Pension Fund

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• Pension Fund
• Operations

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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

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Pension Fund Terminology Summary
ERISA and PBGC
Public vs. Private
Trusteed vs. Insured vs. Self-Directed
Under Funded vs. Over
Defined Benefit vs. Contribution
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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

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Background on Pension Funds

• Public pension funds
• Social security
• State and local governments
• Many public pensions are funded on a
  pay-as-you-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

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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 1990s

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Types of Private Pension Plans

• Defined-contribution plan
• Provides benefits determined by the accumulated
  contributions and the funds 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

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Types of Private Pension Plans

• 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-as-you-go for many years before funding
  began

Under-funded Pension Plan
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Types of Private Pension Plans

• 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)

Over-funded Pension Plan
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Pension Regulations

• Regulations vary depending on the type of
  plandefined 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

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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

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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

13
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

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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

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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

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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

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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

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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

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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

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Performance of Pension Funds

• Determinants of a pension funds stock portfolio
  performance

?PERF f (?MKT, ?MANAB)
Where
PERF Performance
MKT General market conditions
MANAB The ability of the funds management
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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

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Performance of Pension Funds

• Determinants of a pension funds bond portfolio
  performance

?PERF f (?Rf, ?RP, ?MANAB)
Where
PERF Performance
Rf Risk-free interest rate
RP Risk premium
MANAB The ability of the funds management
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Performance of Pension Funds

• Performance evaluation
• Compare to the passive strategy benchmark
• Any difference from the benchmark results from
• The managers shift in the proportions of stocks
  and bonds
• The composition of bonds and stocks

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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

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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

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Pension Fund Terminology Summary
Public vs. Private
ERISA and PBGC
Trusteed vs. Insured vs. Self-Directed
Under Funded vs. Over
Defined Benefit vs. Contribution