CHAPTER

Pension Fund
27 Operations

2003 South-Western/Thomson Learning

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
Pension Fund Terminology Summary

Public vs. ERISA and

Private PBGC

Trusteed vs.
Insured vs.
Self-
Directed
Under
Funded vs. Defined
Over Benefit vs.
Contribution
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
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
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
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
Types of Private Pension Plans

Under-funded Pension Plan

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
Types of Private Pension Plans

Over-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)
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
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
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
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
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
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
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
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
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
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
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

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
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
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
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
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
Pension Fund Terminology Summary

Public vs. ERISA and

Private PBGC

Trusteed vs.
Insured vs.
Self-
Under Directed Defined
Funded vs. Benefit vs.
Over Contribution