Pension Fund Operations 27

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 ERISA and PBGC Public vs. Private Trusteed vs. Insured vs. Self-Directed Under Funded vs. Over Defined 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 1990’s

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

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

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

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

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 fund’s stock portfolio performance PERF= f (MKT, MANAB) Where: PERF = Performance MKT = General market conditions MANAB = The ability of the fund’s 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 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

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

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. Private ERISA and PBGC Trusteed vs. Insured vs. Self-Directed Under Funded vs. Over Defined Benefit vs. Contribution