chapter 27 pension fund operations. chapter objectives n describe the different types of private...

CHAPTER

2727Pension Fund

Operations

© 2003 South-Western/Thomson Learning

Chapter ObjectivesChapter 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 SummaryPension Fund Terminology Summary

Public vs. Private

Public vs. Private

Under Funded vs.Over


ERISA and PBGC

ERISA and PBGC

Defined Benefit vs.Contribution


Trusteed vs.Insured vs. Self-Directed


Pension Fund DevelopmentsPension 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 FundsBackground 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

Types of Private Pension PlansTypes 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


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


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


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

Pension RegulationsPension 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


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


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


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 ManagementPension 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


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


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


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 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


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 FundsPerformance of Pension Funds

Determinants of a pension fund’s stock portfolio performance

PERF = Performance

Where:

PERF= f (MKT, MANAB)

MKT = General market conditions

MANAB = The ability of the fund’s management


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


Determinants of a pension fund’s bond portfolio performance

PERF = Performance

RP =Risk premium

Where:

PERF= f (Rf, RP, MANAB)

Rf = Risk-free interest rate

MANAB = The ability of the fund’s management


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 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 IssuesOther 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 SummaryPension Fund Terminology Summary

Public vs. Private

Public vs. Private



ERISA and PBGC

ERISA and PBGC





chapter 27 pension fund operations. chapter objectives n describe the different types of private...

Documents

terminology of pension

public pension plans

obligations n

pension management styles

safety of pension plans

corporation n

pensioners n

overfunded n