Treatment of Pension Plans in a Corporate Valuation

Failure to adjust corporate valuations for pension assets and liabilities that are separable from the business operations can lead to dramatically misvalued companies. During the 1990s, equity and credit analysts generally relied on the pension costs as reported under Statement of Financial Accounting Standards No. 87. Analysts applauded the rewards of pension plans and ignored the risks. Many were unprepared to see pension income replaced by expense, surpluses by deficits, and contribution holidays by cash demands.I explore the impact of a defined-benefit pension plan on the value of its corporate sponsor. I begin by separating the pension plan from the operating business. In fact, reported pension costs are largely irrelevant to valuing the plan sponsor, and the standard pension liability measurement is incorrect. To understand the value and risk that pension plans bring to their sponsors, analysts must separate the plans from the operating business, ignore the annual cost figures, and focus on the pension assets and liabilities.The overall valuation approach I describe may sound straightforward, but of course, the application involves some devilish details. Complicating factors in determining the pension plan's effect on corporate valuation include the tax-exempt status of the plan, excessive surpluses or deficits, and the risk in the mismatch between plan assets and liabilities. The most important devilish details, however, relate to valuing pension liabilities—in particular, choosing the discount rate and using the accumulated benefit obligation (ABO) instead of the projected benefit obligation (PBO). Liabilities and service costs (included in compensation expense) should be based on the ABO, not the PBO.Earnings valuation models must adjust for debt and for financial assets that are separable from the business operations. A pension plan is simply a combination of debtlike liabilities and nonoperating financial assets. Therefore, when valuing the operating business, analysts must remove the pension plan data—except for the service cost, which is a current compensation expense. The effect of the pension plan is captured simply by adding the pension assets to and subtracting the pension liabilities from the value of the operating business. Failure to separate the pension plan can dramatically overvalue companies when pension assets are outgrowing liabilities and undervalue them when the reverse is true.