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Chapter Eighteen

Chapter Eighteen. Pension Funds. Chapter Outline. Overview Investments of Pension Funds Regulation. 1. Pension Funds Overview. Pension funds offer savings plans through which fund participants accumulate tax-deferred savings during their working years for their retirement

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Chapter Eighteen

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  1. Chapter Eighteen Pension Funds

  2. Chapter Outline • Overview • Investments of Pension Funds • Regulation

  3. 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

  4. 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)

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

  6. 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

  7. 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

  8. 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

  9. Assets in 401 (k) Plans ($Bns)

  10. 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

  11. 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

  12. Financial Assets in Defined Benefit Funds

  13. Financial Assets in Defined Contribution Pension Funds

  14. 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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