McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Eighteen Pension Funds

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Outline 1.Overview 2.Investments of Pension Funds 3.Regulation 1.Overview 2.Investments of Pension Funds 3.Regulation

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved Pension Funds Overview Pension funds offer savings plans through which fund participants accumulate tax-deferred savings during their working years for their retirement First established in 1759 to benefit the widows and children of church ministers American Express established the first corporate pension fund in 1875 By 1940, only 400 pensions funds were in existence Currently there are over 700,000 pension funds; 30.9% of household fin. assets are in pension funds Pension funds offer savings plans through which fund participants accumulate tax-deferred savings during their working years for their retirement First established in 1759 to benefit the widows and children of church ministers American Express established the first corporate pension fund in 1875 By 1940, only 400 pensions funds were in existence Currently there are over 700,000 pension funds; 30.9% of household fin. assets are in pension funds

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved Pension Funds, Two Distinct Sectors Private pension funds –funds administered by a private corporation (e.g., insurance company, mutual fund) Public pension funds –funds administered by a federal, state, or local government (e.g., Social Security) Private pension funds –funds administered by a private corporation (e.g., insurance company, mutual fund) Public pension funds –funds administered by a federal, state, or local government (e.g., Social Security)

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved Pension Fund Reserves, ($Bn.)

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved Insured vs. Noninsured Pension Funds Pension plan - document that governs the operations of a pension fund Insured pension plan - a pension fund administered by a life insurance company –there is no separate pool of assets backing the pension plan but the funds are pooled and invested in the general assets of the insurance company Noninsured pension plans - a pension fund administered by a financial institution other than a life insurance company Pension plan - document that governs the operations of a pension fund Insured pension plan - a pension fund administered by a life insurance company –there is no separate pool of assets backing the pension plan but the funds are pooled and invested in the general assets of the insurance company Noninsured pension plans - a pension fund administered by a financial institution other than a life insurance company

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved Defined Benefit vs. Defined Contribution Pension Funds Defined benefit pension - pension plan in which the employer agrees to provide the employee with a specific cash benefit upon retirement -- 3 types –Flat benefit formula - pays a flat amount for every year of employment –Career average formula - pays benefits based on the average salary over the entire period of employment –Final pay formula - pays benefits based on a percentage of the average salary during a specified number of years times the number of years of service Defined contribution benefit plan - pension plan in which the employer agrees to make a specified contribution to the pension fund during the employee’s working years; no commitment to providing specified retirement income Defined benefit pension - pension plan in which the employer agrees to provide the employee with a specific cash benefit upon retirement -- 3 types –Flat benefit formula - pays a flat amount for every year of employment –Career average formula - pays benefits based on the average salary over the entire period of employment –Final pay formula - pays benefits based on a percentage of the average salary during a specified number of years times the number of years of service Defined contribution benefit plan - pension plan in which the employer agrees to make a specified contribution to the pension fund during the employee’s working years; no commitment to providing specified retirement income

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved Private Pension Funds Created by private entities (e.g., manufacturing, mining, or transportation firms) and are administered by private corporations (FIs) Increasingly dominated by defined contribution plans Types of private pension plans –401(k) - employer-sponsored plans that supplement a firm’s basic retirement plan –individual retirement accounts (IRA’s) - self directed, tax deferred retirement accounts, may contribute up to $3,000/yr. (special type developed in 1998: Roth IRA) –Keogh accounts - retirement account available only to self- employed, tax deferred Created by private entities (e.g., manufacturing, mining, or transportation firms) and are administered by private corporations (FIs) Increasingly dominated by defined contribution plans Types of private pension plans –401(k) - employer-sponsored plans that supplement a firm’s basic retirement plan –individual retirement accounts (IRA’s) - self directed, tax deferred retirement accounts, may contribute up to $3,000/yr. (special type developed in 1998: Roth IRA) –Keogh accounts - retirement account available only to self- employed, tax deferred

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved Assets in 401 (k) Plans ($Bns)

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved Public Pension Funds State or local government pension funds –set up for state or local government employees –funded on a “pay as you go” basis meaning that collections from current employees are the source of payments to the current retirees Federal government pension funds - two types –federal government employees, civil service employees, military and railroad employees not covered by SS –Social Security - funded on a “pay as you go” basis with benefits paid to most retired individuals from employees present contributions State or local government pension funds –set up for state or local government employees –funded on a “pay as you go” basis meaning that collections from current employees are the source of payments to the current retirees Federal government pension funds - two types –federal government employees, civil service employees, military and railroad employees not covered by SS –Social Security - funded on a “pay as you go” basis with benefits paid to most retired individuals from employees present contributions

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved Financial Asset Investments Employer and employee pension fund contributions are invested in financial assets Private pension funds –the largest institutional investor in the U.S. stock market –totaled $4,444.4 billion in 2004 of which 64.34% is invested in corporate equities or equity mutual funds Public pension funds –state and local pension funds held most of their assets in corporate equities (58.13% in 2004) –Social security contributions are invested in relatively low- risk, low-return Treasury securities Employer and employee pension fund contributions are invested in financial assets Private pension funds –the largest institutional investor in the U.S. stock market –totaled $4,444.4 billion in 2004 of which 64.34% is invested in corporate equities or equity mutual funds Public pension funds –state and local pension funds held most of their assets in corporate equities (58.13% in 2004) –Social security contributions are invested in relatively low- risk, low-return Treasury securities

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved Financial Assets in Defined Benefit Funds

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved Financial Assets in Defined Contribution Pension Funds

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved Regulation of Pension Funds Employee Retirement Income Security Act (ERISA) of 1974 Funding - ERISA established guidelines for funding and set penalties for fund deficiencies Vesting of Benefits - ERISA requires that a plan must have a minimum vesting requirement Fiduciary Responsibilities - ERISA set standards governing the pension plan management Transferability - allowed employees to transfer pension credits from one employer to another Insurance - ERISA established the Pension Benefit Guarantee Corporation (PBGC) Employee Retirement Income Security Act (ERISA) of 1974 Funding - ERISA established guidelines for funding and set penalties for fund deficiencies Vesting of Benefits - ERISA requires that a plan must have a minimum vesting requirement Fiduciary Responsibilities - ERISA set standards governing the pension plan management Transferability - allowed employees to transfer pension credits from one employer to another Insurance - ERISA established the Pension Benefit Guarantee Corporation (PBGC)