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