Pensions.  Modeling pensions and even understanding them is a challenge.  Pension information is calculated by actuaries and is compiled in a report that is updated at least once per year.  Pensions contain five elements relevant to modeling:  (i) Expense.  This is an actuarial / accounting number that is imbedded in the income statement, (ii) Payments to retirees.  The cash that is paid out to retirees in any given year, (iii) Pension Funding.  Cash taken from the company and invested in accounts owned by the pension fund (ii and iii are typically taken together for modeling purposes), (iv) Pension assets.  The investments the pension fund has made to provide for retirees, (v) Liability.  A calculation by actuaries of the amount the company owes to retirees in present value terms.  At the outset, pensions appear similar to taxation in their modeling treatment.  There are assets, liabilities, an accounting expense number, and cash payments.  They are quite similar in this regard.  The difference is that pension numbers do not tie together like tax numbers.  The normal equation that balances income and cash differences with changes in assets and liabilities does not apply.  Why?  The liability moves independently of the accounting expense.  The liability calculation is so complex that it takes specialists to perform.  What you need to know is that it always moves around and it is based on things like:  discount rate, how long people live (mortality tables), when they retire, how long they will stay with the company, etc.  When these independent inputs change, the liability can shift suddenly and without relationship to what was expensed on the income statement in the prior period.  If your model is wired up in a standard fashion, either your balance sheet will not balance or you will generate “false” cash (or both) when this occurs.  This issue will be discussed later.  First, how the five pension elements work together is discussed below:

  1. Expense.  Always mentally treat pension expense as non-cash.  The number that is on the income statement is a combination of what current employees “earn” in benefits each year, the burn off of discount rate for retirees, earnings from investments, and a smoothing out of the aforementioned liability.  Pensions can produce net income under the right conditions.  Pension expense is part of benefit cost and tends to track labor expense in the income statement.  It will be embedded in COGS and SG&A.  It is best to have a pensions expert / actuary identify the total cost that was booked or will be booked. 
  2. Pension Funding.  What is paid out to employees is fairly well known and projected.  What is paid out of the company an into pension assets is influenced by the liability calculation, ERISA laws and regulations, Pension Protection Act laws, etc.  Pension funding is the cash leaving the company.
  3. Assets & Liabilities.  Pension assets are investments in securities and other assets.  Obviously, these assets will fluctuate in value.  As previously mentioned, the liabilities fluctuate in value as well.  These value fluctuations are not run through the income statement however, they are run through other comprehensive income (OCI) which is an equity account on the liability side of the balance sheet.  Funding to assets obviously increases the asset base and payments draw it down.

This background is detailed, but it will help you deal with pension information when you are faced with it.  Modeling pension information is best done with a good amount of simplification.  The methods that follow may make your accountant cringe, but they will help you create a model that is usable and useful to your needs.  When modeling, of the elements, the two important ones are expense and funding.  Unless there are known or expected results pending on the liability side or asset side, these are best ignored (carried forward with some adjustments) for projections to avoid getting in the business of asset market projections.  If you are trying to “model history” you will, of course, need to take into account all of the elements. 

Determine the accounting expense for pension in the projections and determine the pension cash funding in the projections.  The best source of projections is the actuarial report (or from the actuaries themselves) or your internal pension personnel.  Projecting pension cash funding is a dark art that seems to always defy intuition.

The projected pension expense that is relevant to your model is the projected expense that is in the model, not what is in an actuarial report (this is important).  If you created the projections, determine what the imbedded pension expense was in the base year(s), then use that to calculate the pension expense in your projection.  If the projections came from someone else, find out what method, if any, they used to estimate pension expense (it is often ignored).  It is also often the case that no data is available in the early stages of model creation because of the level of discussions taking place.  When it is unknown, base the future expense on labor cost ratios or other ratios.  Understand that when you ignore pension effects in a model you are assuming that the accounting expense is equal to the cash funding.  This is rarely the case, and the differences can be large.

Please download the free pension excel spreadsheet example:  Pension.  This example once again includes truncated statements to show the flow of entries across the three statements.  Once you have the accounting expense used in the model’s projections and the forecasted funding, create a separate tab to reconcile the pension effects.  Add back the “non-cash” expenses and subtract out the actual funding so you will have the correct cash flow as on row 44 coming from the subtotal on row 11.  To make your model easy to follow and simple to use (accountants cringe) plug the difference to changes in pension liability as on row 34 from the calculation on row 16.  This is not correct.  Please wire up the broad detail and adjust OCI if you would like to have a proper pension balance sheet.  In most modeling cases, however, the important emphasis is on cash flow for credit and valuation analysis.  The fact that you have adjusted for pension cash flow is already a leap forward compared to many models.  In practice, the difference between expense and cash can be very large.  Seldom is the difference to the good.

In the example, the expense line on row 6 represents the accounting expense imbedded in the income statement.  This may be from the expense detail, or calculated separately using expense ratios.  Again, ensure that it is the modeled expense, not the actuary’s projection (unless, of course, you used the actuarial projection as a component of expense in the model).  The projected funding on row 8 will come from the pension report or a custom projection from the actuary.  Obtain the longest projection you can reasonably extract (even beyond your model period) from the actuaries to understand the profile of future funding.  Pension funding can be very jumpy and tends to revert to expense over time.  Shorter time horizons can dramatically distort long-term cash flow and value.  The adjustment to cash line on row 11 carries the difference between expense and funding to the cash flow statement.  Your cash flow statement should contain this amount in the operating cash section.  The pension liability roll-forward on row 16 allows your balance sheet to balance.  Again - this is not the correct way to reflect what is happening from an accounting standpoint, but it is very useful for modeling.  Alternatively, you could also plug into OCI to avoid moving the total liability section of the balance sheet (which may influence credit ratios, etc.).

Note the “Final year cash adjustment” on row 10.  This adjustment is put in place because the last year of pension funding and expense often is not related to the ongoing, perpetual cash funding needs of the pension.  If you are using a discounted operating cash flow valuation method where the terminal value is calculated with the final year cash flow, you can introduce significant error by carrying over what happens to be in the last year of the funding projection.  The last year of funding needs to be adjusted for the ongoing / perpetual cash expense of the pension.  This is a really fun conversation to have with your actuary, by the way.  Few will want to opine on this number, but you should endeavor to have the experts give one to you.  The number will never be “correct”, but you know making the last year of funding perpetual is wrong.

It is also helpful to include a switch in the model to remove the effect of pension completely.  This would add back all of the accounting expense to the cash flow statement and not adjust for actual cash funding (the expense is generally left in the income statement to avoid unintended tax impacts).  Some valuation techniques involve treating the pension liability as debt.  If you do this, you should not also “ding” the model for pension related cash flow, nor for expenses related to pension, as you have captured those in the debt-proxy.  Make certain that you know when the switch is thrown by making it obvious in any output.  Also, take care that you have the correct total liability that includes future service, not just past obligations (if not, removing expense is improper).  A nice technique here is to ask an insurance company (that is not having a liquidity crisis) for a price to purchase the assets and liabilities of the plan.  Then, you have a market value for the net liability and you can take it out of your model.  If the model is good, there should not be a large difference between the cash flow calculation and the determined total net liability.  If there is, continue investigating until there is some convergence.

Know that the funding profile (especially short term) can have little relationship to the economic impact of the pension obligation.  Even when you have correctly adjusted for pension cash flow, understand what is behind it to avoid under or over valuing the liability.