Retirement planning by the Vulcans

“Live long and prosper” is best known as a Spock greeting in Star Trek but may be the new call to arms for retirees, pension plans, and employers.  It seems that on average, we’re living longer.  Surely that’s good news – more rounds of golf, more time with the (future) grandkids, more time to enjoy retirement.  Who can argue against that?!  Of course, those activities, retirement in general, requires substantial retirement savings.  Traditionally those savings have come from employer-organized defined benefit (DB) pension plans.  I’ve written about pension plans before here and here.  Given my prior posts, does pension accounting really deserve another look?  In my opinion, absolutely.  Especially with the latest revelation that we’re living longer.

You may ask yourself, “What impact does average life span have on pension plans?”  That’s a good question, and a bit complex but to keep it simple, if you promise to pay your best friend $100 a year until they pass away you quickly understand how their expected lifespan matters.  Longer life = more money that you owe them.  The same is true for pension plans except that it is on a much bigger scale.

Take the University of Toronto as an example.  They owe their employees over $4 billion for future retirement payments.  If those employees live longer, U of T is on the hook for even more than that.  Now the good news – if you can call it that – U of T has put away $2.9 billion as savings towards that pension liability.  That pension asset doesn’t change as employee lifespan changes.  Perhaps you’ve seen the problem already: $2.9 billion in assets – $4 billion in liabilities = trouble.  Yes, that’s right.  U of T as an unfunded pension plan to the tune of $1.1 billion.  Take a look at the liability portion of U of T’s latest (April 30, 2013) balance sheet below (the columns are from left to right: April 30, 2013, April 30, 2012, April 30, 2011).  What’s the biggest liability U of T has?  Pensions.  The “Deferred capital contributions” are just a fancy way of accounting for revenue and all of that amount has already been received as cash but U of T can’t call it revenue yet, so let’s remove the $1,076.4 from the bottom of the column.  That leaves $3,254.7 million of actual liabilities.  Now take the “Accrued pension liability” plus the “Employee future benefit obligation …” for a total of ($1,122.9 + $734.7) $1,857.6 million.  That is  57% of U of T’s real liabilities.  Nearly $2 billion is owed with no savings for that portion.

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Perhaps you say to yourself, “big deal.  U of T is a massive enterprise with billions of dollars of revenue.”  And you’d be partly correct. U of T does have billions of dollars of revenue but in fact they have very little flexibility on raising additional dollars of revenue.  As large as U of T is (~50,000 students), the unfunded pension liabilities are almost double the total amount of tuition dollars raised every year.

This situation is not sustainable.  As more employees retire and live longer, the pension assets will quickly be used to support them.  Current employees who contribute to the plan are not really saving anything for themselves; they’re funding the older, retired faculty as they golf and play with their grandkids.  Another way of looking at this is that for every dollar of tuition that a U of T student pays, a portion of that is going to fund a retired U of T employee – an individual that is not contributing to the student’s current experience.

What is U of T’s plan to get out of this mess?  Beyond a terrible reversal in the expected lifespan of its retirees and employees, U of T must be hoping for a dramatic positive performance in the stock market.  If they could double their pension asset within a reasonable window, say 10 years, they would mostly be out of this mess.  Of course that would require an average rate or return of about 10%, far in excess of traditional pension plan returns.  Other than that miracle cure, all they can do is continue to save excess cash where they can and add it to the pension assets.  That’s tough to do when you have to provide services to 50,000 current students, support Nobel prize-winning researchers, and maintain 100 year old buildings.

Three last points: (1) U of T is not the only enterprise in this mess.  I could quickly identify about 25-50 other large, well known Canadian businesses that have similar pension problems.  (2) Accounting standards around pension plans (for instance, IAS 19) are finally providing relevant information to financial statement users – I encourage you to ask your financial accounting instructor for their opinion on the standards and on pension plans in general.  (3) Why does this matter to you?  You are likely YEARS away from retirement, pension plans are the farthest thing from your mind.  Similar to many other problems in the world however, the problems of one generation get passed to the next.  As a future employee, a future contributor to CPP, a future caregiver to your parents, as a student paying tuition, this pension problem is yours.  Sorry.  I encourage you read some more, here’s a recent Globe and Mail commentary that you may find interesting.

I’d be interested in your thoughts on pension plans.  How do you think U of T should get out of this mess?  Is it fair to pass the buck to the next (your) generation?  What are your plans for funding your retirement? Comment below.

Note: this blog was originally posted on my site hosted by Pearson Education(http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)

Barbie needs some cash

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Looking at Mega Brands most recent audited financial statements (December 31, 2012), in many ways they look financially stable.  Their current ratio (current assets/current liabilities) is in decent shape, their debt:equity ratio (total liabilities/total equity) is improving year over year, they had positive earnings for the past two years, and they have a positive cash balance.  So the transaction I’m about to describe wasn’t done in a panic, it was done to take a reasonably healthy company and make it stronger.  Imagine for a second that you are the CEO or CFO of Mega Brands.  You don’t like paying 10% interest since that requires more cash than you feel is really deserved for debt repayment.  You need your other cash resources for day-to-day operations, and you don’t have excess assets that you can sell to generate cash.  What do you do?

Well, you look closely at your balance sheet and you remember that in 2010 Mega Brands issues a whole bunch of warrants.  Warrants are just like a stock option.  It is a financial instrument that gives the investor the right to purchase a common share of the company at a set price.  For general background on options and warrants, see this.  The investors originally paid to get the warrants ($0.50/warrant) and then have to pay again if they exercise their option to purchase the common share (called the strike price, $9.94/share in this case).  Obviously no investor would exercise their warrant if the common share was trading at a price below the strike price.  These particular warrants expire about two years from now and in most cases, finance theory suggests that a holding strategy is optimal.

Mega Brands wanted to raise some cash and had ~240,000,000 warrants still outstanding.  If they could convince all those warrant holders to exercise their warrants, pay the exercise price Mega Brands would receive ~$115 Million.  That essentially enough to cover all the long term debt which would then wipe out the debt with the 10% interest payment.  Early news releases don’t suggest any modified terms, rather Mega Brands executives just had some friendly chats with the major holders of the warrants (i.e. institutional investors) and explained the situation.  The warrants were already in the money since the common shares were trading above $13.  Remember that a warrant holder receives a common share (market value ~$13/share) by paying $9.94/share.  That’s a good deal.  Further, the executives explained that the cash they raised would be used to repay that expensive 10% debt thereby reducing the interest cost and increasing cash available for expansion and dividends.  Win-win for the company and the warrant holders.  No surprise then that approximately 1/2 of the warrant holders have agreed to early exercise.

What will be the impact on the financial statements?  Let’s do this on a single share basis, but in reality closer to 600,000 shares will be issued.  First Mega Brands receives the exercise price from the warrant holders (Dr Cash $9.94) removes the warrant value from equity since the warrants no longer exist (remove at the initial value Dr Warrants (equity) $10) and recognize the new common share being issued in exchange (Cr Share capital $19.94).  Then Mega Brands will turn around and use that cash to reduce their debt, Cr Cash XX, Dr Long term debt XX.  So when the next financial statements get released we should see an increase in equity and an equal decrease in liabilities.

Warrants and options are very common financial instruments.  Mega Brands move to tap into them as a way to raise cash is interesting and a little unusual but quite admirable.

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The full financial statements are here.  I encourage you to look at the balance sheet (page 5), and Notes 15 and 16 in particular (pages 33-35).

Note: this blog was originally posted on my site hosted by Pearson Education(http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)