finance

1. The Importance of a Corporate Finance
Approach to Managing Defined Benefit Plans
Vanguard Investment Counseling & Research
Executive summary. A number of factors influence the investment objectives of Author
pension plan sponsors and the risk measurements they use in managing assets in Kimberly A. Stockton
defined benefit plans. This brief focuses on the financial status of the sponsoring
company. We provide guidelines for assessing the impact of the plan on the
company, and describe how this will influence its decisions about asset allocation.
The corporate finance approach When the pension plan is viewed as a
Different plan sponsors, of course, have part of the sponsoring corporation, the
different constraints and objectives that can general objective of increasing shareholder
vary widely with the health of the corporation value drives investment decisions in the
and 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’s
to pension accounting and funding rules have financial statements.2 Generally speaking,
generally raised awareness of the relationship a sponsoring company’s exposure to pension
between a company’s pension plan and its risk can be measured by comparing the
bottom line. These new rules have resulted size and cost of the pension plan to the
in more transparency and in more volatility size and earnings of the company. Also
flowing through from the pension plan to the important is how these relative measures
company’s financial statements.1 As a result, vary over time.3
a plan sponsor may need to evaluate the risk
of the pension plan in the context of its
impact 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.
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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.
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3. The second factor is fairly straightforward.
Companies with weak financials will of course Figure 1. The impact of a drop in plan funding status
be less able than strong companies to weather on the sponsoring company’s balance sheet
negative changes in the pension plan’s financials.
For example, companies that are burdened with Company A
debt and have little shareholder equity could be Today: Plan Future: Plan
in danger of violating their debt covenants if their 100% funded 75% funded
pension liabilities increase significantly. Current liabilities $ 1,900 $ 1,900
Liabilities for pension benefits — 500
We illustrate the third factor, the size of the plan Deferred income taxes 800 600
relative to the size of the company, in Figure 1, Other long-term liabilities 16,750 16,750
in which we show the impact of a drop in funding Total liabilities $19,450 $19,750
status from 100% to 75% on the company balance
sheet for two different companies. The plan assets Common stock $ 1,500 $ 1,500
and liabilities are the same in both cases, but because Retained earnings 14,500 14,500
Company B is much smaller than Company A, the
Accumulated other
ratio of plan assets to company assets is much higher comprehensive income 7,250 6,950
for Company B. As a result, the drop in funding Total shareholders’ equity $23,250 $22,950
status, not unlike that experienced by many plans in
Total liabilities and
2000–2002, produces large hits to shareholder equity, shareholders’ equity $42,700 $42,700
which declines by 13%. Compare this with the
result 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 shareholder
equity dropping by only 1.3%. Also, it’s important to Company B
note that for this example we have changed only the
Today: Plan Future: Plan
net pension liability and offsetting required entries. 100% funded 75% funded
If company earnings were declining at the same time
Current liabilities $ 190 $ 190
as pension earnings, the result could be a lot worse.
Liabilities for pension benefits — 500
Deferred income taxes 80 –120
Balance sheet risk measurement
Other long-term liabilities 1,675 1,675
With respect to risk measurement in general,
Total liabilities $1,945 $2,245
downside risk, as well as expected pension
outcomes, should be considered relative to the
Common stock $ 150 $ 150
corporation. This can be done with stochastic asset-
Retained earnings 1,450 1,450
liability modeling. For example, for an allocation of
Accumulated other
60% equities and 40% bonds, a plan sponsor could
comprehensive income 725 425
begin with an ALM process that provides expected
Total shareholders’ equity $2,325 $2,025
funded status (with returns in the 50th percentile of
Total liabilities and
distributions) and downside funded status (reflecting
shareholders’ equity $4,270 $4,270
the 10th percentile of return distributions). The next
step 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.
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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.
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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 and
In 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 around
it is likely that they will within the next few years. And,
the mean. For example, if the (expected) standard
analysts evaluating public companies are now typically
deviation of pension expense is $40 and the mean
adjusting pension expense to account for current
pension expense is $90, a rough rule of thumb is
market values.6 Therefore, it is a good idea for plan
that pension expense can be expected to fall
sponsors to evaluate the impact of the pension plan’s
between $50 and $130 roughly two-thirds of the
expense not only using the current rules, but also
time for the period estimated.9
using 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.
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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.
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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.
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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
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