Pension Plan Economics and Corporate Finance

Just published is an article I wrote about the urgent need for appraisers and deal-makers to make sure that they have adequately assessed the economics associated with defined benefit plan funding. Entitled "Pension Plans: The $20 Trillion Elephant in the (Valuation) Room" by Susan Mangiero (Business Valuation Update, July 2013), the objectives of this article are threefold: (1) shed light on the magnitude of the pension underfunding problem and the possible dire impact on enterprise value; (2) remind appraisers of the need to thoroughly understand and evaluate pension plan economics or engage someone to assist them; and (3) explain the adverse consequences on deal-making and corporate strategy when pension plan funding gaps are given short shrift. CEOs, Chief Financial Officers, private equity, venture capital, merger and acquisition and bank lending professionals will want to read this article as it showcases this timely and urgent topic.

Click to read my article about pension plan valuation.

In a related post, ERISA attorney Stephen D. Rosenberg wrote a commentary on his "Boston ERISA & Insurance Litigation Blog" (June 17, 2013) about why he believes that appraisers should not be designed as ERISA fiduciaries. He expresses doubt about whether imposing a fiduciary standard on appraisers will "improve the analysis provided to plan fiduciaries." He suggests that such a move by regulators could create a reluctance for valuation professionals to assume the liability associating with appraising a company with an ERISA plan.

For those who missed our program about appraiser liability, visit the Business Valuation Resources website to obtain a copy of "Valuation and ERISA Fiduciary Liability: Traps for the Unwary Appraiser." The program took place on May 14, 2013. Speakers included myself (Dr. Susan Mangiero), ERISA attorney James Cole with Groom Law Group and Mr. Robert Schlegel with the Houlihan Valuation Advisors.

Fiduciary Shortcuts To Valuation Can Be Dangerous

Despite a plethora of information about how to implement shortcuts to enhance workplace productivity, fiduciaries need to ask themselves whether a "jack in the box" approach that equates speed with care and diligence is worth pursuing.

This topic of shortcuts came up recently in a discussion with appraisal colleagues about the dangers of using a "plug and play" model to estimate value. Although New York Times journalist Mark Cohen rightly cites the merits of having a business valuation done, he lists all sorts of new tools such as iPhone valuation apps that some might conclude are valid substitutes for the real thing. Rest assured that punching in a few numbers versus hiring an independent and knowledgeable third party specialist to undertake a thorough assessment of value is a big mistake, especially if the underlying assumptions and algorithms of a "quick fix" solution are unknown to the user. See "Do You Know What Your Business is Worth? You Should," January 30, 2013.

It's bad enough that a small company owner opts for a drive-in appraisal. It's arguably worse when institutional investors do so, especially as their portfolios are increasingly chock a block with "hard to value" holdings. In the event that a valuation incorrectly reflects the extent to which an investment portfolio can decline, all sorts of nasty things can occur. A pension, endowment or foundation could end up overpaying fees to its asset managers. Any attempts to hedge could be thwarted by having too much or too little protection in place due to incorrect valuation numbers. Asset allocation decisions could be distorted which in turn could mean that certain asset management relationships are redundant or insufficient.

Poor valuations also invite litigation or enforcement or both. As I wrote in "Financial Model Mistakes Can Cost Millions of Dollars," Expert Witnesses, American Bar Association, Section of Litigation, May 31, 2011:

"Care must be taken to construct a model and to test it. Underlying assumptions must be revisited on an ongoing basis, preferably by an independent expert who will not receive a raise or bonus tied to flawed results from a bad model. Someone has to kick the proverbial tires to make sure that answers make sense and to minimize the adverse consequences associated with mistakes in a formula, bad assumptions, incorrect use, wild results that bear no resemblance to expected outcomes, difficulty in predicting outputs, and/or undue complexity that makes it hard for others to understand and replicate outputs. Absent fraud or sloppiness, precise model results may be expensive to produce and therefore unrealistic in practice. As a consequence, a “court or other user may find a model acceptable if relaxing some of the assumptions does not dramatically affect the outcome.” Susan Mangiero, “The Risks of Ignoring Model Risk” in Litigation Services Handbook: The Role of the Financial Expert (Roman L. Weil et al, eds., John Wiley & Sons, 3d ed. 2005).

In recent months, it is noteworthy that regulators have pushed valuation process and policies further up the list of enforcement priorities. Indeed, in reading various complaints that allege bad valuation policies and procedures, I have been surprised at the increased level of specificity cited by regulators about what they think should have been done by individuals with fiduciary oversight responsibilities. Besides the focus of the U.S. Department of Labor, the U.S. Securities and Exchange Commission has brought actions against multiple fund managers in the last quarter alone. Consider the valuation requirements of new Dodd-Frank rules (and overseas equivalent regulatory focus) and it is clear that questions about how numbers and models are derived will continue to be asked.

For further reference, interested readers can check out the following items: