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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)
1. Under a defined benefit plan, the employer agrees to give retirees a specific defined benefit, such as $500 per
Chapter 29. Mini Case for Pension Plan Management
A. How important are pension funds to the U. S. Economy?
B. Define the following pension fund terms:
Southeast Tile Distributors Inc. is a building tile wholesaler that originated in Atlanta but is now considering expansion
throughout the region to take advantage of continued strong population growth. The company has been a "mom and pop"
operation supplemented by part-time workers, so it currently has no corporate retirement plan. However, the firm's owner,
Andy Johnson, believes that it will be necessary to start a corporate pension plan to attract the quality employees needed to
make the expansion succeed. Andy has asked you, a recent business school graduate who has just joined the firm, to learn
all that you can about pension funds, and then prepare a briefing paper on the subject. To help you get started, he sketched
out the following questions:
Pension funds constitute the largest class of investors. In 2011, the funds had assets of over $17.9 trillion and they owned
45% IRA assets. Thus, pension funds are a major force in the financial markets.
Interest rate: 10%
8. The actuarial rate of return is the rate of return at which the fund's assets are assumed to be invested.
9. The Employee Retirement Income Security Act Of 1974 (ERISA) is the basic federal law governing the
administration and structure of corporate pension plans.
10. The Pension Benefit Guarantee Corporation (PBGC) is a government-run insurance company created by the
ERISA to ensure that employees of companies which go bankrupt before their plans are fully funded will receive
benefits.
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.)
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 plans is relatively simple: the annual contribution is shown on the firm's income statement and a note
explains the entry. However, the reporting of defined benefit plans is more complex. In this case, the fund's overall
funding status must be reported directly on the balance sheet if the plan is underfunded, and the annual pension
expense must be shown on the income statement. In addition, the firm must provide information concerning the
breakdown of the fund's annual pension expense and the composition of the fund's assets in the notes section of
the annual report.
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 pension rights upon leaving the company prior to retirement, the
rights are said to be nonvested. Most plans today have deferred vesting, in which pension rights are nonvested for
the first few years, say 5, and then become fully vested at that point.
6. A portable pension plan is one that an employee can carry from one employer to another. Portability is
especially important in industries where job changes are frequent--as in trucking and construction--and union-
administered plans are typically used to make portability possible.
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?
The employee will draw an annual pension (an annuity) of $20,000 for 15 years. Thus, the firm must accumulate
$152,121.59 in the pension plan by the time the employee retires to fully fund the retirement:
7. If the present value of expected retirement benefits is equal to plan assets on hand, the plan is said to be fully
funded. If assets exceed the present value of benefits, then the plan is overfunded, while the plan is underfunded if
the present value of benefits exceeds assets. If the plan is underfunded, an unfunded pension liability is said to
exist.
Annual pension payment: $20,000
Required value using the PV function: $152,122
Since the company has 40 years to accumulate this amount, its annual pension contribution is:
Interest rate: 10%
Number of years: 40
Required amount: $152,122
Required contribution using the PMT function:
344$
G. What are the two components of a plan's funding strategy? What is the primary goal of a plan's investment strategy?
To the extent that defined benefit plans encourage employees to stay with a single company, they reduce training costs.
4. The militancy of unions when a company faces financial adversity?
Since defined benefit plan benefits are usually tied to the number of years worked and the final (or last several)
year's salary, unions are more likely to work with a firm to ensure its survival if it has a defined benefit plan.
The two components of a plan's funding strategy are: (1) How fast should any unfunded liability be reduced? (2)
What rate of return should be assumed in the actuarial calculations?
The primary goal of a plan's investment strategy is to structure the portfolio to minimize the risk of not achieving
the assumed actuarial rate of return.
Defined benefit plans are more costly to firms when older workers are hired as opposed to younger workers,
because the firm has a much shorter time to accumulate the needed funds.
2. The possibility of sex discrimination in hiring?
Since women live longer than men, female employees are more costly than male employees to firms that have
defined benefit plans.
3. Employee training costs?
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 place most of the risks on the employees, because their benefits depend on the return that the
fund assets earn, and, in the case of a profit sharing plan, the profits of the company. The cash balance plan seems
to be a "middle of the road" plan in terms of risk for both employees and employers. The company's payment
obligations are fixed and known, while employees are guaranteed a specified return, often the T-bill rate. So far,
this type of plan has saved companies money, because the rates paid on the accounts have been substantially less
than the returns companies have actually earned on the assets backing the 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?
E. Discuss the risks to both the plan sponsor and plan beneficiaries under the four types of pension plans.
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 health care costs are forecasted to be as high, or
higher, than pension costs. A 1990 FASB rule requires companies to accrue, or set up a reserve for, future medical
benefits for retirees. Prior to this rule, companies merely deducted these benefit payments from income in the year
of payment. Now, they must take current write-offs to account for vested future medical benefits. This new rule has
focused the need for companies to carefully assess their abilities to continue generous health plans for retirees,
and many companies are now trimming benefits.
The two components of a plan's funding strategy are: (1) How fast should any unfunded liability be reduced? (2)
What rate of return should be assumed in the actuarial calculations?
The primary goal of a plan's investment strategy is to structure the portfolio to minimize the risk of not achieving
the assumed actuarial rate of return.
H. How can a corporate financial manager judge the performance of pension plan managers?
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 for the riskiness of the portfolio. This is called alpha analysis,
where alpha is the realized return minus the SML return for a portfolio with the same beta. Another way to judge a
portfolio manager is to compare his or her historical returns with other managers having the same investment
objectives.
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 promised pensions to employees, and then recovers the excess
for the firm. This action is controversial because some people believe that pension fund assets belong to the
employees, and hence firms that do this are "robbing" their employees. Conversely, courts have held that pension
fund assets belong to the firm, and hence firms can recover assets as long as this action does not jeopardize the
employee's future pension benefits.
J. What has happened to the cost of retiree health benefits over the last decade? How are retiree health benefits
reported to shareholders?
I. What is meant by "tapping" pension fund assets? Why is this action so controversial?
10/28/2015
1. Under a defined benefit plan, the employer agrees to give retirees a specific defined benefit, such as $500 per
month, 80 percent of his or her average salary over the 5 years preceding retirement, or 2.5 percent of his or her
highest salary for each year of employment.
2. In a defined contribution plan, companies agree to make specific payments into a retirement fund, and then the
retirees receive benefits from the plan depending on the investment success of the plan.
3. Under a profit sharing plan, the employer makes payments into the retirement fund that vary with the level of
corporate profits.
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 contribution plan in others. Cash balance plans work like this: an account
is created for each employee. The company promises to put a specified percentage of the employee's monthly
salary into the plan, and to pay a specified return on the plan's assets, often the T-bill rate.
Chapter 29. Mini Case for Pension Plan Management
A. How important are pension funds to the U. S. Economy?
B. Define the following pension fund terms:
Southeast Tile Distributors Inc. is a building tile wholesaler that originated in Atlanta but is now considering expansion
throughout the region to take advantage of continued strong population growth. The company has been a "mom and pop"
operation supplemented by part-time workers, so it currently has no corporate retirement plan. However, the firm's owner,
Andy Johnson, believes that it will be necessary to start a corporate pension plan to attract the quality employees needed to
make the expansion succeed. Andy has asked you, a recent business school graduate who has just joined the firm, to learn
all that you can about pension funds, and then prepare a briefing paper on the subject. To help you get started, he sketched
out the following questions:
Pension funds constitute the largest class of investors. In 2011, the funds had assets of over $17.9 trillion and they owned
45% IRA assets. Thus, pension funds are a major force in the financial markets.
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 pension rights upon leaving the company prior to retirement, the
rights are said to be nonvested. Most plans today have deferred vesting, in which pension rights are nonvested for
the first few years, say 5, and then become fully vested at that point.
8. The actuarial rate of return is the rate of return at which the fund's assets are assumed to be invested.
9. The Employee Retirement Income Security Act Of 1974 (ERISA) is the basic federal law governing the
administration and structure of corporate pension plans.
10. The Pension Benefit Guarantee Corporation (PBGC) is a government-run insurance company created by the
ERISA to ensure that employees of companies which go bankrupt before their plans are fully funded will receive
benefits.
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.)
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 plans is relatively simple: the annual contribution is shown on the firm's income statement and a note
explains the entry. However, the reporting of defined benefit plans is more complex. In this case, the fund's overall
funding status must be reported directly on the balance sheet if the plan is underfunded, and the annual pension
expense must be shown on the income statement. In addition, the firm must provide information concerning the
breakdown of the fund's annual pension expense and the composition of the fund's assets in the notes section of
the annual report.
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 pension rights upon leaving the company prior to retirement, the
rights are said to be nonvested. Most plans today have deferred vesting, in which pension rights are nonvested for
the first few years, say 5, and then become fully vested at that point.
6. A portable pension plan is one that an employee can carry from one employer to another. Portability is
especially important in industries where job changes are frequent--as in trucking and construction--and union-
administered plans are typically used to make portability possible.
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?
The employee will draw an annual pension (an annuity) of $20,000 for 15 years. Thus, the firm must accumulate
$152,121.59 in the pension plan by the time the employee retires to fully fund the retirement:
7. If the present value of expected retirement benefits is equal to plan assets on hand, the plan is said to be fully
funded. If assets exceed the present value of benefits, then the plan is overfunded, while the plan is underfunded if
the present value of benefits exceeds assets. If the plan is underfunded, an unfunded pension liability is said to
exist.
G. What are the two components of a plan's funding strategy? What is the primary goal of a plan's investment strategy?
To the extent that defined benefit plans encourage employees to stay with a single company, they reduce training costs.
4. The militancy of unions when a company faces financial adversity?
Since defined benefit plan benefits are usually tied to the number of years worked and the final (or last several)
year's salary, unions are more likely to work with a firm to ensure its survival if it has a defined benefit plan.
The two components of a plan's funding strategy are: (1) How fast should any unfunded liability be reduced? (2)
Defined benefit plans are more costly to firms when older workers are hired as opposed to younger workers,
because the firm has a much shorter time to accumulate the needed funds.
2. The possibility of sex discrimination in hiring?
Since women live longer than men, female employees are more costly than male employees to firms that have
defined benefit plans.
3. Employee training costs?
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 place most of the risks on the employees, because their benefits depend on the return that the
fund assets earn, and, in the case of a profit sharing plan, the profits of the company. The cash balance plan seems
to be a "middle of the road" plan in terms of risk for both employees and employers. The company's payment
obligations are fixed and known, while employees are guaranteed a specified return, often the T-bill rate. So far,
this type of plan has saved companies money, because the rates paid on the accounts have been substantially less
than the returns companies have actually earned on the assets backing the 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?
E. Discuss the risks to both the plan sponsor and plan beneficiaries under the four types of pension plans.
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 health care costs are forecasted to be as high, or
higher, than pension costs. A 1990 FASB rule requires companies to accrue, or set up a reserve for, future medical
benefits for retirees. Prior to this rule, companies merely deducted these benefit payments from income in the year
of payment. Now, they must take current write-offs to account for vested future medical benefits. This new rule has
focused the need for companies to carefully assess their abilities to continue generous health plans for retirees,
and many companies are now trimming benefits.
The two components of a plan's funding strategy are: (1) How fast should any unfunded liability be reduced? (2)
What rate of return should be assumed in the actuarial calculations?
The primary goal of a plan's investment strategy is to structure the portfolio to minimize the risk of not achieving
the assumed actuarial rate of return.
H. How can a corporate financial manager judge the performance of pension plan managers?
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 for the riskiness of the portfolio. This is called alpha analysis,
where alpha is the realized return minus the SML return for a portfolio with the same beta. Another way to judge a
portfolio manager is to compare his or her historical returns with other managers having the same investment
objectives.
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 promised pensions to employees, and then recovers the excess
for the firm. This action is controversial because some people believe that pension fund assets belong to the
employees, and hence firms that do this are "robbing" their employees. Conversely, courts have held that pension
fund assets belong to the firm, and hence firms can recover assets as long as this action does not jeopardize the
employee's future pension benefits.
J. What has happened to the cost of retiree health benefits over the last decade? How are retiree health benefits
reported to shareholders?
I. What is meant by "tapping" pension fund assets? Why is this action so controversial?
