Transcript Document
CHAPTER
27
© 2003 South-Western/Thomson Learning
Pension Fund
Operations
Chapter Objectives
Describe the different types of private pension
funds and the terminology of pension funds
Describe the pension management styles
Explain how pension funds can become
underfunded and overfunded
Describe the role of the Pension Benefit
Guaranty Corporation in enhancing the safety
of pension plans
Pension Fund Terminology Summary
ERISA and
PBGC
Public vs.
Private
Under
Funded vs.
Over
Trusteed vs.
Insured vs.
SelfDirected
Defined
Benefit vs.
Contribution
Pension Fund Developments
Pension plans are a recent development
Depression and union bargaining after World
War II
From “pay as you go” to funded pensions
From defined benefit to defined contribution
pensions
Pension funds have become a major capital
market participant
Background on Pension Funds
Public pension funds
Social security
State and local governments
Many public pensions are funded on a pay-asyou-go system
Pension fund is unfunded
Current contributions support previous employees
Depends on current cash flows of entity to support
pensioners
Many public pension plans are fully funded
Types of Private Pension Plans
Defined-benefit plan
Annual contributions are determined by the
benefits “defined” in the plan paid at retirement
If value of pension assets exceeds (over funded)
current and future benefits owed, employer may
Reduce
future contributions
Distribute surplus to shareholders
Occurred during stock and bond boom of the 1990’s
Types of Private Pension Plans
Defined-contribution plan
Provides benefits determined by the accumulated
contributions and the fund’s investment
performance
“Contributions” are designated in plan, not
amounts available at retirement
Firm knows with certainty the amount of the
contribution
Provides uncertain benefits to participants
Types of Private Pension Plans
Under-funded Pension Plan
Future pension obligations of a defined-benefit plan
are uncertain because obligations are fixed payments
to retirees and payments depend on salary level,
retirement ages and life expectancies
Over-optimistic projections (estimated rates of return) can
mean inadequate cash to cover obligations
High risk investments might be used to generate higher
returns with varied results
Many companies are under funded for they were “pay-asyou-go” for many years before funding began
Types of Private Pension Plans
Over-funded Pension Plan
When investment returns for defined-benefit plans
perform better than expected, there are funds in
excess of the amount needed to meet obligations
A portion of the surplus can be credited to the income
statement of a corporation
Encourages exchange of defined benefit for insured
pension purchase (liquidation of plan)
Pension Regulations
Regulations vary depending on the type of
plan—defined benefit more regulated
Criticism of plans led to regulation
Unfair treatment in terms of vesting or service
requirements needed to qualify for a pension
Some plans were underfunded and could not pay
the benefits they promised
Employees did not benefit when plans had excess
earnings but received reduced benefits when plans
performance faltered
Pension Regulations
Employee Retirement Income Security Act of
1974 (ERISA)
Vesting standards
Corrected under-funded plans
Fiduciary responsible investing
Pension Benefit Guarantee Corporation
Enforced by U.S. Department of Labor
Many pension plans cancelled after ERISA
after funding required
Pension Regulations
The Pension Benefit Guaranty Corporation
Intended to provide insurance on pension plans
Federally chartered agency that guarantees
beneficiaries of defined contribution plans get
benefits
Receives no government support
Funds come from annual premiums and other
income from active pension plans
Monitors plans
Takes over failed plans (bankruptcy of firm) and
pays minimum benefits to beneficiaries
Pension Regulations
Accounting regulations
Allow companies to more quickly recognize gains
and losses
May increase the volatility of funds’ returns
Rules may affect portfolio composition
Underfunded plans shown as a liability on the
balance sheet
Volatility of returns also depends on the
composition of the portfolio
Pension Fund Management
Management of “insured” portfolios
Some plans are managed by life insurance
companies
Insured plans purchase annuity policies so the life
insurance company can provide benefits to the
employees upon retirement
Retirement benefits are “assured” by credit
strength of life insurance company
No federal insurance coverage
Pension Fund Management
Management of trusteed portfolios
Managed by the trust department of a financial
institution
ERISA required that a fiduciary be involved in
managing retirees’ funds
Corporations specify guidelines
Returns
Risks
Some companies have allocation systems to try
and minimize risks
Pension Fund Management
Differences between trusteed and insured
portfolios
Trusts offer higher returns with higher risk via
investment in stocks
Mortgages are more important in insurance
company portfolios
Both invest in bonds
Risky investments by pension funds include
LBOs and stock speculation
Pension Fund Management
Management of private versus public pensions
Private business vs. state, municipal pensions
Private pension portfolios dominated by common
stock
Public pension portfolios more evenly invested in
stock, bonds and other credit instruments
Pension Fund Management
Pension funds use their large ownership stakes
in companies to influence corporate policies
and management
Examples of government pension funds that are
actively involved in issues of corporate control
California
Pension Employees Retirement System or
CalPERS
New York State Government Retirement Fund
TIAA
Pension Fund Management
Management of interest rate risk is important
if portfolios hold long-term, fixed-rate bonds
Funds willing to accept market returns can
purchase index portfolios for bonds and stocks
Futures are used to hedge market downturns
Approaches to risk vary
Performance of Pension Funds
Determinants of a pension fund’s stock
portfolio performance
PERF= f (MKT, MANAB)
Where:
PERF = Performance
MKT = General market conditions
MANAB = The ability of the fund’s management
Performance of Pension Funds
Stock portfolio performance closely related to
market conditions
Changes in management ability
Performance can vary depending on the skills of the
manager
Efficiency of the fund affects expenses and
performance
Performance of Pension Funds
Determinants of a pension fund’s bond
portfolio performance
PERF= f (Rf, RP, MANAB)
Where:
PERF = Performance
Rf = Risk-free interest rate
RP =Risk premium
MANAB = The ability of the fund’s management
Performance of Pension Funds
Performance evaluation
Compare to the passive strategy benchmark
Any difference from the benchmark results from
The
manager’s shift in the proportions of stocks and
bonds
The composition of bonds and stocks
Performance of Pension Funds
Performance of pension portfolio managers
Research showed funds earned less than a market
index
Expenses were not included in the study
Companies might do better to invest in index
mutual funds
Other Issues
Interaction with other financial institutions
Participation in financial markets
Foreign investment by pension funds
Several funds allocate a portion of investments to
foreign stocks and bonds
Some risks are hedged
Other funds take positions for speculative
purposes
Pension Fund Terminology Summary
Public vs.
Private
Under
Funded vs.
Over
ERISA and
PBGC
Trusteed vs.
Insured vs.
SelfDirected
Defined
Benefit vs.
Contribution