CHAPTER 27 Pension Fund Operations. Chapter Objectives n Describe the different types of private...
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CHAPTER
2727Pension Fund
Operations
© 2003 South-Western/Thomson Learning
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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
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Pension Fund Terminology SummaryPension Fund Terminology Summary
Public vs. Private
Public vs. Private
Under Funded vs.Over
Under Funded vs.Over
ERISA and PBGC
ERISA and PBGC
Defined Benefit vs.Contribution
Defined Benefit vs.Contribution
Trusteed vs.Insured vs. Self-Directed
Trusteed vs.Insured vs. Self-Directed
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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
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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
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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
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Types of Private Pension PlansTypes 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
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Types of Private Pension PlansTypes 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
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Types of Private Pension PlansTypes 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
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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
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Pension RegulationsPension 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
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Pension RegulationsPension 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
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Pension RegulationsPension 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
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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
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Pension Fund ManagementPension 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
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Pension Fund ManagementPension 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
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Pension Fund ManagementPension 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
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Pension Fund ManagementPension 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
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Pension Fund ManagementPension 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
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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
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Performance of Pension FundsPerformance 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
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Performance of Pension FundsPerformance of Pension Funds
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
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Performance of Pension FundsPerformance 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
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Performance of Pension FundsPerformance 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
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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
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Pension Fund Terminology SummaryPension Fund Terminology Summary
Public vs. Private
Public vs. Private
Under Funded vs.Over
Under Funded vs.Over
ERISA and PBGC
ERISA and PBGC
Defined Benefit vs.Contribution
Defined Benefit vs.Contribution
Trusteed vs.Insured vs. Self-Directed
Trusteed vs.Insured vs. Self-Directed