Financial Modeling and Valuation for Post-Employment Benefits

Financial Modeling for DC Plans

Modeling DC plan expenses is integrated within operating expense predictions. By forecasting SG&A (Selling, General, and Administrative) expenses, you are indirectly also modeling the DC plan expenses for employees within those operations. The reason this method is usually problem-free is that DC plan expenses are typically a function of salaries, paid in cash. As a result, these expenses have the same driving factors as short-term benefits and other parts of operating costs. The cash flows generated mirror the recognized expense. On the balance sheet, the only notable effect is that of accrued liabilities, which are already forecasted using working capital ratios.

Financial Modeling for DB Plans

Modeling DB plans, including OPEBs, is a bit more involved. Key areas to model include the service cost, net interest expense or income, remeasurements, and future contributions by the employer. These components form the basis for the amounts recognized on the income statement and affect the net pension asset/liability on the balance sheet. Plan contributions are reported on the cash flow statement.

Valuation Considerations for DB Plans

Valuation of DB and OPEB plans must consider the funded status of the plans and future service costs.

Funded Status

Valuation of DB plans necessitates a thorough examination of the plan’s funded status, which reflects the company’s financial obligation towards the plan’s beneficiaries. The funded status is the difference between the plan’s assets and the pension obligation.

Underfunded Plans

If the plan’s liabilities exceed its assets, it is underfunded. In valuations, this shortfall is treated as a form of debt, factoring into calculations of enterprise value or equity value. When calculating enterprise value, it is essential to adjust for the net pension liability if the plan is underfunded. This adjustment ensures that the valuation reflects all claims on the company’s resources.

The present value of an underfunded pension is integrated into the valuation by reducing enterprise value by the net pension liability. This step aligns the valuation with the present value principles that underpin the DCF methodology.

Overfunded Plans

When a plan has more assets than obligations, it is overfunded. However, overfunded amounts are typically excluded from valuation analyses, as excess assets are dedicated to future benefit payments and are not available to shareholders or other capital providers.

Future Service Costs

Future service costs represent the expected growth in pension obligations due to ongoing employee service. These costs are akin to accruing expenses for future periods where employees earn benefits.

For valuation purposes, future service costs should be handled similarly to share-based compensation. Though not cash outflows, they should be subtracted from free cash flow within a discounted cash flow (DCF) model. This treatment ensures that service costs are appropriately accounted for as a company obligation.

Discounted Cash Flow (DCF) Model Exclusions

In a DCF model, certain items related to DB pension plans are excluded to avoid double-counting and ensure accurate valuation. Net Interest Expense/Income represents the time value of money effect on the discounted pension obligation. Since DCF models inherently account for the time value of money, including net interest again would be redundant.

Question 1

Which of the following best describes the treatment of an underfunded defined benefit pension plan in an enterprise value calculation?

1. It should be ignored as it does not affect the cash flows of the company.
2. It should be added back to the enterprise value as it represents future obligations.
3. It should be treated as a form of debt and deducted from the enterprise value.

Solution

The correct answer is C:

An underfunded defined benefit pension plan represents an obligation of the company to make up for the shortfall in plan assets to meet future pension liabilities. In valuation, this unfunded liability is treated similarly to debt because it is a claim on the company’s resources that must be satisfied. Therefore, when calculating the enterprise value, the net pension liability should be deducted to reflect the company’s true economic value.

A is incorrect: The underfunded status of a pension plan represents a claim on the company’s resources and affects the value available to capital providers.

B is incorrect: The underfunded status is a liability, not an asset, and thus should not be added back to the enterprise value.

Question 2

When adjusting free cash flows in a discounted cash flow model for a company with a defined benefit pension plan, what is the most appropriate treatment of future service costs?

1. They should be ignored as they are non-cash expenses.
2. They should be added back to EBIT when calculating free cash flow.
3. They should be deducted from free cash flow.

Solution

The correct answer is C:

Future service costs represent the incremental obligations a company accrues from ongoing employee service. Although these costs do not result in immediate cash outflows, they signify future economic sacrifices and are thus treated as expenses. In a DCF model, they are subtracted from free cash flow to ensure that the valuation captures all present and future obligations of the company.

A is incorrect: Adding future service costs to operating cash flow would overstate the cash available to investors.

B is incorrect: Future service costs, while attributable to future periods, represent current obligations that accrue and therefore must be included in the valuation analysis.

Reading 12: Employee Compensation: Post-Employment and Shared-Based

Los 12 (e) Explain financial modeling and valuation considerations for post-employment benefits