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Table 5.1 Sample Plan Funded Status
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Value 1. Assetsa 2. Liabilityb 3. Funded status % [ 1. / 2. ] 4. Surplus/(Deficit) [ 2. 1. ]
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Underfunded Plan $90 $100 90% ($10)
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100% Funded Plan $100 $100 100% $0
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Overfunded Plan $120 $100 120% $20
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Assets = market value of assets. Liability = either the current liability or accumulated benefit obligation.
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Societal good. Maintaining the funded status of pension plans at over 100 percent helps the entire society. When an employer does not maintain well-funded plans, everyone pays the price if the plans go into bankruptcy and the Pension Benefit Guaranty Corporation (PBGC) must take over the plan. Society s interest is that all companies honor their debts to suppliers, to landlords and, yes, to employees.
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Funding a pension plan above 100 percent is a decision that moves into the other factors to consider. Competing Uses for Corporate Capital Overall Capital Structure. Companies face decisions about how to use their capital on a daily basis. Should they invest in a new factory, should they refinance their existing debt, should they sell a division and use the proceeds to retire some debt All of these decisions relate to the overall capital structure (debt versus equity) of the corporation. Thousands of Wall Street professionals, including investment bankers, spend all day working on finding the optimal capital structure that structure that will maximize the value of the shareholders. In general, as a company takes on debt, it can expand capacity and grow faster. However, with the increased debt comes increased risk for bankruptcy. There is a point at which a company has added so much debt that the risk/reward trade-off goes negative and shareholder value is reduced. Pension plans on one level are like any other debt of the organization. If a company had an underfunded plan, it could simply issue more debt, use the proceeds to pay off the fund s shortfall, and have the plan be perfectly funded. But on one level, all this accomplishes is replacing one form of debt (pension liability) with another (publicly traded debt). Ultimately all of these decisions impact the risk borne by shareholders, since a company is only an artificial legal structure to represent the interests of the owners/shareholders. Refer to the box on Boots later in this chapter for further discussion on the overall shareholder risk issue. Impact on Financial Statement. Well-funded plans, those over 100 percent funded, are in a good position to manage the impact of the pension plan on their financial statements. At the simplest level, if you have put away enough money to cover the current promised benefits, all you are left with is paying for the benefit accruing this year. Accountants call this value of benefits accruing this year service cost. Since employers can control the service cost by making changes to the plan, they are entirely in control of the ultimate cost that shows up in their income statement. However, if a pension plan is less than 100 percent funded, that is,
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underfunded, the accountants require companies to pay off this shortfall, much like you have to pay off the mortgage on your home. In the pension plan world, this mortgage is also comparable with an adjustable rate mortgage, one that changes every year. However, unlike adjustable rate mortgages where homeowners win when the interest rates go down, companies lose when the interest rates go down. And that is exactly what has happened since mid-2000 through the end of 2005. Impact on Investment Risk Tolerance. It is worth mentioning that the funded status of the plan will most likely have an impact on how much risk you take in the plan s investments. Most investment advisers would recommend that plans that are less than 100 percent funded invest in a lower-risk portfolio since the downside of negative returns could drastically affect the employer and participants. A lower-risk portfolio would be one with a high percentage of assets in stable, fixed-income vehicles that are highly liquid. Conversely, if the plan is overfunded, many investment advisers would recommend a more aggressive portfolio since the employer and employees will not be negatively impacted. A more aggressive portfolio would include more equity exposure, global and developing market exposure, as well as possibly less liquid investments like private equity. Ultimately, these decisions should be based on a consideration of all the stakeholders shareholders, participants, and management.
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