1. Discuss pension funds and their services.

Pension funds provide a savings plan for employees that can be used for retirement.
The amount of money is commonly increased in 4 ways:
a. New contributions by the employees sponsored by such plan
b. New contributions by the employer sponsored by such plan on behalf of the
employee
c. Dividends or interest earned by the fund (investment in debt/ equity securities)
d. Appreciation in the values of the securities in which it has invested
● Public Pension Funds
- Can either be state, local or federal. Most known is Social Security.
- Many are funded on a pay-as-you-go basis. Existing employee and employer
contributors are supporting previous employees.
- At some point, this strategy could cause future benefits owed to outweigh
contributions to an extent the fund may not be able to fulfill its promise or would
need to obtain more contributions to do so.
● Private Pension Funds
- Created by private agencies (Industrial organizations, Labor organizations, etc.)
- Some are so large that they are major investors in corporate securities
● Defined- Benefit Plans
- Contributions are dictated by the benefits that will eventually be provided
- The future pension obligation is uncertain
- These payments are dependent on salary levels, retirement ages and life
expectancies
- The higher the future returns on the plan’s investments, the lower the level of
funds that must be invested today to satisfy future payments and vice versa
● Defined- Contribution Plans
- Provides benefits that are determined by the accumulated contributions and the
fund’s investment performance
- A firm knows with certainty the amount of funds to contribute
- Outnumber defined-benefit plans but defined-benefit plans have more
participants and a greater aggregate value of assets.
PENSION FUND MANAGEMENT
● Managed by life insurance companies
- Life insurance companies purchase annuity policies to provide benefits to
employees upon retirement
- Insurance company becomes the legal owner of the assets
- Concentrate on investing the pension plan contributions as bonds and mortgages
● Managed by the trust departments of financial institutions
- Trust department invests the contributions and pays benefits to employees upon
retirement
- Day-to-day investment decisions of the trust department are controlled by the
managing institution
- Corporation owning the pension fund usually specifies general guidelines that the
institution should follow
- They commonly concentrate their investments in stocks
- Offer potentially higher returns than insured plans can achieve, but also have a
higher degree of risk

Asset Allocation of Pension Funds

● Return vs risk
- Pension managers have to balance return against risk
- Pension funds that achieve higher returns on their existing investments can more
easily meet their obligations to participate in the plan
- The degree of risk assumed by pension fund managers may be influenced by
their compensation incentives. If the portfolio performs very well, pension fund
managers are rewarded. However, they are not penalized when their portfolio
performs poorly. This gives the managers an incentive to take more risk than is
appropriate.
 ● Hedging pension fund portfolio risk
- Pension fund portfolio managers who are concerned about their exposure to risk
can implement strategies to hedge that risk.
- If they expect an increase in interest rates which causes the price of their bonds
to fall over the next month, they may hedge by selling bond futures contracts
- If their stocks are exposed to risk over the next month, they would sell stock
index futures and buy put options on stocks to hedge that risk.
● Passive investment strategy
- Pension funds can ensure that its investment strategy is consistently aligned with
the board’s recommended long-term allocation across investments. It also
ensures that the pension fund portfolio avoids excessively risky investments.
Furthermore, it ensures that no money is diverted to alternative investments
triggered by favors or bribes to anyone who oversees the pension fund
● Matched funding strategy
- Investment decisions are made with the objective of generating cash flows that
match planned outflow payments.
- Investing in long term bonds to fund long term liabilities, and investing in
intermediate bonds to fund intermediate liabilities
- It gives the assurance that future liabilities are covered regardless of market
movements. It also limits the manager’s discretion by allowing only investments
that match future payouts.
● Projective funding strategy
- This strategy offers managers more flexibility in constructing a pension portfolio
that can benefit from expected market and interest rate movements.

PENSION FUND PERFORMANCE

- Pension contributions are invested into a “portfolio” of stocks and bonds
- To diversify; investment performance is crucial to their operations
> TO BE ABLE TO PROVIDE PENSION PAYMENTS

Pension Fund’s Stock Portfolio Performance:

MKT - general market conditions

MANAB - abilities of the pension fund management

1. CHANGE IN MARKET CONDITIONS

- stock portfolio performance → closely related → market conditions
(stock portfolio performed poorly during the credit crisis of 2008)
2. CHANGE IN MANAGEMENT ABILITIES
- composition of the stocks in a pension fund’s portfolio is determined by the fund’s
portfolio managers (different management styles/abilities/techniques in managing
a pension fund)
 - operating efficiencies of a pension fund is a factor to fund’s related expenses
(properly and efficiently managed fund could result to lesser expenses, thus,
resulting to higher returns)

Pension Fund’s Stock Portfolio Performance:

Rf - risk-free rate
RP - risk premium
MANAB - abilities of the portfolio’s managers

1. CHANGES IN RISK-FREE RATE

- Bond’s Price → inversely related to → changes in the Rf
- If Rf rates decline substantially, required return for investors also decrease, and
bond portfolios managed by pension funds perform well
2. CHANGES IN RISK PREMIUM
- weak economic conditions will result to higher risk premiums and lower bond prices →
bonds tend to perform poorly
3. MANAGEMENT ABILITIES
- If a pension fund’s portfolio manager can effectively adjust the bond portfolio in
response to accurate forecasts of changes in interest rates or shifts in bond risk
premiums, a bond portfolio should experience relatively high performance.
- Portfolio managers have the ability to change the composition of a pension portfolio → to
be able to manage the portfolio’s potential return and risks
- Ability to strategize and to effectively switch to different investments to respond to
factors (e.g. interest rate changes, market factors, etc.)

EVALUATION OF PENSION FUND PERFORMANCE

“Compare a Pension Fund Performance to a Passive Strategy benchmark representing
the same mix of securities”

Example: assume that an actively managed pension fund presently has a stock portfolio
and a bond portfolio. The risk-adjusted returns on the fund’s actively managed stock portfolio
could be compared to a “benchmark stock index” (e.g. exchange-traded fund representing
the stock index). In addition, the risk-adjusted returns on the pension fund’s actively managed
bond portfolio could be compared to a benchmark bond index.

- THIS COMPARISON CAN DETERMINE WHETHER THE PORTFOLIO

MANAGERS OF THE PENSION FUND ARE ACHIEVING BETTER
PERFORMANCE THAN IF THE PENSION FUND USED A PASSIVE
MANAGEMENT STRATEGY!
2. Risks that pension funds face.
Pension funds, specifically defined-benefit pension funds, are usually subject to the risk
of being underfunded because the amount of money needed by a pension fund to pay
employees after retirement cannot be perfectly forecasted. Also, the rate of return that
most of its investments will earn until the money is distributed to the retiree is uncertain.

Underfunded private defined-benefit pension plans

- A pension fund may be underfunded because of its high expectations in the
future return on the money set aside for its employees. Because of this,
corporations would set aside a smaller amount of funds in anticipation of future
pension payment obligations. In addition, they would choose to lower the amount
of funds invested today.
- Since the allocation of money to the pension fund represents an expense, the
allocation of less money decreases the employer’s expenses, and increases its
earnings. This means that they have more cash that it can use for other
purposes.
- However, in the long run, pension funds would need to access additional funds to
offset the deficiency that is caused by its failure to set sufficient funds each
period to meet the expected payouts after the employees retire.

Underfunded public defined-benefit pension plans

- Every government agency that offers a defined-benefit plan is expected to set
aside funds each pay period for each employee who is participating in the plan to
ensure that it will have sufficient funding upon their retirement. However, most of
these plans do not consistently allocate funds to cover future obligations. The
overestimation of the rate of return, political motivation, and corruption contribute
to the underfunding of these pension plans.
● Overestimated rate of return
- Many government agencies set aside a smaller amount of money
to meet future obligations which is justified by their expectations of
a high rate of return on their pension fund investments. However,
pension funds can become underfunded once the rate of return on
their investment is lower than what they expected.
● Political motivation
- Some pension funds are underfunded for political reasons wherein
government officials prefer to use the funds for other purposes
rather than setting it aside for pension plans. This strategy can
lead to serious underfunding problems in the long run that it will
need to be corrected.
- This problem can be corrected by imposing higher state taxes,
reducing government employee pensions, or reducing expenses
needed for education or other services. However, this problem
has been largely ignored because politicians are unlikely to be
 elected if they impose high taxes or reduce government employee
pensions.
● Corruption
- Management of defined-benefit pension fund is guided by its
trustees, who have a fiduciary responsibility to serve the retirees
who receive pension benefits. They set policies for the investment
strategy that can be implemented by portfolio managers.
○ Bribes to trustees
- Trustees may be tempted to make decisions that are
mostly intended to benefit themselves at the expense of
the pension fund participants that they represent. Trustees
should not be subject to potential conflicts of interest.
- Some bribes come from investment companies since
trustees have the power to select a particular investment
company to manage the fund. This can generate millions
of dollars of annual income for the investment company.
○ Payment of excessive benefits
- Some trustees of public pension funds engage in actions
that favor particular pension participants like giving some
retirees supplemental payments which they were not
entitled to, and granting some city employees excessive
pension benefits even when pension funds are
underfunded.
○ Ineffective oversight by trustees
- There may be cases where trustees are hired for political
reasons and do not have the financial qualifications to
adequately oversee the management of the pension funds.

3. Regulatory aspects imposed on pension funds.

Regulations imposed on pension funds depend on their type. All plans must comply with
the set of Internal Revenue Service tax rules that apply to pension fund income.
a. ERISA (Employee Retirement Income Security Act of 1974)
- A.k.a. Pension Reform Act and its 1989 revisions
- Imposed on defined-contribution plans
- Requires a pension fund to choose one of two vesting schedule options
which determine when an employee has a legal right to the contributed
funds (a. 100% vesting after five years of service; b. Graded vesting, with
20% vesting in the 3rd year, 40% in the 4th, 60% in the 5th, 80% in the
6th and 100% in the 7th year); with either alternative, taxes on the vested
amount are still deferred until retirement when the funds become
available
- Concentrate in high-grade securities
- “Fiduciary responsibility” : portfolio managers are encouraged to serve the
interests of the employees
 - Allows employees changing employers to transfer any vested amount into
the pension plan of their new employer or to invest it in an Individual
Retirement Account (IRA)
b. The Pension Benefit Guaranty Corporation (PBGC)
- Established by ERISA to provide insurance on pension plans
- Guarantees that participants of defined-benefit pension plans will receive
their benefits upon retirement
- If the funds become incapable of completely providing the benefits
promised, PBGC will make up for the difference
- It does not receive government support as it is financed by premiums,
income from assets acquired from terminated pension plans, and income
from investments, as well as employer-liability payments when an
employer terminates its pension plan
- It has no regulatory powers
- PBGC periodically monitors the plans. If judged inadequate, it is
terminated and the PBGC (or a PBGC appointee) takes control as the
fund manager. PBGC has a claim on part of a firm’s net worth if it is
needed to support the underfunded pension assets.
- Funding requirements depend on the pension funds PBGC monitors and
are volatile overtime.
c. Pension Protection Act of 2006
- If a company’s defined-benefit pension plan is underfunded, this act
requires the firm to increase its contributions to the pension plan so that it
will be fully funded within 7 years.
- They may have less cash for other purposes which might cause operating
performance to suffer.
 4. Global Pension Funds Industry Trends

GLOBAL PENSION FUNDS INDUSTRY

- have been the primary means for meeting the retirement requirements of an aging global
population.
- Expected to continue growing strongly over the five years (between 2020 to 2025).
- This strong growth was a result of favorable investment returns and growing levels of
contributions.
- Populations are aging and people are becoming accustomed to higher standards of
living, thus, greater emphasis was placed on individuals to provide for their own
retirement.
 5. Describe the likely economic scenarios transacted between suppliers of funds
and users of funds without financial institutions.

Transactions in financial markets where the suppliers of funds do not go through financial
institutions or intermediaries are termed as “Direct Transfer or Direct Financing”. There are a lot
of advantages as well as disadvantages if participants in the financial markets transact directly
with each other without financial institutions.

Importance of Financial Institutions to the Economy

- The people who save are not necessarily the people who have profitable investment
opportunities available to them.

Ex:
Assume that you have saved P20,000 this year, but it is difficult for lending/borrowing
activities to prosper because there are no financial markets. Without investment opportunities
that will permit you to earn income with your savings, you will just hold on to the P20,000 and
earn no interest. However, another person in the name of ‘Mark’ can have a productive use for
your P20,000: ‘Mark’ can use it to establish a small business, which is expected to generate an
extra P10,000 income per year.

Assumption 1:
If you could easily have contact with ‘Mark’, you could lend him the P20,000 with
an interest of P1,000 per year, and both of you would be better off. You would earn
P1,000 per year on your P20,000, instead of the zero amount that you would earn
otherwise; while Mark would earn the extra P9,000 per year.

Assumption 2:
If there are no financial institutions, you and Mark might never get together. You
would both be stuck with the status quo, and both of you would be worse off. Without
financial institutions in financial markets as financial intermediaries, it is hard to transfer
funds from a person who has no investment opportunities to one who has them.

Financial markets and Financial Institutions are thus essential to promoting economic
efficiency.
- They channel funds from savers to spenders
- It allows funds in financial markets to move quickly
- There is an efficient capital allocation
> THUS, STIMULATING PRODUCTION AND EFFICIENCY FOR THE
OVERALL ECONOMY!
DISADVANTAGES:

a. Insufficient access to information

Because financial markets are ‘imperfect’ and that there exists a number of
asymmetric information (, then, transacting without financial institutions could
lead to bad investment decisions made by both suppliers of funds and users of
funds.

b. Costly
Because of the possible lack of information in participating in financial market
transactions without financial institutions, these participants would most likely
incur more costs greater than the cost that they would’ve paid if they transacted
with a financial institution.

both could lead to...

c. Slow trading activity
Since it would be much more difficult to have direct contact between suppliers of
funds and users of funds, there would only be little trading activity and few
alternatives, which does not stimulate economic growth.

d. Barriers to Globalization of Financial Markets

Robust and active financial institutions in financial markets facilitate international
flow of funds between countries. Without financial institutions, international
financial transactions would not be efficient.

According to Mark Chahwan, co-founder and chief executive of Sarwa, said:

“ideally, you need to save enough pension to generate 70 or even 80 percent of
your previous income, which is a tall order in 15 years”

If you are already planning for your retirement, without financial institutions, it would be
difficult for you to have a direct transaction with a deficit unit that can provide you
enough return for your retirement plans.

Hence, it is essential to transact with pension funds, as they have the expertise as to
the industry, and can give you a wide variety of pension plans that will aid you in your
retirement.
6. Rationalize the widely-practiced adoption of indirect, rather than direct transfer of
funds from suppliers of funds to users of funds.
- An example of an indirect transfer of funds from surplus to deficit units is through
a financial intermediary. It is widely adopted as compared to direct transfers
because it is less risky since these types of intermediaries specialize in lending
and selling securities. Their expertise can better predict the conditions of the
market which enables them to evaluate the risk and return characteristics of
investments. This can also aid them in effectively diversifying risk among
securities.
- Also, the cost of borrowing is lesser in indirect financing due to economies of
scale. Since an adequate number of borrowings engage in indirect financing,
costs are spread over a large number of participants which lowers cost.