Portfolio Management Unit – II Session No. 14 Topic: Pension Funds Unit – II Session No. 14 Topic: Pension Funds

Session Plan Recap the Previous Session Pension Funds Defined-benefit Plan Elements for DB Plan: – a). Risk Objectives – b). Return Objectives – c). Constraints for DB Plans Summarizing and Q & A

Pension funds Pension funds contain assets that are set aside to support a promise of retirement income. Generally, that promise is made by some enterprise or organization—such as a business, labor union, municipal or state government, or not-for-profit organization—that sets up the pension plan. This organization is referred to as the plan sponsor.

Pension funds Pension plans divide principally into one of two broad types, based on the nature of the promise that was made. (1). Defined-benefit (DB) plans (2). Defined-contribution (DC) plans. A defined-benefit plan is a pension plan that specifies the plan sponsor’s obligations in terms of the benefit to plan participants. In contrast, a defined-contribution plan specifies the sponsor’s obligations in terms of contributions to the pension fund rather than benefits to plan participants.

Pension funds A DB plan sponsor promises the organization’s employees or members a retirement income benefit based on certain defined criteria. All DB plans share one common characteristic: They are promises made by a plan sponsor that generate a future financial obligation or ‘‘pension liability.’’ The sponsor’s promise for DB plans is made for the retirement stage—what the employee will be able to withdraw.

Pension funds The promise for DC plans is made for the current stage—what the plan sponsor will contribute on behalf of the employee. This contribution promise at its most basic might be a fixed percentage of pay that is put into the plan by the employer. DC plans encompass arrangements that are – (1) pension plans, in which the contribution is promised and not the benefit, and – (2) profit-sharing plans

Pension funds The key differences between DC and DB plans are as follows: For DC plans, because the benefit is not promised, the plan sponsor recognizes no financial liability, in contrast to DB plans. DC plan participants bear the risk of investing (i.e., the potential for poor investment results). In contrast, in DB plans the plan sponsor bears this risk (at least in part) because of the sponsor’s obligation to pay specified future pension benefits. Because DC plan contributions are made for individual participants’ benefit, the paid in contributions and the investment returns they generate legally belong to the DC plan participant. Because the records are kept on an individual-account basis, DC plan participants’ retirement assets are more readily portable—that is, subject to certain rules, vesting schedules, and possible tax penalties and payments, a participant can move his or her share of plan assets to a new plan

Pension funds Defined-Benefit Plans: Background and Investment Setting Defined-benefit plans have existed for a long time, with the first such corporate arrangement established in the United States by American Express in Today, the incidence of DB plans varies internationally, although in recent years the overall use of DC plans has been increasing.

Pension funds Three basic liability concepts exist for pension plans: Accumulated benefit obligation (ABO). – The ABO is effectively the present value of pension benefits – To provide retirement income to all beneficiaries for their years of service up to that date (accumulated service). – The ABO excludes the impact of expected future wage and salary increases. Projected benefit obligation (PBO). – The PBO stops the accumulated service – ABO but projects future compensation increases if the benefits are defined. – The PBO thus includes the impact of expected compensation increases. Total future liability. – This is the most comprehensive, but most uncertain, measure of pension plan liability. – Total future liability can be defined as the present value of accumulated and projected future service benefits, including the effects of projected future compensation increases. – This financial concept can be executed internally as a basis for setting investment policy.

Pension funds The investment policy statement elements for a DB plan Risk Objectives Return Objectives Liquidity Requirement Time Horizon Tax Concerns Legal and Regulatory Factors Unique Circumstances

Pension funds Risk Objectives In setting a risk objective, plan sponsors must consider plan status, sponsor financial status and profitability, sponsor and pension fund common risk exposures, plan features, and workforce characteristics (Risk tolerance, to review, is the willingness and ability to bear risk.)

Pension funds Case Let Example: George Fletcher, CFA, is chief financial officer of Apex Sports Equipment Corporation (ASEC), a leading producer of winter and water sports gear. ASEC is a small company, and all of its revenues come from the United States. Product demand has been strong in the past few years, although it is highly cyclical. The company has rising earnings and a strong (low debt) balance sheet. ASEC is a relatively young company, and as such its DB pension plan has no retired employees. This essentially active-lives plan has $100 million in assets and an $8 million surplus in relation to the projected benefit obligation. Several facts concerning the plan follow: – The duration of the plan’s liabilities (which are all U.S. based) is 20 years. – The discount rate applied to these liabilities is 6 percent. – The average age of ASEC’s workforce is 39 years. Based on the information given, discuss ASEC’s risk tolerance.

Pension funds Solution: ASEC appears to have above average risk tolerance, for the following reasons: 1. The plan has a small surplus (8 percent of plan assets); that is, the plan is overfunded by $8 million. 2. The company’s balance sheet is strong (low use of debt). 3. The company is profitable despite operating in a cyclical industry. 4. The average age of its workforce is low.

Pension funds George Fletcher now turns to setting risk objectives for the ASEC pension plan. Because of excellent recent investment results, ASEC has not needed to make a contribution to the pension fund in the two most recent years. Fletcher considers it very important to maintain a plan surplus in relation to PBO. Because an $8 million surplus will be an increasingly small buffer as plan liabilities increase, Fletcher decides that maintaining plan funded status, stated as a ratio of plan assets to PBO at 100 percent or greater, is his top priority. Based on the above information, state an appropriate type of risk objective for ASEC.

Pension funds Solution: An appropriate risk objective for ASEC relates to shortfall risk with respect to the plan’s funded status falling below 100 percent. For example, ASEC may want to minimize the probability that funded status falls below 100 percent, or it may want the probability that funded status falls below 100 percent to be less than or equal to 10 percent. Another relevant type of risk objective would be to minimize the probability that ASEC will need to make future contributions.

Pension funds Return Objectives A DB pension plan’s broad return objective is to achieve returns that adequately fund its pension liabilities on an inflation-adjusted basis. In setting return objectives, the pension sponsor may also specify numerical return objectives. A pension plan must meet its obligations. For a DB pension plan, the return requirement (in the sense of the return the plan needs to achieve on average) depends on a number of factors, including the current funded status of the plan and pension contributions in relation to the accrual of pension benefits.

Pension funds Case let Example: George Fletcher now addresses setting return objectives for ASEC. Because the plan is fully funded, Fletcher is proposing a return objective of 7.5 percent for the plan. Referring to the information as well as to the above facts, answer the following questions: 1. State ASEC’s return requirement. 2. State one purpose Fletcher might have in proposing a desired return of 7.5 percent. 3. Create and justify the return objective element of an investment policy statement for the ASEC pension plan.

Pension funds Solution to Problem 1: The discount rate applied to finding the present value of plan liabilities is 6 percent. This discount rate is ASEC’s return requirement (based on the previous case let). Solution to Problem 2: Besides meeting pension obligations, Fletcher may have one of the following objectives in mind: – To minimize ASEC’s future pension contributions. – To generate pension income (negative pension expense).

Pension funds Liquidity Requirement A DB pension fund receives pension contributions from its sponsor and disburses benefits to retirees. The net cash outflow (benefit payments minus pension contributions) constitutes the pension’s plan liquidity requirement. The following issues affect DB plans’ liquidity requirement: – The greater the number of retired lives, the greater the liquidity requirement, all else equal. – The smaller the corporate contributions in relation to benefit disbursements, the greater the liquidity requirement.

Pension funds Recall the following information from 1 st Case let: ASEC is a relatively young company, and as such its DB pension plan has no retired employees. This essentially active-lives plan has $100 million in assets and an $8 million surplus in relation to the PBO. Several facts concerning the plan follow: – The duration of the plan’s liabilities (which are all U.S.-based) is 20 years. – The discount rate applied to these liabilities is 6 percent. – The average age of the workforce is 39 years. Because of excellent recent investment results, ASEC has not needed to make a contribution to the pension fund in the most recent two years. Based on the above information, characterize ASEC’s current liquidity requirement.

Pension funds Solution: ASEC currently has no retired employees and is not making pension contributions into the fund, but it has no disbursements to cover. Thus, ASEC has had no liquidity requirements recently. Given that the average age of ASEC’s workforce is 39 years, liquidity needs appear to be small for the near term as well.

Pension funds Time Horizon: The investment time horizon for a DB plan depends on the following factors: – Whether the plan is a going concern or plan termination is expected. – The age of the workforce and the proportion of active lives. When the workforce is young and active lives predominate, and when the DB plan is open to new entrants, the plan’s time horizon is longer.

Pension funds Based on the information from previous case let, characterize the time horizon for ASEC’s pension plan. Solution: On average, the plan participants are 39 years old and the duration of plan liabilities is 20 years. The ‘‘time to maturity’’ of the corporate workforce is a key strategic element for any DB pension plan. Having a younger workforce often means that the plan has a longer investment horizon and more time available for wealth compounding to occur. These factors justify ASEC’s adopting a relatively long time horizon for as long as ASEC remains a viable going concern.

Summarizing Who is a Plan Sponsor? Distinguish between defined benefit plan and cash plan. What is Defined-benefit Plan? How to raise the pension funds? Which type of contribution is beneficial to employees? How?