Valuing Pension Benefits

Upon the death of a pension plan recipient, survivor benefits may be distributed to a spouse or other beneficiary.

A valuation may then be necessary to determine the fair market value of the pension plan for estate tax reporting purposes. Determination of fair market value is a matter of judgment, however, and in valuing a pension plan, or interest thereof, four variables in particular are analyzed: expected cash flows; expected term of the cash flow stream; counterparty risk; and the illiquidity of the pension benefits.

The first step in the valuation process is to quantify anticipated cash flows. Such cash flows are based on the structure and term of the pension plan, as well as projected performance of the underlying investment portfolio at such point in time. The determination of the expected cash flows is generally specified by the plan’s documents in the case of a defined benefit plan.

Additionally, since the value of a pension plan is intrinsically tied to the timing of the payouts, one must estimate the term of the pension benefits. In scenarios in which a beneficiary receives benefits until his or her death, actuarial estimates of life expectancy and annual mortality rates should be utilized. The mortality rate in each year is then applied to the value of the potential cash flows to yield the actuarially expected value of the cash flows.

In order to calculate the present value of the pension benefit stream, an appropriate risk-adjusted discount rate must be applied. This discount rate incorporates the time value of money as well as the risk attributable to the uncertainty of a company’s ability to repay such obligations. For many well-capitalized companies, a general corporate bond yield, such as the yield on Moody’s Baa-rated companies, can be utilized as a proxy for the credit-risk-adjusted discount rate. However, as a result of the “Great Recession” and subsequent low interest-rate environment, corporate pension funding deficits have grown to historic levels. Whether or not one’s stated benefits are at risk of being cut, an inadequately funded pension plan will increase potential shortfall risk. Thus, the risk associated with the funding status of the pension must be considered in addition to the overall financial health of the corporate issuer of the plan.

An interest in a corporate pension plan is not publicly traded, and thus, cannot be converted to cash quickly or easily.  One method to liquidate a pension benefit is for a beneficiary to enter into an over-the-counter financial instrument (swap), in which the future pension benefit streams are exchanged for a fixed stream of payments or lump-sum payment. However, one might incur significant fees and costs through this type of transaction. Thus, when valuing the fair market value of such benefits, adjustments for the lack of liquidity should be considered, either as an adjustment in the discount rate or separately as a discount for lack of marketability.

For pension beneficiaries, estate planners, and executors, it can be critical to understand these key value drivers when faced with the challenging task of valuing future pension benefits. Thus, it is always advisable to seek the expertise of a qualified professional, who can help evaluate all the qualitative and quantitative factors and opine on an accurate and defensible conclusion of value.