Question

“There is strong evidence of an impending implosion of the pension funding system in the United States. Local and state financial problems are accelerating because public entities promised pensions they could not afford. It is now time for all government pension plans to employ the use of a liability-based discount rate for the measurement of present value pension obligations. Prompt remedial action is necessary to avoid systemic financial catastrophe!” Discuss.

Items to consider:

Logical Format of Response.

Word count – at least 350 words, and preferably not more than 700 words.

Introduction – to what extent to you agree / disagree?

Background of Issue/s, including description/definition of present value pension obligations, and liability-based discount rate.

Discussion of Issues (with appropriate examples)

Conclusion.

Appropriate use of references.

Originality.

Answer 1

There are basically two types of retirement funds. Defined-contribution plans, such as 401(k)s and IRAs, are tax-advantaged accounts owned and largely funded by employees themselves (sometimes with additional contributions by employers). The only real risk for these funds is that the investments in the account may perform poorly. Over the past 12 years, unfortunately, most stocks have gained little or have actually declined in value. As a result, many people approaching retirement today have far less money than they expected.

There are basically two types of retirement funds. Defined-contribution plans, such as 401(k)s and IRAs, are tax-advantaged accounts owned and largely funded by employees themselves (sometimes with additional contributions by employers). The only real risk for these funds is that the investments in the account may perform poorly. Over the past 12 years, unfortunately, most stocks have gained little or have actually declined in value. As a result, many people approaching retirement today have far less money than they expected.

While such a shortfall is distressing, it doesn’t compare with the dangers posed by the other type of plan. So-called defined-benefit plans promise to pay benefits to retirees based on the length of time they worked and their former salaries. If these plans run short of money, they not only leave retirees unsure that their benefits are safe, they also create a potential cost for whoever has to bail them out (often taxpayers). Such plans can slide along for years hiding their growing internal deficits with accounting tricks. But at some point, the funding gap becomes too big to disguise – which is what is happening now.

A pension's projected benefit obligation (PBO) is an actuarial liability equal to the present value of liabilities earned and the present value of liability from future compensation increases. It measures the amount of money a company must pay into a defined-benefit pension plan to satisfy all pension entitlements that have been earned by employees up to that date, adjusted for expected future salary increase. The magnitude of the obligation is determined through a present value calculation.

Based on ?nancial theory, a discount rate should re?ect the timing and riskiness of the promised
value of future cash-?ows. Thus, more mature pension funds, whose liabilities have shorter
duration and are more likely to be paid, should use lower discount rates than younger funds
because the yield curve is generally upward sloping. Financial theory also argues that the
projected liabilities of mature pension plans are more akin to those of a (shorter duration) bond
rather than of equity and these plans should use lower discount rates.

Three things make pension fund accounting complicated. First, the benefit obligation is a series of payments that must be made to retirees far into the future. Actuaries do their best to make estimates about the retiree population, salary increases and other factors in order to discount the future stream of estimated payments into a single present value. This first complication is unavoidable.
Second, the application of accrual accounting means that actual cash flows are not counted each year. Rather, the computation of the annual pension expense is based on rules that attempt to capture changing assumptions about the future.

Third, the rules require companies to smooth the year-to-year fluctuations in investment returns and actuarial assumptions so that pension fund accounts are not dramatically over- (or under-) stated when their investments produce a single year of above- (or below-) average performance. Although well-intentioned, smoothing makes it even harder for us to see the true economic position of a pension fund at any given point in time.Below is the part of the footnote that calculates the fair value of the plan assets. You can see that the pension fund produced an actual return of 7.9% in the year 2003 ($281 / $3,537). Other than the investment returns, the largest changes are due to employer contributions and benefit payouts:

Now take a look at the calculation of the PBO (see below). Whereas the fair value of plan assets (how much the fund was worth) is a somewhat objective measure, the PBO requires several assumptions which make it more subjective:

You can see that PepsiCo started 2003 with an estimated liability of $4,324, but the liability is increased by service and interest cost. Service cost is the additional liability created because another year has elapsed, for which all current employees get another year's credit for their service. Interest cost is the additional liability created because these employees are one year nearer to their benefit payouts.

The reason for and effect of the additional interest cost is easier to understand with an example. Let's assume that today is 2005 and the company owes $100 in five years, the year 2010. If the discount rate is 10%, then the present value of this obligation is $62 ($100 ÷ 1.1^5 = $62). (For a review of this calculation, see Understanding the Time Value of Money.) Now let one year elapse. At the start of 2006 the funds now have four years instead of five years to earn interest before 2010, the present value of the obligation as of 2006 increases to $68.3 ($100 ÷ 1.1^4 = $68.3). You can see how interest cost depends on the discount rate assumption.

Now, let's continue with PepsiCo's footnote above. Plan amendments refer to changes to the pension plan and they could have a positive or negative impact on cost. Experience loss is more commonly labeled actuarial loss/gain, and it too can be positive or negative. It refers to additional costs created because the changes in actuarial estimates changes made during the year. For example, we don't know the cause in PepsiCo's case, but perhaps it increased its estimate of the average rate of future salary increases or the average age of retirement. Either of these changes would increase the PBO and the additional cost would show up as an actuarial loss.

We see that PepsiCo's liability at the end of the year 2003 was $5,214. That is the PBO. We also see a lesser amount "for service to date." That is the VBO and we can ignore it.

The fair value of the plan assets ($4,245) subtracted by the PBO ($5,214) results in the funded status at the end of 2003 of -$969 million. The bottom line: PespiCo's pension plan at that time was under-funded by almost one billion dollars.

Pension Plans and the Balance Sheet
Now remember we said that pension plans are off-balance-sheet financing, and in PepsiCo's case, the $4.245 billion in assets and $5.214 billion in liabilities are not recognized on the balance sheet. Therefore, typical debt ratios like long-term debt to equity probably do not count the pension liability of $5+ billion. But it's even worse than that. You might think the net deficit of -$969 million would be carried as a liability, but it is not. Again, from the footnotes:

Due to the smoothing rules of pension plan accounting, PepsiCo carried $1,288 in pension plan assets on the balance sheet, at the end of 2003. You can see how the two "unrecognized" lines on the footnote above boost the negative into a positive: the losses for the current year, and prior years, for that matter, are not recognized in full; they are amortized or deferred into the future. Although the current position is negative almost one billion, smoothing captures only part of the loss in the current year--it's not hard to see why smoothing is controversial.

Cash Contributed to the Pension Is Not Pension Cost
Now we have enough understanding to take a look at why cash contributed to the pension plan bears little, if any, resemblance to the pension expense (also known as "pension cost") that is reported on the income statement and reduces reported earnings. We can find actual cash contributed in the statement of cash flows:

Now compare these cash contributions to the pension expense. In each of the three years reported, cash spent was significantly higher than pension expense:

The first two components of pension expense - service and interest cost - are identical to those found in the calculation of PBO. The next component is "expected return on plan assets." Recall that the "fair value of plan assets" includes actual return on plan assets. Expected return on plan assets is similar, except the company gets to substitute an estimate of the future return on plan assets. It is important to keep in mind that this estimate is an assumption the company can tweak to change the pension expense. Finally, the two "amortization" items are again due to the effects of smoothing. Some people have gone so far as to say the pension expense is a bogus number due to the assumptions and smoothing.





Read more: Financial Statements: Pension Below is the part of the footnote that calculates the fair value of the plan assets. You can see that the pension fund produced an actual return of 7.9% in the year 2003 ($281 / $3,537). Other than the investment returns, the largest changes are due to employer contributions and benefit payouts:

Now take a look at the calculation of the PBO (see below). Whereas the fair value of plan assets (how much the fund was worth) is a somewhat objective measure, the PBO requires several assumptions which make it more subjective:

You can see that PepsiCo started 2003 with an estimated liability of $4,324, but the liability is increased by service and interest cost. Service cost is the additional liability created because another year has elapsed, for which all current employees get another year's credit for their service. Interest cost is the additional liability created because these employees are one year nearer to their benefit payouts.

The reason for and effect of the additional interest cost is easier to understand with an example. Let's assume that today is 2005 and the company owes $100 in five years, the year 2010. If the discount rate is 10%, then the present value of this obligation is $62 ($100 ÷ 1.1^5 = $62). (For a review of this calculation, see Understanding the Time Value of Money.) Now let one year elapse. At the start of 2006 the funds now have four years instead of five years to earn interest before 2010, the present value of the obligation as of 2006 increases to $68.3 ($100 ÷ 1.1^4 = $68.3). You can see how interest cost depends on the discount rate assumption.

Now, let's continue with PepsiCo's footnote above. Plan amendments refer to changes to the pension plan and they could have a positive or negative impact on cost. Experience loss is more commonly labeled actuarial loss/gain, and it too can be positive or negative. It refers to additional costs created because the changes in actuarial estimates changes made during the year. For example, we don't know the cause in PepsiCo's case, but perhaps it increased its estimate of the average rate of future salary increases or the average age of retirement. Either of these changes would increase the PBO and the additional cost would show up as an actuarial loss.

We see that PepsiCo's liability at the end of the year 2003 was $5,214. That is the PBO. We also see a lesser amount "for service to date." That is the VBO and we can ignore it.

The fair value of the plan assets ($4,245) subtracted by the PBO ($5,214) results in the funded status at the end of 2003 of -$969 million. The bottom line: PespiCo's pension plan at that time was under-funded by almost one billion dollars.

Pension Plans and the Balance Sheet
Now remember we said that pension plans are off-balance-sheet financing, and in PepsiCo's case, the $4.245 billion in assets and $5.214 billion in liabilities are not recognized on the balance sheet. Therefore, typical debt ratios like long-term debt to equity probably do not count the pension liability of $5+ billion. But it's even worse than that. You might think the net deficit of -$969 million would be carried as a liability, but it is not. Again, from the footnotes:

Due to the smoothing rules of pension plan accounting, PepsiCo carried $1,288 in pension plan assets on the balance sheet, at the end of 2003. You can see how the two "unrecognized" lines on the footnote above boost the negative into a positive: the losses for the current year, and prior years, for that matter, are not recognized in full; they are amortized or deferred into the future. Although the current position is negative almost one billion, smoothing captures only part of the loss in the current year--it's not hard to see why smoothing is controversial.

Cash Contributed to the Pension Is Not Pension Cost
Now we have enough understanding to take a look at why cash contributed to the pension plan bears little, if any, resemblance to the pension expense (also known as "pension cost") that is reported on the income statement and reduces reported earnings. We can find actual cash contributed in the statement of cash flows:

Now compare these cash contributions to the pension expense. In each of the three years reported, cash spent was significantly higher than pension expense:

The first two components of pension expense - service and interest cost - are identical to those found in the calculation of PBO. The next component is "expected return on plan assets." Recall that the "fair value of plan assets" includes actual return on plan assets. Expected return on plan assets is similar, except the company gets to substitute an estimate of the future return on plan assets. It is important to keep in mind that this estimate is an assumption the company can tweak to change the pension expense. Finally, the two "amortization" items are again due to the effects of smoothing. Some people have gone so far as to say the pension expense is a bogus number due to the assumptions and smoothing.