Accounting for Corporate Pensions
The key to a successful defined benefit pension plan is managing risk. The pension plan is a significant employee benefit that supports retention and corporate culture in the long-term. The pension plan liability may represent a considerable proportion of the corporation's balance sheet and materially impact the income statement. Accounting for a defined benefit pension plan is notorious for its arcane regulations and the dual regimes of statutory and financial accounting. A few critical elements are crucial to managing the pension.
Accounting regimes are distinct with materially different outcomes with statutory or financial reporting.
Valuation changes to the asset or liability cause material changes to the balance sheet and income statement.
Equity Markets and Interest Rates are the primary drivers of valuation changes and are manageable risks.
The liability grows every year from the annual accrual of benefits, the normal (i.e., service) cost.
Labor force changes (e.g., terminations and new hires) are the most significant demographic factor of the pension liability.
Higher interest rates are favorable for the pension plan as the service cost decline is greater than the interest expense increase.
Many factors impact the funded status (e.g., asset minus liabilities). The two critical components are equity risk (i.e., assets) and interest rate risk (i.e., liability). These risks are manageable through careful asset-liability management and a prudent contribution policy. Understanding the accounting impact helps address these risks.
The Strategic Context
There are three strategic rationales for offering a defined benefit pension plan. First, they provide a form of deferred compensation. Second, they aid in employee retention. Third, they enable the sponsor to turn a cost center into a profit center. While other minor rationales exist, these have the most immediate and enduring impacts on the firm.
Deferred compensation reduces current wages for future payments during retirement. The firm’s direct benefit is increased current cash flows with obligatory payments during retirement to the employees. The statutory regulations codify this obligation. It protects the money placed aside for the sole benefit of the beneficiaries and thus out of the firm’s discretionary control. Both stakeholders receive a benefit: one current and one deferred.
A pension augments employee retention by providing a rationale for employees to stay with the sponsor and reduce costly employee turnover. This outcome is a function of the pension benefit’s extended accrual period (i.e., it vests after many years of service) and the lack of portability. The employee receives a two-fold benefit: financial security during retirement and the prospect of lower asset management costs and better performance from professional investment. As before, benefits exist for both stakeholders.
The third benefit accrues to the sponsor through the management of the assets and liabilities. While the payment into the pension trust is a direct cost, achieving an implicit benefit to the sponsor is possible. To the extent that the sponsor earns more on the pension’s invested assets of the pension than the discount rate used to calculate their present value, it is advantageous for the company to provide the benefit. Historically, the return on a diversified portfolio of equities and bonds returned more than the performance of a similar liability. Thus, the sponsor can turn a cost center into a profit center.
The key measure for transforming a plan from a cost center to a profit center is the return on capital (ROC) deployed by the plan sponsor. Suppose the ROC is higher than the discount rate used to value the pension liabilities. In that case, the plan sponsor improves its ROC by the margin between the two. For high growth companies, the diversified portfolio return is usually insufficient to achieve this outcome, thus obviating a defined benefit plan. These companies enable employee retention via equity compensation (e.g., stock & options).
In contrast, those firms with a lower than market ROC may benefit materially from sponsoring a pension plan. The starting potential is apparent. Borrow the higher return on capital of the market to help pay future benefits. Leverage professional and low-cost investment advice that scale delivers to achieve this outcome. Unfortunately, realizing this potential is rare.
Most pension plans endured a deficit position over the last two decades. Whether the result of managerial incentives, behavioral flaws, or poor investment management, the driver is mostly irrelevant to the outcome. This outcome is tragic given the material benefits to all the critical stakeholders. The significant insight for the sponsor is that the past is not prelude. A strategic plan sponsor needs to answer only a few key questions to deliver on the promise of defined benefit pension plans.
Does the market return on capital exceed the sponsor’s?
If yes, then there is potential to reduce the cost of contributions.
Are investments fully diversified at low-cost for the target return?
Active investment is uncertain, control costs.
Is the plan underfunded?
If yes, commit to contributions or higher funded ratio volatility.
In this context, knowledge of pension plan accounting enables a fuller framing of the pension sponsor’s strategic choice.