investment strategies.
During the major bull market of recent years, many de¬ned bene¬t plans have

become overfunded. Some corporate sponsors have terminated their overfunded
plans, used some of the proceeds to buy annuities to cover the plan™s liabilities,
and then reclaimed the remainder.
Retiree health bene¬ts have become a major problem for employers for two rea-

sons: (1) these costs are escalating faster than in¬‚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 ¬‚ows as they
occur.


Questions
(29-1) De¬ne each of the following terms:
a. De¬ned bene¬t plan
b. De¬ned contribution plan
29-27
Problems


c. Pro¬t sharing plan
d. Cash balance plan
e. Vesting
f. Portability
g. Fully funded; overfunded; underfunded
h. Actuarial rate of return
i. Employee Retirement Income Security Act (ERISA)
j. Pension Bene¬t Guarantee Corporation (PBGC)
k. FASB reporting requirements
l. Funding strategy
m. Investment strategy
n. Asset allocation models
o. Jensen alpha
p. “Tapping” fund assets
q. Retiree health bene¬ts
(29-2) Suppose you just started employment at a large ¬rm that offers a de¬ned bene¬t
plan, a cash balance plan, and a de¬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
¬rm of both a de¬ned bene¬t plan and a de¬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 ¬rm™s ¬nancial
condition?
(29-5) A ¬rm™s pension fund assets are currently invested only in domestic stocks and
bonds. The outside manager recommends that “hard assets” such as precious met-
als and real estate, and foreign ¬nancial assets, be added to the fund. What effect
would the addition of these assets have on the fund™s risk/return trade-off?
(29-6) How does the type of pension fund a company uses in¬‚uence each of the follow-
ing:
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 “¬‚exible” 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 “head tax” to the PBGC irrespec-
tive of the ¬nancial condition of their plans?



Problems
(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 bene¬ts for 15 years,
Contributions and die at age 80. Mr. Jones™s salary is $20,000 per year, but wages are expected
to increase at the 5 percent annual rate of in¬‚ation. CC has a de¬ned bene¬t plan
in which workers receive 1 percent of the ¬nal year™s wage for each year
employed. The retirement bene¬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 bene¬t cash ¬‚ows occur at year-end.
a. How much will Mr. Jones receive in annual retirement bene¬ts?
b. What is CC™s required annual contribution to fully fund Mr. Jones™s retirement
bene¬ts?
29-28 Pension Plan Management
Chapter 29


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 CC™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 “reasonable” for CC to lower Ms. Brown™s annual retirement
bene¬t to a level that would mean that she received the same present value as
Mr. Smith?
(29-2) Houston Metals Inc. has a small pension fund that is managed by a professional
portfolio manager. All of the fund™s assets are invested in corporate equities. Last
Performance Measurement
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 portfolio™s
beta was 1.2.
a. Compute the portfolio™s alpha.
b. What does the portfolio alpha imply about the manager™s performance last year?
c. What can the ¬rm™s ¬nancial manager conclude about the portfolio manager™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
Plan Funding
bene¬t obligations:


Years Annual Total Payment

11“15 $2,500,000
16“20 2,000,000
21“25 1,500,000
26“30 1,000,000
31“35 500,000



The current value of the ¬rm™s pension fund is $6 million. Assume that all cash
¬‚ows occur at year-end.
a. Consolidated™s actuarial rate of return is 10 percent. What is the present value
of the ¬rm™s pension fund bene¬ts?
b. Is the plan underfunded or overfunded?



Cyberproblem
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Cyberproblems.




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Thomson Analytics Academic online database to work this chapter™s problems.
29-29
Selected Additional References


Mini Case
Southeast Tile Distributors Inc. is a building tile wholesaler d. Assume that an employee joins the ¬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

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. 6
( 7 .)



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