Bethlehem Case Study

1. Many U.S. corporations have offered defined-benefit (DB) pension plans. Who are all the
stakeholders in this U.S. corporate defined-benefit system?
In a corporate defined-benefit (DB) system, the sponsor (employer) has committed to
make fixed monthly payments, similar to annuities, to plan participants (current or former
employee and to surviving spouses) from retirement to death. The benefits were based on a
formula that was typically a function of salary, and length of service. In a funded DB plan, the
sponsor sets aside funds towards a pension asset, which should typically have funds matching or
exceeding the liabilities (NPV of future payments). If a company is unable to pay out the pension
benefits, it can ask for bankruptcy protection and the Pension Benefit Guaranty Corporation
(PBGC, a government agency) will take over and supply the benefits to the participants.
2. For what type of firms and institutions does offering a DB pension plan still make sense
today? Why?
For most firms, defined contribution (DC) plans are much less costly and thus it makes
sense to offer DC plans to their employees like 401(k). In these plans, the risk of investment
lies with the employees and the firm can have a policy of matching some fixed percentage of
employees contribution. But there are certain firms and institutions for which DB plan still
makes sense. For example, firms and institutions that provide high level of training to their
employees can offer DB pension plans because such plans encourage loyalty. Since the benefits
are defined and are a function of the years of service, the longer the employee stays at a
company, the higher will be the benefits. Also since all of the risk of managing the pension fund
is borne by the sponsor, benefits are kind of guaranteed for the employees. Such firms do not
want to worry about training the employees and then losing them to another firm soon after. DB
pension plans will motivate the employees to stay at the firm. Other firms, or government
institutions which have lowers salaries can offer DB plans to attract employees. For example,
armed forces such as military and marines can offer DB plans to compensate for the low income
by providing stable retirement benefits.
3. How should firms invest their DB pension plan assets what would be a desirable
portfolio allocation? Does your answer to this question depend on the financial health of
the firm or is your investment advice sound regardless of the financial health of the firm?
Just like individual portfolio management, firms should diversify their pension plan
investments to include both bonds and stocks. The investments in the market could yield high
returns which could help the firm in lowering their contribution to the pension funds. Of course,
there is also a risk of losing a lot of money, so to hedge against that, firms should further
diversify their equity investments to lower the overall risk (variability) of their portfolio. In my
opinion, they should invest in value stocks rather than growth firms to lower their risk. The
desired pension plan assets should at least equal the liabilities, if not more than that.

The above strategy can be followed by any firm, no matter their financial health. If a firm
is financially healthy, they can reap the benefits from their diverse portfolio and invest in other
good projects to grow the company, instead of making higher contributions to the pension funds.
4. The top of Exhibit 10 gives the pension plan portfolio of Bethlehem Steel at the end of
2000. Assess the appropriateness of this allocation from the perspective of the following
groups: Bethlehem Steel lower-level workers, Bethlehem Steel shareholders, and the U.S.
govt.
As given in Exhibit 10, Bethlehem Steel has invested more in corporate equities than in
fixed income securities. Also, the portfolio beta is 1, that is, the portfolio is as risky as the
market. Because of market fluctuations, the fund lost around $600 million in one year (1999 to
2000). For lower-level workers, their main concern is that they might not be able to get the
promised benefits when they retire. The risk of not receiving the pension benefits is also
confirmed by looking at the total assets and liabilities which are off by about $1 billion.
Bethlehem Steel shareholders would prefer to invest more in the corporate equities to be able to
get a high return so that the company doesnt have to contribute as much to the pension funds.
They would also be concerned about the image of the company if liabilities exceed the assets by
too much and the company seemed unable to deliver the benefits to its employees. This might
affect the Bethlehems stock prices. The governments main concern is that PBGC will have to
cover the employees benefits if the company is unable match the liabilities and the plan remains
underfunded. Thus, the government would like to see more fixed income security investments to
ensure the ability of the company to pay current liabilities.
5. Should we have a Pension Benefit Guaranty Corporation (PBGC)? Do we need to
provide insurance to workers receiving DB pension plans from firms? If so, do we need this
insurance to be provided by the federal government or could a private insurance company
do a better job?
Having PBGC insure the corporations pension plans was a good idea back in the 1980s,
as this provided security and peace of mind for the employees. But now with the growth in big
private insurance companies, the market should be open to private insurance companies. Even
though PBGC doesnt utilize tax dollars at the moment, with all the companies abusing the
insurance by terminating the pension plans, PBGC might not be able to cover all the liabilities
with just the premiums collected from the corporations. These DB plans were based on the
concept of risk reduction for employees. While the government works to ensure that principal,
the private sector can bring greater expertise and thus can add more value than what the
government can on its own.
6. At the end of 2000, what is the theoretically appropriate discount rate for Bethlehem
Steel to use when discounting its future pension liabilities (forget various accounting and
regulatory rules)? Justify your answer.
To determine whether the pension fund assets match the future liabilities, the
future pension liabilities will have to be discounted back to the current time period.
For that we would have to determine what interest rate we can obtain on these

assets. Therefore the appropriate discount rate is determined by calculating the

weighted average of the returns expected from different sources of fundings such
as equities, corporate bonds, and treasury bills. The below data is taken from
Exhibit 8 and Exhibit 10 and then the weighted average cost is calculated:
Amount
of
Investm
ent
Cash
Fixed
Income
Securitie
s
Corporat
e
Equities
Total

$214

Weight of
Investmen
t
4%

$1,494

26%

$4,017

70%

$5,725

100%
Weighted
Average

Return

Comments
Assuming that the cash is invested
3%
in money market

Pro-rated for US treasury bills

([633/1495]*5.45%) and
6.62%
Corporate/Internatoinal bonds
([862/1495]*7.48%)
11.00% Assumption

9.56%

Thus the appropriate discount rate for Bethlehems future pension liabilities is
9.56%.