Friday, October 21, 2011

Defined Pension Plans

Many US companies have underfunded pension plans, which are not shown on thier balance sheets. In a good case, its several years of earnings. In a bad case, the company may be bankrupt.

We are looking at 'Defined Benefits Pension Plans' where the company is liable for providing stipulated retirement benefits for employees at a future point in time. These are unlike the 'Defined Contribution Benefit Plans', where the employee/employer contribute a fixed amount (401K plans in the US, similar to CPF in Singapore). Liabilities for defined benefit pension plans may be quite big, are not on the balance sheet, and therefore ignored by the financial ratios (eg: PE, debt/Equity).

How are Pension Costs Calculated

Aim here is to understand the meaning behind the pension numbers in the financial statement, process and assumptions that go into the numbers we read. Here is how I imagine it they are calculated (I am not an accountant).

Step 1: Get the current 'fair value' of pension fund assets: This is quite straightforward and objective, as most pension plans consist of liquid assets (equities or bonds).

Step 2: Calculate the Projected Benefit Obligation (PBO): really a series of guesses upon guesses:
  • Estimate how much will be owed in future. There is a lot of guesswork here based on the employees' pay rises, retirement age, etc. Some terminology: changes to the final PBO as a result of these assumptions changing are labelled as 'Actuarial loss/gain' or 'Experience loss/gain'.
  • Reduce this to a number in the present by applying a 'discount rate'. This gives the PBO: an estimate of how much you need today to pay off your future obligations.
Step 3: Compare these numbers from steps 1 and 2: Is the plan under or over funded? 'Funded status' must be stated n the footnotes, but if underfunded, the liability does not have to be recognized on the balance sheet...hide it it the footnotes somewhere.

Step 4: Calculate how much the pension cost in the current year, then decide how much of that to expense in the income statement.

Calculate the current pension cost. This appears in the footnotes, something like 'Components of Pension Expense' or 'Net Periodic Benefit Cost'.... It consists of:
  • Service cost: Because all employees are now 1 year closer to retirement.
  • Interest cost: Because we now have 1 year less to payout our obligations. This depends on the 'Discount rate' in Step 2 (higher rate --> lower PBO --> higher interest expense every year).
  • Subtract the Expected return on assets. This can be increased/decreased.
  • The result is how much you expect the pension to cost you every year.
But....this amount does not have to be fully recognized in the income statement. It may be smoothed out (exceptional gains or losses can be deferred over five years).

In summary, its quite a complex model to reduce a set of future estimates into a few simple numbers, and in the end those numbers may not even be added to the income statement or balance sheet.

Summary of Things to Check

From Investopedia:

1) Locate the 'Funded status', if underfunded, is the liability recognized on the balance sheet?

2) Check the assumptions used:
  • Rate of salary increase used to calculate the graph in Step 2.
  • Discount Rate (step 2): Is it reasonably low? I'm not sure....what is a reasonable expected annual compound growth rate for equities or bond investments?
  • Expected Return On Assets in Step 3: Should not be significantly higher than the discount rate.
3) Is the pension cost/expense fully expensed in the income statement, or deferred?

4) See what proportion of the plan is funded by equities and bonds. Bonds are safer: as they are held to maturity, the only risk in holding them is that the underlying company goes bankrupt. Equities may rise or fall in value when the time comes to sell them.

A look at UPS

I'm using United Parcel Services (UPS) as an example, simply because its the next stock I'm looking at. Numbers are from its 2010 annual report. Page numbers refer to the page number in Adobe Acrobat (not the numbers printed at the bottom of the page).

Funding Status:
  • (p89) UPS' pension plan is worth 20m886m, with a BPO of 25,619m. As calculated, it is underfunded by 4.7bn. And all of this underfunding is recognized on the balance sheet (p90).
Assumptions used (mostly on p87 'Actuarial Assumptions'):
  • UPS has been using between 6.5-7% for the past 3 years. This may be acceptable: to me its not conservative, but not high either. p60 states that a 0.25% decrease in the discount rate results in a 850m increase in projected Pension Plan obligations.
  • Return on assets: UPS has used between 9%, and 8.75% in the past 3 years. Seems high, either for equities or bonds. p60 states that a 0.25% decrease in ROA will increase costs by 46m/year.
  • Rate of salary increase. UPS has used 4.5%, seems realistic.
There is an interesting note on p60:

"Our 2011 pension expense will be higher than our 2010 expense due primarily to two negative factors: the decline in discount rate used to determine expense from 6.58% for 2010 to 5.98% for 2011, (good: 6% discount rate is conservative) and the required amortization of unrecognized losses, the majority of which relate to 2008 asset losses, outside of the corridor we utilize for accounting purposes. These negative factors are partially offset by the additional discretionary contributions that we made in 2010 and 2011 that increased the expected return on assets used for expense calculation purposes." (Did they buy equities....? probably not good to buy high in 2010 and 2011 to make up for losses in 2008.)

Is the pension cost fully expensed?
  • The Net Periodic Cost is calculated at $903m (add columns on p87). This was fully expensed in 2011 (p69 cashflow statement - the amount is added to CFO i.e.: deducted from earnings).
  • I think p90 shows a buildup of pension costs from past years (total $5900m in 'Amounts Recognized in AOCI'). Not sure of the terminology - I think it means this just has to be recognized in future years, which is what they were talking about above (interesting note on p60).
Conclusion for UPS Pension Plan:
  • Can't find anything wrong.
  • Wait for the 2011 Annual Report, to see what the BPO looks like with a more realistic 5.98% discount rate, and how much of the of the $5900m accumulated costs (loss) they recognize.

1 comment:


Defined bebefit plans were a great idea.