When it comes to defined benefit pension plans, strong asset returns can be misleading—they don’t necessarily improve funding levels. The real goals for most companies that sponsor a pension plan are an acceptable funded status and the minimization of cash contributions. To determine if a plan is on track towards these outcomes, sponsors must look beyond asset returns and understand the five ways that a pension plan affects the company’s overall financial picture.
1. Cash Contributions
For starters, in order to ensure that the plan pays out all its promised benefits, the company is responsible for making cash contributions, which can vary widely from year to year. Cash-laden companies, such as some in the oil and gas industry, may have sufficient reserves to handle contributions in most likely economic scenarios. For others, an unexpected spike in contributions could initiate a crisis.
2. Funded Status
An obvious funding target is 100%, but there are other trigger points that plan sponsors need to watch too.
If a plan has a funded status below 80%, a company must send a notice to its members and to the Pension Benefit Guaranty Corporation (PBGC), and further steps might be necessary to determine whether the plan is “at risk.”
Lump sum payments—one-time payments made to former employees to pay off all of their previously promised benefits—may also be restricted. This denies companies a strategy that might help them reduce pension liabilities. On top of all this, a company cannot make any benefit improvements unless it funds them in full up front.
To avoid these constraints, many companies choose to make discretionary contributions to remain above the 80% funded status trigger.
If a plan’s funded status falls to 60%, it triggers further constraints: benefit accruals are frozen, lump sum payments are forbidden altogether, and executive benefits outside the plan can be restricted.
Even if a fund does not fall below the 80% or 60% triggers, any shortfall below 100% funded status often means the company will have to make cash contributions, which can be large. In bad market years, when sagging investment returns weigh on the value of pension plan assets, a plan’s funded status can tip closer to a shortfall — and take a toll on the company balance sheet.
3. Pension Liability
A plan’s funded status is only part of the picture. The pension liability that appears on the corporate balance sheet provides a straightforward measure of the market value of the plan’s assets minus its liabilities, discounted using the yield on high-quality corporate bonds.
The accounting for measuring pension liability is regulated by Statement of Financial Accounting Standards 87, and is directly linked to the markets, calculated without any smoothing or adjustments.
4. Pension Expense
On the other hand, calculating pension expenses on corporate income statements is a bit trickier; in fact, pension expenses can seem illogical at times.
Pension expenses start with the two basic operating costs of pension plans: the cost of paying out benefits as they come due (service cost), and the cost of the growth in a plan’s liabilities (interest cost). Care needs to be taken in using these costs and any assumptions about future plan assets to avoid potential distortions in corporate earnings.
5. PBGC Payments
In addition, on top of managing cash contributions, funded status, and pension liabilities and expenses, a company has to pay the Pension Benefit Guaranty Corporation, which protects private-sector pensioners in the event that their sponsoring firms go under. In essence, the PBGC is an insurance policy, funded collectively by premiums from the private firms whose plans it guarantees.
The weak economy has caused an increasing number of companies to default on their promised benefits and fall back on the PBGC. As a result, PBGC premiums are rising, and with no government backstop in place behind the insurance, the PBGC provides an additional source of worry.
By assessing plans’ assets in relation to their changing liabilities, rather than on the basis of absolute returns, plan sponsors can exert more control over funding levels and cash contributions — factors that can significantly impact the bottom line.
Learn more about how pension plans affect the corporation in Russell Investments' Corporate Pension Finance Handbook.
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The information, analyses and opinions set forth herein are intended to serve as general information only and should not be relied upon by any individual or entity as advice or recommendations specific to that individual entity. Anyone using this material should consult with their own attorney, accountant, financial or tax adviser or consultants on whom they rely for investment advice specific to their own circumstances.
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First used: July 2013