Defined Pension / Benefit Obligations

One of the interesting topics in the CFA Level II material is the mechanics for Defined Pension / Benefit Obligations. Previously, in the Rotman Finance I exam / CFA Level I material, I posted an example of the basic mechanics of how a pension plan would be valued (how much would be the PV of future benefit cash flows based on life expectancy and % of salary expectations and what rate of saving would be required to save the required FV to generate those future CF's).

However, if you notice, the "mechanics" of a pension plan are suspiciously similar to that of a bond. And that should come as no surprise. In the retirement or payout phase of retirement, it is as if the retiree is cashing out a fixed income investment (getting regular payments over time) or similar to amortizing a bond liability for the pension plan. However, when they are still "young and saving money" the pension plan is receiving regular payments overtime. The because the payments are regular and defined, they have all the characteristics of a bond.

This metaphor extends even further when you think about what the worker is doing. First a few contrasting scenarios:

Scenario 1: The worker makes a salary of $100k per year.

Scenario 2: The worker makes a salary of $70k per year, but has a defined benefit plan where the company contributes $30k per year into it.

In both of these scenarios the worker (assuming fair treatment) is being given the same value through salary (note also, the I/S in both scenarios reflects a $100k expense with regards to this worker... the only difference is that the $30k would be recognized as deferred wages or change in pension benefit non-cash expense on the CF/S).

However, let's take a closer look at that $30k. What is another way of looking at this? Well, another perspective is to say that the worker is deferring $30k of salary in the hope of future gain as realized through the defined pension benefit. In essence, the worker is loaning money to the company. Assuming that the DPO/DBO is as risk free as the company can guarantee (it is a contractual obligation) in terms of seniority of capital, this money actually ranks as quite senior (priority claim). This is a topic of particular interest with the recent financial crisis, especially as it related to Chrysler and it's recent financial trouble and relationship with the UAW / CAW.

This answers the next question: What is the appropriate discount rate for these funds? Well if you assume this obligation to be one of the most senior forms of claims against the company, it should have the most risk free rate the company can afford which is usually the same rating as it's highest quality bond.

This also raises an interesting point, if you were a lender or potential acquirer (through M&A or LBO) and you were analyzing a company with a defined benefit plan, would you consider the liability similar to debt? While it is not strictly a form of debt in the same way as a revolving credit facility, debenture, high yield bond, PIK or other, it noticably has many of the same characteristics (and is often modeled as a bond liability).