PENSION FUNDS

Chapter 9
Pension Plans
A pension fund plan is a fund that is established for
the payment of retirement benefits. The entities that
establish pension funds, called plan sponsors, may
be:
- private business entities acting for their
employees;
- state and local entities on behalf of their
employees;
- unions on behalf of their members; and
- individuals for themselves.
Pension Plans
Pension funds are financed by contributions by the
employer and/or the employee; in some plans
employer contributions are matched in some
measure by employees.
The key factor explaining pension fund growth is that
the employer’s contributions and a specified amount
of the employee’s contributions, as well as the
earnings of the fund’s assets, are tax exempt.
Types of Pension Plans
The basic and widely used types of pension plans are:
● Defined contribution plans: In a defined contribution
plan, the plan sponsor is responsible only for
making specified contributions into the plan on
behalf of qualifying participants. The amount
contributed is typically either a percentage of the
employee’s salary or a percentage of profits. The
plan sponsor does not guarantee any certain amount
at retirement.
Types of Pension Plans
The basic and widely used types of pension plans are:
● Defined contribution plans: The payments that will
be made to qualifying participants upon retirement
will depend on the growth of the plan assets, that is,
payment is determined by the investment
performance of the assets in which the pension fund
invests.
The employer makes a specified contribution to a
specific plan/program, and the employee chooses
how it is invested.
Types of Pension Plans
● Defined contribution plans: To the employee, the
plan is attractive because it offers some control over
how the pension money is managed. In fact, plan
sponsors frequently offer participants the
opportunity to invest in one of a family of mutual
funds.
● Defined benefit plans: In a defined benefit plan, the
plan sponsor agrees to make specified amount
payments to qualifying employees at retirement. The
retirement payments are determined by a formula
that usually takes into account the length of service
of the employee and the employee’s earnings.
Types of Pension Plans
● Defined benefit plans: The pension obligations are
effectively the debt obligation of the plan sponsor, which
assumes the risk of having insufficient funds in the plan
to satisfy the contractual payments that must be made to
retired employees.
A plan sponsor establishing a defined benefit plan can
use the payments made into the fund to purchase an
annuity policy from a life insurance company. Benefits
become vested when an employee reaches a certain age
and completes enough years of service so that he or she
meets the minimum requirements for receiving benefits
upon retirement.
Types of Pension Plans
● Hybrid pension plans: A hybrid often called a
designer pension combines features of both defined
contribution plans and defined benefit plans. A
survey by institutional investor reveals that a new
phenomenon in pension planning, a hybrid plan, has
attracted surprising support. These plans, called
designer pensions, combine features of both basic
types of pensions.
Types of Pension Plans
● Hybrid pension plans: The appeal of these hybrids is
that each of the basic types of plans has flaws: The
defined contribution plan causes the employee to
bear all the investment risk, while the defined benefit
plan is expensive and hard to implement when few
workers work for only one company over many
years.
Although hybrids come in many forms, a good
example is the floor-offset plan. In this plan, the
employer contributes a certain amount each year to a
fund, as in a defined contribution approach.
Types of Pension Plans
● Hybrid pension plans: The employer guarantees a
certain minimum level of cash benefits, depending
on an employee’s years of service, as in a defined
benefit plan. The employer manages the pension
fund and informs the employee periodically of the
value of his or her account. If the managed fund
does not generate sufficient growth to achieve the
preset level of benefits, the employee is obliged to
add the amount of the deficit. In such a plan, the
employer and the participating employees share the
risk of providing retirement benefits.