Time Value of Money

n 2006, the U.S. pension system was

significantly underfundedcompanies in the S&P 500 needed an additional $40 billion to cover their pension commitments. This same situation existed in the U.K. and many other nations. Several factors contributed to this problem, including questionable applications of the time value of money. First, note that there are two types of pension plansdefined contribution plans, where a company provides a specific amount of money, often based on profits, to help its employees when they retire, and defined benefit plans, where the company promises to make specific lifetime pension payments to employees when they retire. The payments depend on each employees final pay at retirement, years of service with the company, and how long the employees live. Actuaries can estimate these factors, but the companys future obligations still are uncertain under a defined benefit plan. As we noted in Chapter 1, a dollar in the future is worth less than a dollar today. Using the time value of money tools in this chapter, we can estimate how much is needed today to make the promised future payments. The amount needed today is actually the present value of the future payments. This present value is called the pension liability, because it represents a claim against the company. Under our pension laws, the company is supposed to set aside enough money each year to meet these future claims. The amount of money that has been set aside, which is invested in a portfolio of stocks, bonds, real estate, and other assets, is called the pension asset. If the pension asset is less than the pension liability, then a defined benefit plan is said to be underfunded. When a company with an underfunded pension plan goes bankrupt, the pension obligations are assumed by the Pension Benefit Guarantee Corporation, a government agency that is implicitly backed by the U.S. government, which means taxpayers. When many companies are underfunded, a very real possibility exists that you, as a taxpayer, will have to bail out the system. Note too that limits exist on the payments to each employee, so if you are highly paid and your employer

goes bankrupt, you will also be a loser. How does the time value of money fit into all this? To see the connection, suppose a plans pension assets are initially exactly equal to its liabilities, and then interest rates decline. As you will see, falling interest rates cause the present value of liabilities to increase. Simultaneously, the future earning power of the pension assets will probably be reduced, so unless the company increases its annual contributions the plan will become underfunded. This is exactly what happened

chapter 2