Pension Plan Contributions, Free Cash Flows and Financial Slack

Calculating pension plan cash flows using financial statement information

Derivation of Contributions and Benefits Paid

Included in the provisions of the recently released SFAS No. 132 [FASB, 1998], “Employers’ Disclosures about Pensions and Other Postretirement Benefits“, is the requirement to disclose cash flows associated with pension plans; i.e. contributions (CONTA) made by the firm to the pension plan and benefits (BENA) paid by the plan to retirees. These disclosures were not provided under SFAS 87, the accounting standard in effect for the sample of firms we examined. However, these cash flows can be estimated (albeit with some measurement error¹⁴). In order to analyze the relationship between contributions and firms’ funding status, one must derive them from the given SFAS 87 disclosures.

Estimating Contributions

The pension amount shown on the balance sheet, the accrued pension liability (prepaid pension cost), reflects the difference between the plan assets and PBO less any unrecorded plan assets/ liabilities. Each year, the balance sheet liability is increased by the amount of the net periodic (smoothed) pension expense recognized under SFAS 87 and reduced by employer pension contributions made during the year.

Using the given balance sheet amounts and the reported pension cost, the unknown variable "Contributions", can be derived as:

Contributions = Pension expense -  accrued pension liability.

Minimum Liability Adjustment

The above estimate will be incorrect if the firm is subject to the accrual of a minimum pension adjustment. The FASB required firms with pension plans in which the ABO is greater than plan assets to record on the balance sheet a minimum pension liability equal to the difference between the two. Thus, the minimum liability adjustment (required to effect this liability) also affects the opening or closing balance of the accrued pension liability, although it is not included in net pension cost. Thus, in the estimation of the contribution, the minimum liability adjustment needs to be removed from the opening and closing balances of the accrued pension liability.

Estimating Benefits

To estimate the cash benefits paid to retirees in the current period, the following information is required:

• 
  opening and ending balances of the pension plan assets,
  
• 
  actual return on plan assets (PENROA), and
  
• 
  pension plan contributions as estimated above.
  

Given these items, cash benefits paid to current retirees can be estimated as

Benefits paid to retirees = Contributions + PENROA -  plan assets

EXHIBIT 1

SUMMARY STATISTICS

	Variable	Mean	Minimum	25%	Median	75%	Maximum
	UNSCALED
	Contributions	11.8	0.0	0.0	0.4	3.4	7760.0
	PBO	359.2	0.0	0.0	18.6	119.2	82027.0
	Pension assets	361.1	0.0	0.0	17.3	119.4	77210.0
	Net funding	1.8	-22264.0	-3.1	0.0	1.3	10435.0
	Free cash flow	61.3	-17513.0	-1.5	1.0	27.2	10715.0
	Benefits	28.1	0.0	0.0	1.0	7.4	6637.7
	Tax rate	22.2	0.0	0.0	23.1	36.6	60.0
	Total assets	3860.0	0.5	57.2	353.4	1870.3	351041.0
	SCALED BY TOTAL ASSETS
	CONTA	0.0033	0	0	0.0008	0.0044	0.0448
	FUNDA	0.0001	-0.1957	-0.0074	0	0.0025	0.2329
	FCFA	0.0020	-1.0243	-0.0211	0.0113	0.0547	0.4971
	BENA	0.0071	0	0	0.0024	0.0085	0.1790
	PENROA	0.0142	-0.0306	0.0019	0.0072	0.0188	0.2185

Notes:

1. 
   Contributions are estimated as the pension expense minus the change in the accrued pension liability (net of minimum liability). CONTA are contributions scaled by total assets.
   
2. 
   Net Funding is estimated as the fair market value of pension assets minus the Projected Benefit Obligation (PBO). FUNDA is net funding scaled by total assets
   
3. 
   Free cash flow is net operating cash flow minus capital expenditures. FCFA is free cash flow scaled by total assets
   
4. 
   Benefits paid are estimated as pension contributions minus (plus) increases (decreases) in the fair market value of pension plan assets plus the actual return on assets. BENA is benefits paid scaled by total assets.
   
5. 
   The Tax rate is estimated as the tax payments (or tax expense) divided by pretax income. It is winsorized to fall in the range of 0%-60%.
   
6. 
   Pension assets are plan assets at fair market value.
   
7. 
   PENROA in the actual return on plan assets (scaled by total assets).
   
8. 
   Number of observations = 8,643 firm-years made up of 1,683 firms.
   

EXHIBIT 2

CORRELATION MATRIX

	FCFA	FUNDA	BENA	PENROA	TAX
CONTA	0.109	-0.316	0.488	0.254	0.086
FCFA		0.034	0.075	0.082	0.223
FUNDA			0.013	0.278	0.082
BENA				0.547	0.052
PENROA					-0.004

Notes:

1. CONTA is pension plan contributions divided by total assets of the firm.

2. TAX is the tax rate.

3. FCFA represents free cash flow scaled by total assets of the firm.

4. FUNDA is the net funding status scaled by total assets.

5. BENA is Benefits paid divided by total assets.