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29-3 a. Find the present value (today's value) of the firm's obligations.
To simplify calculations, find the value of each 5-year period's payment as of the
beginning of the period. For example, the value at Time 10 of the payments for Years
11-15 is:
0 10 15 20 25 30
| | | | | |
b. Since the assets are less than the PV of benefits, the plan is underfunded.
0.89.
$6,772,460
$6,000,000
benefits ofPV
valuemarket Fund
ratio Funding
Answers and Solutions: 29 - 1
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
r = 10%
b. Define the following pension fund terms:
1. Defined benefit plan
2. Defined contribution plan
3. Profit sharing plan
4. Cash balance plan
5. Vesting
6. Portability
7. Fully funded; overfunded; underfunded
8. Actuarial rate of return
9. Employee Retirement Income Security Act (ERISA)
10. Pension Benefit Guarantee Corporation (PBGC)
Answer: 1. Under a defined benefit plan, the employer agrees to give retirees a specific
2. In a defined contribution plan, companies agree to make specific payments into a
Mini Case: 29 - 2
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
4. The cash balance plan is a new type of retirement plan developed in the late
1990s. It is like a defined benefit plan in some respects and like a defined
5. An employee is vested if he or she has the right to receive pension benefits even
if they leave the company prior to retirement. If the employee loses his or her
6. A portable pension plan is one that an employee can carry from one employer to
7. If the present value of expected retirement benefits is equal to plan assets on
10. The Pension Benefit Guarantee Corporation (PBGC) is a government-run
Mini Case: 29 - 3
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
c. What two organizations provide guidelines for reporting pension fund activities
to stockholders? Describe briefly how pension fund data are reported in a firm's
financial statements. (hint: consider both defined contribution and defined
benefit plans.)
Answer: The Financial Accounting Standards Board (FASB), together with the SEC,
establishes the rules under which a firm reports its financial results, including its
income and asset positions, to stockholders. The reporting of defined contribution
d. Assume that an employee joins the firm at age 25, works for 40 years to age 65,
and then retires. The employee lives another 15 years, to age 80, and during
retirement draws a pension of $20,000 at the end of each year. How much must
the firm contribute annually (at year-end) over the employee's working life to
fully fund the plan by retirement age if the plan's actuarial expected rate of
return is 10% and its assumed interest rate for discounting pension benefits also
is 10%? Draw a graph which shows the value of the employee's pension fund
over time. Why is real-world pension fund management much more complex
than indicated in this illustration?
Answer: The employee will draw an annual pension (an annuity) of $20,000 for 15 years.
Alternatively, using a financial calculator, input n = 15, i = 10, PMT = 20000, and
Mini Case: 29 - 4
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
A graph of the employee's pension fund assets looks like this:
Real-world pension fund management is much more complex because of
e. Discuss the risks to both the plan sponsor and plan beneficiaries under the four
types of pension plans.
Answer: The defined benefit plan places most of the risks on the company, because it
guarantees to pay a more or less fixed retirement benefit regardless of its ability to
fully fund the plan. Conversely, the defined contribution and profit sharing plans
f. How does the type of pension plan influence decisions in each of the following
areas:
1. The possibility of age discrimination in hiring?
Mini Case: 29 - 5
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
Yea rs
of Do llars
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20
40
60
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20 40 60 80
Yea rs
of Do llars
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20
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20 40 60 80
Answer: Defined benefit plans are more costly to firms when older workers are hired as
f. 2. The possibility of sex discrimination in hiring?
f. 3. Employee training costs?
f. 4. The militancy of unions when a company faces financial adversity?
Answer: Since defined benefit plan benefits are usually tied to the number of years worked and
g. What are the two components of a plan's funding strategy? What is the primary
goal of a plan's investment strategy?
Answer: The two components of a plan's funding strategy are:
h. How can a corporate financial manager judge the performance of pension plan
managers?
Answer: Pension plan managers can be judged in several ways. One way is to compare the
realized return on the manager's portfolio with the equilibrium return commensurate
Mini Case: 29 - 6
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
i. What is meant by "tapping" pension fund assets? Why is this action so
controversial?
Answer: Pension fund assets are tapped when a company terminates an overfunded defined
benefit plan, uses a portion of the funds to purchase annuities which provide the
j. What has happened to the cost of retiree health benefits over the last decade?
How are retiree health benefits reported to shareholders?
Answer: Because of the increased number of retirees, and the dramatic escalation in health
care costs over the past 10 years, many companies are facing situations where retiree
Mini Case: 29 - 7
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
