Pension Obligation Assumptions
Most defined benefit pension plans are based on the employee’s ending salary and years worked. The benefits in many cases will not be paid for many years, but the benefits will then be paid out for a number of years. In order to properly account for the liability, many assumptions need to be made:
- How many more years will the employee work?
- What will be the employee’s ending salary?
- How many years will the employee collect a pension in retirement?
- What type of return can be earned on assets in the fund?
- What is the appropriate rate to discount the liability to present value?
The longer the employee works, the more benefit will be accrued. This increases the potential liability by increasing final salary (more years of raises) and by applying a larger multiple since many plans are based on years of service (for example, the pension equals 1% of ending salary for each year of service). On the other hand, since the retirement is further away it will be discounted back a larger number of years when calculating the present value, which will partially offset the other effects.
The higher the ending salary (or projected annual salary increase) the higher the future (and present) liability.
The longer the employee is expected to live/collect benefits, the higher the liability.
The higher the expected return on assets, the less the company will have to contribute to the fund in order to meet the future obligations.
The higher the discount rate used, the lower the present value of the future liability.
For more information, see all articles on: Accounting, Financial Statement Analysis, Fundamental Analysis See also:
The Intelligent Investor: The Classic Text on Value Investing
Financial Statement Analysis: A Practitioner's Guide, 3rd Edition
Managing Investment Portfolios: A Dynamic Process (CFA Institute Investment Series)
