1. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Financial Markets and Institutions 11 th Edition by Jeff Madura

2. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Background on Pension Funds Public versus Private Pension Funds  Public Pension Funds  Can be either state, local, or federal.  The best-known government pension fund is Social Security.  Many public pension plans are funded on a pay-as-you-go basis.  Private Pension Plans  Created by private agencies, including industrial, labor, service, nonprofit, charitable, and educational organizations. 2

3. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Background on Pension Funds Defined-Benefit versus Defined-Contribution Plans  Defined-Benefit Plans  Contributions are dictated by the benefits that will eventually be provided.  The future pension obligations of a defined benefit plan are uncertain because the obligations are stated in terms of fixed payments to retirees.  The amount the plan needs today will be uncertain because of the uncertain rate of return on today’s investments. 3

4. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Background on Pension Funds Defined-Benefit versus Defined-Contribution Plans (cont.)  Defined-Contribution Plans  Provides benefits that are determined by the accumulated contributions and the fund’s investment performance.  Some firms match a portion of the contribution made by their employees.  With this type of plan, a firm knows with certainty the amount of funds to contribute, whereas that amount is undetermined in a defined-benefit plan.  The benefits to the participants are uncertain. 4

5. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Background on Pension Funds Pension Fund Participation in Financial Markets To set up a pension fund, a sponsor corporation establishes a trust pension fund through a commercial bank’s trust department or an insured pension fund through an insurance company.  Managers of pension funds instruct securities firms on the type and amount of investment instruments to purchase. 5

6. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 25.9 Interaction between Pension Funds and Other Financial Institutions 6

7. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Background on Pension Funds Pension Regulations  ERISA  Defined-contribution plans are subject to guidelines specified by the Employee Retirement Income Security Act (ERISA) of 1974 (also called the Pension Reform Act) and its 1989 revisions.  Requires a pension fund to choose one of two vesting schedule options, which determine when an employee has a legal right to the contributed funds:  Employee’s contributions are always 100% vested  Employer’s contributions are always 100% vested after 5 years and may be vested sooner 7

8. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Background on Pension Funds Pension Regulations (cont.)  The Pension Benefit Guaranty Corporation  ERISA established the Pension Benefit Guaranty Corporation (PBGC) to provide insurance on pension plans.  guarantees that participants of defined-benefit pension plans will receive their benefits upon retirement (up to a maximum of about $4,600/mo.)  Premiums are paid by employers – currently $57/yr/participant 8

9. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Pension Fund Management  Regardless of the manner in which funds are contributed to a pension plan, the funds received must be managed (invested) until needed to pay benefits.  Pension fund management can be classified according to the strategy used to manage the portfolio.  Matched funding: investment decisions are made with the objective of generating cash flows that match planned outflow payments.  Projective funding: offers managers more flexibility in constructing a pension portfolio that can benefit from expected market and interest rate movements. 9

10. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Pension Fund Management Management of Insured versus Trust Portfolios  Some pension plans are managed by life insurance companies.  Contributions to such plans, called insured plans, are often used to purchase annuity policies so that the life insurance companies can provide benefits to employees upon retirement.  Some pension funds are managed by the trust departments of financial institutions, such as commercial banks. 10

11. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Pension Fund Management Management of Insured versus Trust Portfolios (cont.)  Although the day-to-day investment decisions controlled by the managing institution, the corporation owning the pension normally specifies general guidelines :  The percentage of the portfolio that should be used for stocks or bonds.  A desired minimum rate of return on the overall portfolio.  The maximum amount to be invested in real estate.  The minimum acceptable quality ratings for bonds.  The maximum amount to be invested in any one industry.  The average maturity of bonds held in the portfolio.  The maximum amount to be invested in options.  The minimum size of companies in which to invest. 11

12. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Pension Fund Management Management of Portfolio Risk  Pension fund managers often struggle with the decision of whether to pursue investments with high expected return that have high risk.  Many pension fund managers pursued risky investments prior to the credit crisis, which resulted in major losses during the credit crisis.  Hedging Risk  Pension fund portfolio managers are very concerned about interest rate risk. 12

13. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Performance of Pension Funds Performance of Pension Portfolio Managers  Many pension funds hire several portfolio managers to manage the assets.  The general objective of portfolio managers is to make investments that will earn a large enough return to adequately meet future payment obligations. 13

14. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 401(k) Plans ■Defined Contribution Plans ■Employees may contribute up to $18,000 per year ■$23,500 if age 50 or older ■Maximum total contributions of $52,000 per year ■Employers may not be “top-heavy” with their contributions ■Excessive employer contributions for highest-paid employees ■Contributions are not taxed till withdrawn ■Earnings are not taxed till withdrawn ■10% penalty on withdrawals prior to age 59.5 ■Withdrawals must begin by age 70.5 14

15. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Individual Retirement Accounts - IRAs ■Anyone can set up an IRA ■Maximum contribution of $5,500/yr ■$6,500 if age 50 or older ■Contributions may be taxable if you have a retirement plan at work and make more than $60,000 ■Withdrawals work same as 401(k) ■Roth IRA – contributions are always taxable ■Withdrawals are never taxable ■Income limits on setting up a Roth IRA 15

16. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Social Security ■Government-Sponsored Defined Benefit Plan ■Full program is OASDI (old-age, survivors, and disability insurance) ■Funded through FICA (Federal Insurance Contributions Act) ■Originated in 1935 ■Tax was 2% on earnings up to $3,000 ■Medicare was added in 1966 ■Current tax is 12.4% for OASDI and 2.9% for Medicare ■Employer and employee split 50/50 ■Maximum earnings of $118,500 for OASDI ■No maximum on Medicare 16

17. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Social Security ■Retirement benefits are based on quarters worked and amount of contributions ■If you were born in 1960 or later, full retirement benefits begin at age 67 ■70% if begin at age 62 ■86.7% if begin at age 65 ■124% if begin at age 70 or later 17

18. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Social Security ■Contributions are “invested” in U.S. Treasury bills ■Since Federal Government runs a deficit, social security contributions are “spent” each year ■Each generation’s benefits are dependent on the next generation’s contributions. ■In 1935, there were 37 workers for every retiree and life expectancy was age 61. ■Today, there are 3 workers for every retiree and life expectancy is age 75. 18