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Chapter Eighteen Pension Funds

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Chapter Outline

1. Overview

2. Investments of Pension Funds

3. Regulation

1. Overview

2. Investments of Pension Funds

3. Regulation

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1. 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

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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)

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Pension Fund Reserves, 1990-2004 ($Bn.)

0

1000

2000

3000

4000

5000

1990 1995 2000 2002 2004

Federal GovernmentLife insurance companiesOther private pension fundsState and local government

0

1000

2000

3000

4000

5000

1990 1995 2000 2002 2004

Federal GovernmentLife insurance companiesOther private pension fundsState and local government

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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

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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

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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

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Assets in 401 (k) Plans ($Bns)

0

200

400

600

800

1000

1200

1400

1600

1800

2000

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

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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

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2. 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

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Financial Assets in Defined Benefit Funds

39.76

11.3814.27

13.83

20.76

Corporate Entities

Mutual Funds

U.S. Gov. Securities

Corp./Foreign Bonds

Miscellaneous

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Financial Assets in Defined Contribution Pension Funds

36.83

36.74

2.84

3.06

20.53

Corporate Entities

Mutual Funds

U.S. Gov. Securities

Corp./Foreign Bonds

Miscellaneous

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3. 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)