Mini Case: 29 – 8
MINI CASE
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:
a. How important are pension funds to the U. S. Economy?
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
the investment success of the plan.
Mini Case: 29 – 9
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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.
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
frequent—as in trucking and construction—and union-administered plans are
typically used to make portability possible.
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
plans.
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.)
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.
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.
accumulate this amount, its annual pension contribution is $343.71:
Real-world pension fund management is much more complex because of
uncertainties regarding (1) how long the employee will work for the firm, (2) the
salary of the employee over time, and (3) the rate of return that can be earned on
pension contributions.
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
company. The cash balance plan seems to be a “middle of the road” plan in terms of
f. How does the type of pension plan influence decisions in each of the following
areas:
1. The possibility of age discrimination in hiring?
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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?
g. What are the two components of a plan’s funding strategy? What is the primary
goal of a plan’s investment strategy?
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
website, in whole or in part.
i. What is meant by “tapping” pension fund assets? Why is this action so
controversial?
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?
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.