LP Pension Funding Model

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Several companies have learned that a well-funded and comprehensive employee benefits package constitutes an important part of the compensation plan needed to attract and retain key personnel. An employee stock ownership plan, profit-sharing arrangements, and deferred compensation to fund employee retirement are all used to allow productive employees to share in the firm's growth and development. Among the fringe benefits offered under the cafeteria-style benefits plans is comprehensive medical and dental care furnished through local health maintenance organizations, on-site daycare centers for employee children, and "eldercare" support for the aging parents and other dependents of workers.

Many companies also provide their employees with so-called "defined benefit" pension plans. Under defined benefit plans, employers usually offer workers a fixed percentage of their final salary as a retirement annuity. In a typical arrangement, a company might offer employees a retirement annuity of 1.5% of their final salary for each year employed. A 10-year veteran would earn a retirement annuity of 15% of final salary, a 20-year veteran would earn a retirement annuity of 30% of final salary, and so on. Because each employee's retirement benefits are defined by the company, the company itself is obligated to pay for promised benefits.

Over time, numerous firms have found it increasingly difficult to forecast the future rate of return on invested assets, the future rate of inflation, and the morbidity (death rate) of young, healthy, active retirees. As a result, several organizations have discontinued traditional defined benefit pension plans and instead have begun to offer new "defined contribution" plans. A defined contribution plan features a matching of company plus employee retirement contributions, with no prescribed set of retirement income benefits defined beforehand. Each employee is typically eligible to contribute up to 10% of their pre-tax income into the plan, with the company matching the first 5% or so of such contributions. Both company and employee contributions compound on a tax-deferred basis until the point of retirement. At that time, employees can use their pension funds to purchase an annuity, or draw a pension income from earned interest, plus dividends and capital gains.

Defined contribution plans have some obvious advantages over traditional defined benefit pension plans. From the company's perspective, defined benefit pension plans became much less attractive when accounting rule changes during the late 1980s required them to record as a liability any earned but not funded pension obligations. Unfunded pension liabilities caused gigantic one-time charges against operating income during the early 1990s for AT&T, General Motors, IBM, and a host of other large corporations. Faced with enormous one-time charges during an initial catch-up phase, plus the prospect of massive and rapidly growing retirement expenses over time, many large and small firms have simply elected to discontinue their defined contribution plan altogether. From the employee's perspective, defined contribution plans are attractive because they are portable from one employer to another. Rather than face the prospect of losing pension benefits after changing from one employer to another, employees appreciate the advantage of being able to take their pension plans with them as they switch jobs. Defined contribution plans are also attractive because

CASE STUDY (continued)

they allow employees to tailor retirement funding contributions to fit individual needs. Younger employees faced with the necessity of buying a home or paying for children's educational expenses can limit pension contributions to minimal levels; older workers with greater discretionary income and a more imminent retirement can provide the maximum pension contribution allowed by law. An added benefit of defined contribution compensation plans is that individual workers can allocate pension investments according to individual risk preferences. Older workers who are extremely risk averse can focus their investments on short-term government securities; younger and more venturesome employees can devote a larger share of their retirement investment portfolio to common stocks.

Workers appreciate companies that offer flexible defined contribution pension plans and closely related profit-sharing and deferred compensation arrangements. To maximize plan benefits, firms must make modest efforts to educate and inform employees about retirement income needs and objectives. Until recently, compensation consultants suggested that employees could retire comfortably on a retirement income that totaled 80% of their final salary. However, concerns about the underfunding of federal Social Security and Medicaid programs and apprehension about the rapid escalation of medical care costs make retirement with sufficient assets to fund a pension income equal to 100% of final salary a worthy goal. To fund such a nest egg requires substantial regular savings and an impressive rate of return on pension plan assets. Workers who save 10% of income for an extended period, say, 30 years, have historically been able to fund a retirement income equal to 100% of final salary. This assumes, of course, that the pension plan portfolio is able to earn significant returns over time. Investing in a broadly diversified portfolio of common stocks has historically provided the best returns. Since 1926, the real (after-inflation) rate of return on NYSE stocks is 6.4% per year; the real return on bonds is only 0.5% per year. Indeed, over every 30-year investment horizon during that time interval, stocks have beat short-term bonds (money market instruments) and long-term bonds. The added return from common stocks is the predictable reward for assuming the greater risks of stock-market investing. However, to be sure of earning the market risk premium on stocks, one must invest in several different companies (at least 30) for several years (at least 30). For most pension plans, investments in no-load low-expense common stock index funds work best in the long run. However, bond market funds have a place in some pension portfolios, especially for those at or near the retirement age.

To illustrate the type of retirement income funding model that a company might make available to employees, consider the following scenario. Suppose that an individual employee has accumulated a pension portfolio worth $250,000 and hopes to receive initial post-retirement income of $500 per month, or $6,000 per year. To provide a total return from current income (yield) plus growth (capital gains) of at least 7%, a minimum of 25% of the portfolio should be invested in common stocks. To limit risk, stocks should total no more than 50% of the overall portfolio, and a minimum of 5% should be invested in long-term taxable bonds, 5% in medium-term tax-exempt bonds, and 5% in a short-term money-market mutual fund. Moreover, not more than 75% of the overall portfolio should be invested in stocks plus long-term taxable bonds, and at least $30,000 should be available in money markets plus medium-term tax-exempt bonds to provide sufficient liquidity to fund emergencies. Assume that common stocks have a before-tax dividend yield of 3.5%, with expected growth from capital appreciation of 6.5% per year. Similar figures for long-term taxable bonds are 6% plus 1.5%, 4% plus 1% for medium-term tax-exempt bonds, and 4.5% plus 0% for money market instruments. Also assume that the effective marginal tax rate is 30%.

A. Set up the linear programming problem that a benefits officer might use to determine the total-return maximizing allocation of the employee's pension portfolio. Use the inequality forms of the constraint conditions.

CASE STUDY (continued)

B. Solve this linear programming problem and interpret all solution values. Also determine the employee's expected before-tax and after-tax income levels.

C. Calculate the amount of unrealized capital gain earned per year on this investment portfolio.

D. What is the total return opportunity cost of the $6,000 after-tax income constraint?

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