In the previous blog, we talked about the defined benefit and defined contribution pension schemes, how they are funded, managed and why certain companies prefer one scheme over the other. So now, that you are acquainted with the working of pension schemes; the next obvious question would be how and what all these calculations work and mean in real life. Answering your question, this article explains how the pension expenses and provisions are calculated. It also aids in detecting earnings manipulation consequently impacting the employee’s retirement benefits.
In case of defined contribution, every year, some amount is expensed by the company so there is no complexity at all. But in case of defined benefit, the accounting is a bit tedious job. But as mentioned earlier, one should only understand the logic of the process to make sound investment decisions.
For providing monthly or yearly pension to the retired employee till the time of his/her death, the company is required to make certain set of assumptions, expected life of employee and compensation growth rate being the primary ones. As one might think, at this juncture, this process indeed appears tedious and calls for a specialized knowledge. Generally, actuaries help such companies calculate their liability (Projected Benefit Obligation or simply PBO) for providing pension over the life of retired employees.
Let’s try to understand this by a simple example. Assume Mr. ABC joined a Public Sector Unit (PSU) at the age of 21 and his yearly salary is Rs. 5 lakhs. He is going to retire at the age of 61 as per the prevailing rules. Now let’s assume, he is going to survive till the age of 76 and his annual salary is expected to increase by 4% per annum. The applicable discount rate is assumed to be 8%. The retirement benefit is fixed at 2% of the last drawn salary multiplied by the number of years of actual service.
The liability at the end of first year of service will be:
1.Terminal salary amounts to Rs. 5*(1.04) ^39 i.e. Rs. 23.08 lakhs.
(Note that the salary will increase for 39 years, when his service is for 40 years)
2.The annual pension will be 2% of Rs. 23.08 lakhs which is equal to Rs. 0.46 lakhs.
3.Now, calculating the future value of this annuity for 15 years gives us Rs. 12.53 lakhs.
This can be done either with the help of a financial calculator or Microsoft Excel as follows:
- On a financial calculator, input PMT as Rs. 0.46 lakhs, N as 15 and I/Y as 8%.
- In excel, use FV function and input the required parameters.
4.Now, the final step is the calculation of present liability as its future value is Rs. 12.53 lakhs. The future value is then discounted for 54 years, which gives the present liability as Rs. 0.19 lakhs.
(54 years is calculated as 15 years of pension+40 years of service minus 1 at the end of 1st year.)
Thus, Rs. 0.19 lakhs is the company’s current obligation and the company has to make provisions for it. The company will, thus, invest in certain assets that will earn returns year on year. If these assets are more than the liabilities, the plan is said to be overfunded and vice versa. If the assets fail to earn the projected returns, the company will record Actuarial losses and if it earns more than the projected returns, the company will earn Actuarial Profits. In case of losses, the company will have to make additional provisions for the next year, over and above the contribution required for that particular year.
This expense is termed as ‘pension expense’ and is calculated as:
Pension expense = contribution – (Ending Funded Status – Beginning funded status)
Well, it definitely, is a lot of definitions and formulas! But there is no need to be scared in case the calculation part is not understood; as you will not actually be doing these calculations. Actuary is the person responsible for these calculations.
So, how should an investor spot the pension problems?
Well, you don’t need to know the calculations! But you need to cross check the assumptions made by the company. Here are certain pointers about the key assumptions, which, if followed, will give a better picture:
- Discount rate – It should ideally be lesser than or equal to expected rate of return on assets which are earmarked for taking care of pension liabilities. An unreasonably high discount rate should raise red flag in the mind of a prudent investor. In case of International Financial Reporting Standards (IFRS), both the rates (expected rate of return on assets and discount rate) have to be necessarily equal.
- Look for the key numbers – How much actual cash is contributed towards the pension scheme? Also, what percentage of total free cash flow (FCF) is being eaten up in pension contributions? The higher the percentage, the less the cash available for investment and dividends.
- Scheme Maturity – The breakdown of scheme membership, split into active, deferred and pensioners; would give an idea whether the scheme is mature or not. If the scheme is mature, bulk of payouts will become due soon, leaving little time for investment returns to compound. Also, if more than half of the assets of the pension funds are in equities, the company is exposed to relatively greater amount of risk.
The whole point of understanding how companies report their pension liability and pension expense for us, as retail investors, is to detect any kind of manipulation of earnings. If earnings have increased for a company because of any of these assumptions, then it is advisable not to invest in such company as such (manipulated) growth is simply not sustainable.
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