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  1. 1. The Importance of a Corporate FinanceApproach to Managing Defined Benefit PlansVanguard Investment Counseling & ResearchExecutive summary. A number of factors influence the investment objectives of Authorpension plan sponsors and the risk measurements they use in managing assets in Kimberly A. Stocktondefined benefit plans. This brief focuses on the financial status of the sponsoringcompany. We provide guidelines for assessing the impact of the plan on thecompany, and describe how this will influence its decisions about asset allocation.The corporate finance approach When the pension plan is viewed as aDifferent plan sponsors, of course, have part of the sponsoring corporation, thedifferent constraints and objectives that can general objective of increasing shareholdervary widely with the health of the corporation value drives investment decisions in theand its approach to managing the pension plan. In such a corporate finance approach,plan. However, changes in the past few years risk measures are related to the company’sto pension accounting and funding rules have financial statements.2 Generally speaking,generally raised awareness of the relationship a sponsoring company’s exposure to pensionbetween a company’s pension plan and its risk can be measured by comparing thebottom line. These new rules have resulted size and cost of the pension plan to thein more transparency and in more volatility size and earnings of the company. Alsoflowing through from the pension plan to the important is how these relative measurescompany’s financial statements.1 As a result, vary over time.3a plan sponsor may need to evaluate the riskof the pension plan in the context of itsimpact on the company.1 For a detailed review of pension reform and its implications, see Stockton (2006).2 A focus on maximizing the benefit to company shareholders in managing pension plans will be in the long-term best interest of the plan beneficiaries, because plan beneficiaries ultimately benefit from a healthy plan that the company will (can) continue to finance.3 Detailed descriptions of relevant metrics are provided in the Appendix.Connect with Vanguard >
  2. 2. The investment solution resulting from this analysis Impact on the balance sheet is straightforward. It involves an iterative process in With the promulgation of FAS 158 by the Financial which a potential asset allocation is proposed and the Accounting Standards Board in 2006 and its impact that choice would have on financial statements implementation by most plans in 2007 the trend , is assessed. The first step is asset-liability modeling toward mark-to-market pension accounting is well (ALM). This process is typically completed by an under way in the United States. FAS 158—phase outside party, such as a financial services or actuarial one of a two-phase pension accounting overhaul— firm. It involves making projections about the plan, moves the plan funding status, formerly buried such as the expected variation in funding status. in the footnotes, to the corporate balance sheet. In particular, FAS 158 requires that corporations Evaluating potential changes in pension plan recognize on their balance sheets the difference metrics is useful and a good first step. However, between the fair value (market value) of plan assets from a corporate finance perspective, these results and the projected benefit obligation (PBO).5 Because need to be integrated with expectations for the these changes in pension plan accounting mean that sponsoring company’s financial statements. This funding deficits will have a more immediate and next step should be done by the plan sponsor material impact on corporate financial statements, and involves making estimations and projections they all but mandate that public sponsoring companies for financial statement metrics. For example, take a corporate finance approach to managing companies may make projections about their their plans. expected operating income. The reporting of unsmoothed market values and Next, the plan sponsor considers the ALM results liabilities on the balance sheet will lead to larger and company accounting projections together, swings in funding ratios than in the past, as variations reviews the constraints posed by them, and in interest rates and market returns flow directly determines its risk tolerance relative to the impact through to the balance sheet. How much impact this the plan is expected to have on the company’s will have on a corporation’s balance sheet will depend financial statements. Depending on the outcome of primarily on three factors: (1) the correlation and this process, either the sponsor selects the proposed relative amplitude of pension earnings and company asset allocation or the process begins again with a earnings, (2) the strength of the company’s financials new proposed allocation. Ultimately, the plan sponsor without the pension plan, and (3) the size of the plan chooses an asset allocation that is expected to relative to the size of the company. provide the dollar impact and risk to the company balance sheet, income, and cash flow that the Company earnings that show a strong positive company can accommodate.4 correlation with pension earnings are a problem when earnings are negative, in part simply because plan earnings compound an already bad result in the financial statements. In addition, lower pension earnings result in lower funding ratios, which could require the sponsor to make a large contribution to the plan at a time when it can least afford it. Finally, a high positive correlation has a larger impact on the balance sheet over time, and results in higher volatility in balance sheet metrics, because from period to period the plan and company earnings move together. 4 U.S. accounting methods are flexible and based on many assumptions that can have a large impact on any company-sensitive analysis. 5 PBO is one pension liability measure; it is defined as the present value of future benefit payments attributable to past service and future salary levels.2 > Vanguard Investment Counseling & Research
  3. 3. The second factor is fairly straightforward.Companies with weak financials will of course Figure 1. The impact of a drop in plan funding statusbe less able than strong companies to weather on the sponsoring company’s balance sheetnegative changes in the pension plan’s financials.For example, companies that are burdened with Company Adebt and have little shareholder equity could be Today: Plan Future: Planin danger of violating their debt covenants if their 100% funded 75% fundedpension liabilities increase significantly. Current liabilities $ 1,900 $ 1,900 Liabilities for pension benefits — 500We illustrate the third factor, the size of the plan Deferred income taxes 800 600relative to the size of the company, in Figure 1, Other long-term liabilities 16,750 16,750in which we show the impact of a drop in funding Total liabilities $19,450 $19,750status from 100% to 75% on the company balancesheet for two different companies. The plan assets Common stock $ 1,500 $ 1,500and liabilities are the same in both cases, but because Retained earnings 14,500 14,500Company B is much smaller than Company A, the Accumulated otherratio of plan assets to company assets is much higher comprehensive income 7,250 6,950for Company B. As a result, the drop in funding Total shareholders’ equity $23,250 $22,950status, not unlike that experienced by many plans in Total liabilities and2000–2002, produces large hits to shareholder equity, shareholders’ equity $42,700 $42,700which declines by 13%. Compare this with theresult for Company A, which experiences relatively Reduction in shareholder equity –1.3%little change on its balance sheet as a result of the Financial leverage ratio 1.84% 1.86%significant change in plan status, with shareholderequity dropping by only 1.3%. Also, it’s important to Company Bnote that for this example we have changed only the Today: Plan Future: Plannet pension liability and offsetting required entries. 100% funded 75% fundedIf company earnings were declining at the same time Current liabilities $ 190 $ 190as pension earnings, the result could be a lot worse. Liabilities for pension benefits — 500 Deferred income taxes 80 –120Balance sheet risk measurement Other long-term liabilities 1,675 1,675With respect to risk measurement in general, Total liabilities $1,945 $2,245downside risk, as well as expected pensionoutcomes, should be considered relative to the Common stock $ 150 $ 150corporation. This can be done with stochastic asset- Retained earnings 1,450 1,450liability modeling. For example, for an allocation of Accumulated other60% equities and 40% bonds, a plan sponsor could comprehensive income 725 425begin with an ALM process that provides expected Total shareholders’ equity $2,325 $2,025funded status (with returns in the 50th percentile of Total liabilities anddistributions) and downside funded status (reflecting shareholders’ equity $4,270 $4,270the 10th percentile of return distributions). The nextstep would be to evaluate how both of these funding Reduction in shareholder equity –13.0%metrics affect the corporation’s balance sheet and Financial leverage ratio 1.84% 2.11%its relevant metrics given the sponsor’s estimates Note: Assumes only pension liabilities changed and a tax rate of 40%.(expected and downside) for shareholder equity This hypothetical example does not represent any particular investment.and liabilities. Vanguard Investment Counseling & Research > 3
  4. 4. Financial leverage ratios Impact on the income statement As discussed, if changes in funding status are From the corporate finance perspective, because having an impact on shareholder equity and liabilities, shareholders are generally averse to earnings they are also affecting the financial leverage ratios surprises and volatility (even if long-term expected for the sponsoring company. Because leverage ratios returns and equity growth rates are high), sponsors are an indication of a company’s ability to meet its will want to consider the potential impact of pension financial obligations, it’s a good idea to estimate the earnings on company operating income and assess potential impact of the pension plan on these ratios their risk tolerance for variations in this metric. and to assess the company’s risk tolerance with respect to changes in them. As shown in Figure 1, Under FAS 87 the expected return on assets is , for Company B, the company with the most exposure combined with estimates of interest cost, service to the pension plan, the financial leverage ratio, in cost, and amortization amounts to determine the this case as measured by total assets divided by total pension expense or income reported in company equity, increases about 15% with the drop in funding financial statements. The delayed-recognition features status, which could have significant implications for in FAS 87 mitigate much of the volatility of pension the company’s ability to manage its debt. Another earnings for most plans. These features include: relevant leverage ratio is total liabilities divided by total shareholder equity, which would increase by • The use of expected, rather than actual, returns to 32% for Company B, from 0.84 to 1.11. Finally, the determine pension earnings. Expected returns are source of debt may be an issue. To the extent that calculated by the sponsor and cover a long time the sponsoring company wants to limit debt and horizon. As a result, they tend to be very stable. focus it on its core business, it may want to establish • A stipulation that companies are not required a threshold for the proportion of debt from the to immediately recalculate pension expenses or pension plan to debt from its core business. income to reflect short-term deviations between actual and expected returns. Deviations beyond The ratio of funding deficit to market value a certain range are recognized over time in Another relevant measurement is the pension plan’s pension earnings. funding deficit relative to the company’s economic value. This provides a general sense of the plan’s • Smoothing of asset values. In pension earnings potential impact on the company. Sponsors may calculations, plans may use the average market want to quantify downside risk here by estimating value of their pension assets over a maximum the probability that the ratio of the funding deficit to of five years. the company’s market capitalization will rise above a threshold value, say, for example, 10%. Again, a However, pension income flows directly through financial services firm could arrive at these estimates to the company’s operating income. So, even in through asset-liability modeling, with the cooperation its smoothed, delayed-recognition form, pension of accountants at the sponsoring company. expense can have a meaningful impact on the corporate bottom line.4 > Vanguard Investment Counseling & Research
  5. 5. In Figure 2, we show pension income for a Figure 2. A comparison of pension expense under hypothetical plan, under both the current rules and current rules and using “adjusted” values using “adjusted” pension expense. Adjusted pension expense is the unsmoothed calculation of pension Pension expense (under current rules) expense, which attempts to capture the full income Service cost $135 and cost for the period. It includes service cost, Interest cost 125 interest cost, and actual returns for the current period.7,8 As shown, and as did happen in 2000–2002, Expected return on plan assets –400 pension expense under the smoothed rules permitted Unrecognized prior service cost 15 by FAS 87 was actually negative, meaning pension Unrecognized actuarial loss 35 returns exceeded costs based on the smoothed Net periodic benefit income (–)/expense (+) $–90 values and expected returns. But, as also shown in Company net operating income before Figure 2, when actual returns (which were negative) pension expense $800 are reflected, pension expense was positive, meaning Company net operating income after costs exceeded returns. pension expense $890 Pension income/operating income 11% We also show the impact of pension expense on operating income for this hypothetical plan. We focus Pension expense (using “adjusted” values) on operating income because pension income flows Downside through to it and because it is a critical part of income Based on: Actual return risk for corporate valuation. In this hypothetical case, the Service cost $135 $135 impact is positive under the current (smoothed) rules. Interest cost 125 125 Pension income boosts company operating income. Actual return on assets 155 355 The opposite is true when adjusted (mark-to-market) Adjusted pension income (–)/ expense is used. In either case, the point is that plan expense (+) $415 $615 sponsors must account for this risk metric and Company net operating income determine how comfortable they are with potential before pension expense $800 $800 changes in pension income relative to company Company net operating income income. As with the balance sheet, we also suggest after pension expense $385 $185 that they use a downside risk measure based on an Pension income/operating income 52% 77% asset return in the fifth or tenth percentile. This hypothetical example does not represent any particular investment. Another factor to consider is how changes in pension income over time affect earnings volatility. A relevant measure of variation for pension andIn addition, although the rules for dealing with pension company operating income is standard deviation,expense do not yet require mark-to-market accounting, which measures the dispersion of values aroundit is likely that they will within the next few years. And, the mean. For example, if the (expected) standardanalysts evaluating public companies are now typically deviation of pension expense is $40 and the meanadjusting pension expense to account for current pension expense is $90, a rough rule of thumb ismarket values.6 Therefore, it is a good idea for plan that pension expense can be expected to fallsponsors to evaluate the impact of the pension plan’s between $50 and $130 roughly two-thirds of theexpense not only using the current rules, but also time for the period estimated.9using unsmoothed, current market values.6 Though there is some evidence they are not doing so correctly or sufficiently (see Coronado, et al., 2008).7 Service cost is the actuarial present value of the projected benefits attributable to employee service in the current year.8 Interest cost is the increase in PBO associated with the passage of time during the year.9 This assignment of a specific probability of outcomes depends on the actual statistical distribution of the random variable in question. The rule of thumb is roughly correct for normally distributed variables. Vanguard Investment Counseling & Research > 5
  6. 6. Or, if the plan sponsor has several plans it wants to Changes in plan expense or funding status could compare, or if it wants to compare its plan to others have an impact, for example, on a company’s return in the industry, coefficient of variation (CV) may be on assets (ROA) or return on equity (ROE) ratios.11 more useful. CV is simply the ratio of the standard deviation to the mean, and it provides a metric that Conclusion allows the sponsor to compare the degree of variation Recent changes in pension accounting and funding in two data sets with different means. rules have had a dramatic impact on many plans. More transparency and a recognition of more Finally, another way to get at the downside of volatility are causing pension plan sponsors to rethink volatility is simply to calculate the probability that their asset allocation decisions. Because the pension future pension expense, or the ratio of pension plan now may be more likely to affect the sponsor’s expense to company operating income, will go above bottom line, the impact on the company will need a threshold level that is meaningful to the sponsoring to be given larger consideration in decisions about company. For example, if the plan sponsor considers the plan. It is advisable to consider how the pension a pension expense/company operating income ratio plan’s assets and liabilities could affect the company’s of 30% too high, it could estimate the probability income, balance sheet, and cash flow, as well as of exceeding that level at any time in the next ten relevant metrics related to its financial statements. years with its given asset allocation. Asset allocation decisions using this corporate Other risk measures finance approach are made through an iterative Corporate cash flow may also be at risk for process. The plan sponsor, with the help of any pension plan sponsors, particularly given the new, outside parties involved, chooses a potential asset more stringent, funding requirements under the allocation and assesses the impact that allocation Pension Protection Act of 2006. So it is advisable would have on its financial statements. It then to evaluate future plan contributions under both determines its risk tolerance relative to that impact. expected and worst-case (downside) scenarios, Depending on the outcome of this process, the and their potential impact on projected company sponsor chooses that asset allocation or begins cash flow. Also, because adjusted pension expense the process again. does not provide the accrual and delayed-recognition features allowed under FAS 87 it captures the actual , References cash changes related to the plan each year. As Coronado, Julia, Olivia S. Mitchell, Steven A. such, it is meaningful to compare it with company Sharpe, and S. Blake Nesbitt, 2008. Footnotes cash flow. Aren’t Enough: The Impact of Pension Accounting on Stock Values. National Bureau of Economic Capital budgeting can also be affected by the cash Research. NBER Working Paper No. 13726. flow needs of the pension plan. Therefore, the impact of expected contributions on planned capital Stockton, Kimberly A., 2006. Pension Reform: expenditures should also be considered, particularly A Shifting Landscape for Plan Sponsors. Valley for plan sponsors with many large projects.10 Forge, Pa.: Investment Counseling & Research, The Vanguard Group. Finally, plan sponsors may want to evaluate the implications for company profitability by examining mixed ratios, particularly those that combine items from the balance sheet and income statement. 10 Here we are referring to capital expenditure as an outlay of cash for a project expected to generate future cash inflows. Examples include investments in property, plan, and equipment; research and development projects; and advertising projects. 11 ROA is net income/assets. ROE is net income/shareholder equity.6 > Vanguard Investment Counseling & Research
  7. 7. Appendix Corporate finance risk metrics for pension plans Metric Description Purpose Balance sheet Expected and downside impact An estimate of expected and downside changes Measure shareholder equity at risk. to shareholder equity. in plan liabilities and assets, and of how these affect company estimates of shareholder equity. Liabilities/shareholder equity. An estimate of potential changes in liabilities Assess financial leverage. and shareholder equity, given asset and liability projections for the plan and company estimates of shareholder equity. Assets/shareholder equity. An estimate of potential changes in assets and Assess financial leverage. shareholder equity, given asset and liability projections for the plan and company estimates of shareholder equity. Plan assets/company assets. Projections of plan assets relative to Assess the balance sheet’s vulnerability company assets. to the pension plan. Probability of plan deficit/ For a given asset allocation, an estimate of the Assess the downside risk of balance company value above threshold. probability that the ratio of the plan deficit to sheet vulnerability. the company market capitalization will go beyond the level that is acceptable to the sponsor. Income statement Adjusted pension expense. An alternate measure of pension expense (not Measure earnings at risk in a reported), calculated as: current period service mark-to-market environment. cost + interest cost + actual returns. Unsmoothed. Attempts to capture the full income and cost for the period. Expected and downside impact Estimates of expected and downside changes in Measure operating earnings at risk. on operating income. pension earnings and of how these affect company estimates of operating income. Standard deviation or coefficient Variability in pension expense, measured as Assess the potential impact on of variation of pension expense. dispersion from the mean. earnings volatility. Mixed ratios Return on assets (ROA). An estimate of change in pension expense or Assess the potential impact on a funding status and its influence on company company’s profitability ratio. ROA (net income/assets). Return on equity (ROE). An estimate of change in pension expense or Assess the potential impact on a funding status and its influence on company company’s profitability ratio. ROE (net income/shareholder equity). Other Contributions/corporate cash flow. Estimates of expected and downside Measure risk to company cash flow. contribution requirements and the potential impact on company cash flow. Expected and downside impact on Estimates of expected and downside Assess impact on capital budgeting. planned capital expenditures. contribution requirements and the potential impact on plans for projects. Vanguard Investment Counseling & Research > 7
  8. 8. P Box 2600 .O. Valley Forge, PA 19482-2600Connect with Vanguard® > CFA ® is a trademark owned by CFA Institute. E-mail > Contributing authors John Ameriks, Ph.D./Principal Joseph H. Davis, Ph.D./Principal Francis M. Kinniry Jr., CFA/Principal Roger Aliaga-Díaz, Ph.D. Donald G. Bennyhoff, CFA Geetesh Bhardwaj, Ph.D. Maria A. Bruno, CFP ® C. William Cole Scott J. Donaldson, CFA, CFP ® Michael Hess Julian Jackson Colleen M. Jaconetti, CPA, CFP ® Karin Peterson LaBarge, Ph.D., CFP ® Christopher B. Philips, CFA Liqian Ren, Ph.D. Kimberly A. Stockton David J. Walker, CFA Yan Zilbering Investment products: Not FDIC-insured • No bank guarantee • May lose value © 2008 The Vanguard Group, Inc. All rights reserved. ICRCFDB 112008