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Chapter 29

Pension Plan Management

ANSWERS TO END-OF-CHAPTER QUESTIONS

 

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Questions

(29-1) Define each of the following terms:
a. Defined benefit plan
b. Defined contribution plan
c. Profit 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 Benefit 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 benefits

(29-2) Suppose you just started employment at a large firm that offers a defined benefit plan, a cash balance plan, and a defined 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 firm of both a defined benefit plan and a defined 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 firm’s financial condition?

(29-5) A firm’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 financial 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 influence each of the following:
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 “flexible” 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 irrespective of the financial condition of their plans?

Problems

(29-1) The Certainty Company (CC) operates in a world of certainty. It has just hired Mr. Jones, age 20, who will retire at age 65, draw retirement benefits for 15 years, 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 inflation. CC has a defined benefit plan in which workers receive 1 percent of the final year’s wage for each year employed. The retirement benefit, 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 benefit cash flows occur at year-end.

a. How much will Mr. Jones receive in annual retirement benefits?
b. What is CC’s required annual contribution to fully fund Mr. Jones’s retirement benefits?
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 benefit 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 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 firm’s financial 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
benefit 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 firm’s pension fund is $6 million. Assume that all cash flows occur at year-end.
a. Consolidated’s actuarial rate of return is 10 percent. What is the present value of the firm’s pension fund benefits?
b. Is the plan underfunded or over funded?

MINI CASE STUDY

Southeast Tile Distributors Inc. is a building tile wholesaler that originated in Atlanta but is now con-sidering 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 nec-essary 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; over funded; underfunded
(8) Actuarial rate of return
(9) Employee Retirement Income Security Act (ERISA)
(10) Pension Benefit Guarantee Corporation (PBGC)
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.)
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 rate of return
is 10 percent? Draw a graph that 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?
e. Discuss the risks to both the plan sponsor and plan beneficiaries under the four types of pension
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?
(2) The possibility of sex discrimination in hiring?
(3) Employee training costs?
(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?