1. Pension Fund Operations27

2. 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

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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

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