26 Pension Fund Operations Chapter Objectives • Distinguish between defined-benefit versus defined contribution pension plans. • Explain how pension funds participate in financial markets. • Explain how pension funds are managed. © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1 Background on Pension Funds*** Public versus Private Pension Funds ■ What is a pension? ■ A savings structure for retirement. ■ Public Pension Funds ■ What does public mean? ■ Government run ■ What is the best-known public pension fund? ■ Social security ■ Private Pension Plans ■ These are created by private agencies including industrial, labor, service, nonprofit, charitable, etc. 2 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Types of Pension Plans***** • Defined-Benefit Plans vs. Defined Contribution Plans • Pension can be either of these • Defined-Benefit Plan - Retirement pan that pays a percentage of your salary for life. • Teachers, military used to. • More risky to the employer because they don’t know how long you will live. This is why Greece went bankrupt. • Defined-Contribution Plan – Retirement plan that takes you and your employers contribution and invests over time for your retirement. • Ex) 401k • More risky to the employee, your risk is that you run out of money. 3 © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 26.1 How Pension Funds Finance Economic Growth 4 © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 26.2 Interaction between Pension Funds and Other Financial Institutions 5 TYPE OF FINANCIAL INSTITUTION INTERACTION WITH PENSION FUNDS Commercial banks • Sometimes manage pension funds. • Sell commercial loans to pension funds in the secondary market. Insurance companies • Create annuities for pension funds. Mutual funds • Serve as investments for some pension funds. Securities firms • Execute securities transactions for pension funds. • Offer investment advice to pension portfolio managers. • Underwrite newly issued stocks and bonds that are purchased by pension funds. © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Pension Fund Management Management of Insured versus Trust Portfolios Some pension plans are managed by life insurance companies. Some pension funds are managed by the trust departments of financial institutions, such as commercial banks. Why does this matter? It means they may invest in different types of assets. Banks invest in stocks and mutual funds, insurance companies invest in others. What would a fund do to hedge the risk of their investments? They do futures and options to hedge assets, like stocks, bonds, etc. 6 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Regulation of Private Pension Plans (2 of 5) Vesting and Regulation of Private Pension Plans • A vesting schedule represents the time at which rights to assets that have accumulated in the employee’s pension fund cannot be taken away. What is vesting? • You meet your service time. For ex you have to work at Alabama 10 years to get the retirement. • Defined-contribution plans are subject to guidelines specified by the Employee Retirement Income Security Act (ERISA) of 1974 (also called the Pension Reform Act) and its 1989 revisions. • Requires that any contributions be invested in a prudent manner. • ERISA established the Pension Benefit Guaranty Corporation (PBGC) to provide insurance on pension plans. 7 © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SUMMARY • For defined-benefit pension plans, the benefits are dictated by a formula that is typically based on the employee’s salary level and number of years of employment. For defined-contribution pension plans, the benefits are determined by the accumulated contributions and the returns on the pension fund investments. • Pension funds participate in financial markets by investing in securities such as stocks and bonds. Many pension funds’ investments require the brokerage services of securities firms. • The valuation and performance of pension fund portfolios are highly influenced by market conditions. However, pension fund managers have an influence on the pension portfolio performance, especially when they have the flexibility to adjust the proportion of risky asset classes in the portfolio. ERISA allows for the diversifying of asset classes in the portfolio. 8 © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
