This chapter presents a multi-period stochastic network model for integrating corporate financial and pension planning. Pension planning in the United States has gained importance with the population aging and the growth of retirement accounts. In certain cases, the pension plan assets are several times larger than the value of the company itself (e.g. General Motors – Market cap: $19 billion, Pension plan assets: $67 billion, Estimated pension fund deficit: $25 billion – in December 31, 2002; see General Motors Corporation (2003)). Thus, pension investment decisions can have a sizeable impact on a company’s long-term financial health. However, pension planning is rarely linked to general corporate planning systems since the domain falls outside traditional corporate budgeting and planning processes.
We develop a consistent framework for combining the pension plan with the corporate financial plan via a stochastic optimization model. The approach can be specialized as a stochastic network, providing possible improvements in computational efficiency and ease of understanding. The goals of the integrated planning model can be readily tailored to the company’s environment to be consistent with the existing corporate strategy. For example, there are numerous measures of risks for a large corporation, such as volatility of earnings, downside risks with respect to target earnings, share price, etc. The developed framework can be adapted to these objectives. In any event, we suggest that several risk measures be displayed to the senior managers so that they better understand the inherent tradeoffs, especially regarding temporal issues.
The general topic of pension planning affects several groups. First, the company desires to minimize its contribution to the plan over time while being able to meet its obligations to the retirees. For defined benefit plans, an annual actuarial valuation is conducted in order to assess the so-called pension surplus or deficit – market value of assets minus adjusted discounted value of liability cash-flows:
- Surplus = Market value of assets minus Discounted (liabilities).
In most cases, there are two general measures of liabilities: (1) accumulated benefit obligations (ABO), and (2) projected benefit obligations (PBO). Roughly speaking, the former represents current legal obligations (say if the plan were to close today), whereas the latter depicts an estimate of the future liabilities (as the company employees age, change positions, etc.). Generally, the PBO is greater than the ABO. Liabilities are defined by FAS 87 (Financial Accounting Standards Statement No: 87) and reported in the company’s financial statements. An important consideration involves the requirement that the company must make contributions when the plan is deemed sufficiently underfunded (as determined by ABO and sometimes PBO). The contribution decision is a major link between the core corporation and the pension plan; we model this as an arc in the stochastic network at each time period, for each scenario (more in the next section). Contributions can also be made voluntarily when the company has sufficient cash and under certain IRS regulations. We will show that this decision can be evaluated in the integrated planning model.
The employees have an important stake in the health of the pension plan. A company falling into bankruptcy will at times turn over the pension plan to the quasi-government agency – the Pension Benefit Guarantee Corporation (PBGC) to administer the plan if the company runs out of funds. This organization protect the employees, but only to a certain degree since the PBGC has limited resources and may not be able to raise benefits, for example, with inflation. Thus, a large surplus is desirable from the employees’ perspective. However, most companies would rather keep funds in the core company, all else being equal, since retained earnings are more flexible than pension funds. It is noteworthy that over the long US bull market many companies have been able to generate accounting “profits” by generating returns above the projected target returns. Recent events have shown that companies should evaluate their assets and liabilities together. Unfortunately, many have not. We will show that careful integrated planning could have largely eliminated the large decrease in surplus or the loss of surpluses.
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