Chapter Eighteen
Pension Funds
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Chapter Outline
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
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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)
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Pension Fund Reserves, 1990-2004 ($Bn.)
5000
4000
3000
2000
1000
0
1990
1995
2000
2002
2004
Federal Government
Life insurance companies
Other private pension funds
State 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
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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
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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 $3,000/yr.
(special type developed in 1998: Roth IRA)
– Keogh accounts - retirement account available only to selfemployed, tax deferred
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Assets in 401 (k) Plans ($Bns)
2000
1800
1600
1400
1200
1000
800
600
400
200
0
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
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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 lowrisk, low-return Treasury securities
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Financial Assets in Defined Benefit Funds
20.76
Corporate Entities
39.76
Mutual Funds
U.S. Gov. Securities
13.83
Corp./Foreign Bonds
Miscellaneous
14.27
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Financial Assets in Defined Contribution
Pension Funds
20.53
Corporate Entities
36.83
Mutual Funds
3.06
2.84
U.S. Gov. Securities
Corp./Foreign Bonds
Miscellaneous
36.74
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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)
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