Financial Markets and Institutions

13th Edition
by Jeff Madura

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 26 Pension Fund Operations
Chapter Objectives

• Distinguish between defined-benefit versus defined

contribution pension plans.
• Explain how pension funds participate in financial markets.
• Discuss the regulation of private pension plans.
• Discuss underfunding of public pension plans.
• Discuss corruption and defined-benefit plans.
• Explain how pension funds are managed.
• Explain the key factors that influence the performance of
pension portfolios.

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2
 Types of Pension Plans (1 of 3)

• Defined-Benefit Plans
• Contributions are dictated by the benefits that will
eventually be provided.
• The future pension obligations of a defined benefit plan are
uncertain because the obligations are stated in terms of
fixed payments to retirees.
• The amount the plan needs today will be uncertain because
of the uncertain rate of return on today’s investments.

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 Types of Pension Plans (2 of 3)

• Defined-Contribution Plans
• Provides benefits that are determined by the accumulated
contributions and the fund’s investment performance.
• Some firms match a portion of the contribution made by
their employees.
• With this type of plan, a firm knows with certainty the
amount of funds to contribute, whereas that amount is
undetermined in a defined-benefit plan.
• The benefits to the participants are uncertain.

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 Types of Pension Plans (3 of 3)

Comparing Pension Plans

• Some employees may favor a defined-contribution plan if they
prefer to make their own investment decisions with their
retirement money.
• Conversely, other employees may favor a defined-benefit plan if
they prefer to know the exact amount of benefits they will receive
at retirement and do not want to be responsible for determining
how to invest their retirement money.
• If financial markets are weak for a few years, the investments
made by many defined benefit plans will likely perform poorly, but
the obligations to the retirees covered by those plans are not
affected by the weak market conditions.
• Defined-contribution plans outnumber defined-benefit plans, but
defined-benefit plans have more participants and a greater
aggregate value of assets.

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 Pension Fund Participation in Financial
Markets (1 of 2)

• Pension funds are major participants in financial markets.

Many of the investments by pension funds in the financial
markets finance economic growth. (Exhibit 26.1)
• Managers of pension funds instruct securities firms on the
type and amount of investment instruments to purchase.
(Exhibit 26.2)
• Pension fund managers participate in various financial
markets, including the stock and bond market, money and
mortgage markets, and futures and options markets.
(Exhibit 26.3)
• Pension funds can exert a degree of governance over
corporations because of their large purchases of stocks and
corporate bonds.

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 Pension Fund Participation in Financial
Markets (2 of 2)

Governance by Pension Funds

• Pension funds can exert a degree of governance over
corporations because of their large purchases of stocks
and corporate bonds.

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 Exhibit 26.1 How Pension Funds Finance
Economic Growth

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 Exhibit 26.2 Interaction between Pension
Funds and Other Financial Institutions

TYPE OF FINANCIAL INTERACTION WITH PENSION FUNDS

INSTITUTION
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.

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 Exhibit 26.3 Participation of Pension
Funds in Financial Markets
FINANCIAL MARKET
Money markets
Bond markets
Mortgage markets
Stock markets
Futures markets
Options markets
Swap markets
HOW PENSION FUNDS PARTICIPATE IN THIS MARKET
• Pension fund managers maintain a small proportion of liquid money market securities that
can be liquidated when they wish to increase the pension fund’s investment in stocks,
bonds, or other alternatives.
• At least 25 percent of a pension fund portfolio is typically allocated to bonds. Portfolios of
defined-benefit plans usually have a higher concentration of bonds than do defined-
contribution plans. Pension fund managers frequently conduct transactions in the bond
market.
• Pension portfolios frequently contain some mortgages, although the relative proportion is
low compared with bonds and stocks.
• At least 30 percent of a pension fund portfolio is typically allocated to stocks. In general,
defined contribution plans maintain a higher concentration of stocks than do defined-
benefit plans.
• Some pension funds use futures contracts on debt securities and on bond indexes to
hedge the exposure of their bond holdings to interest rate risk. In addition, some pension
funds use futures on stock indexes to hedge against market risk. Other pension funds use
futures contracts for speculative purposes.
• Some pension funds use stock options to hedge against movements of particular stocks.
They may also use options on futures contracts to secure downside protection against
bond price movements.
• Pension funds commonly engage in interest rate swaps to hedge the exposure of their
bond and mortgage portfolios to interest rate risk.

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 Regulation of Private Pension Plans (1 of 5)

• Private pension plans are created to serve employees in

the private sector and are governed by federal
regulations.
• A sponsor corporation may establish a trust pension fund
through a commercial bank’s trust department or an
insured pension fund through an insurance company.
• Plans must comply with the Internal Revenue Service tax
rules that apply to pension fund income.

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 Regulation of Private Pension Plans (2 of 5)

Vesting 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.
• 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.

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 Regulation of Private Pension Plans (3 of 5)

Transferability of Private Pension Plans

• ERISA allows employees changing employers to transfer
any vested amount into the private pension plan of their
new employer or to invest it in an Individual Retirement
Account (IRA).
• With either alternative, taxes on the vested amount are still
deferred until retirement when the funds become available.

Tax Benefits of Private Pension Plans

• Benefits provided by the plan must be proportionately equal
relative to income, so that employees earning lower wages
receive equal treatment.

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 Regulation of Private Pension Plans (4 of 5)

Insurance on Private Pension Plans

• ERISA established the Pension Benefit Guaranty
Corporation (PBGC) to provide insurance on pension plans.
• Guarantees that participants of defined-benefit pension
plans will receive their benefits upon retirement.
• The PBGC insures the pensions of approximately 34 million
Americans, or one-fourth of the workforce.
• The PBGC monitors private pension plans periodically to
determine whether they can adequately provide the benefits
they have guaranteed.

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 Regulation of Private Pension Plans (5 of 5)

Underfunded Private Defined-Benefit Pensions

• Implementation of Pension Protection Act to Prevent
Underfunding
• If a company’s defined-benefit pension plan is underfunded,
the Pension Protection Act of 2006 requires the company
to increase its contributions to the pension plan so that it
will be fully funded within 7 years.

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 Underfunded Public Defined-Benefit
Pension Plans (1 of 4)

Overestimated Rate of Return

• The trend of underfunded public defined-benefit pension plans
could have adverse consequences in the long run, because
the agencies will have to raise taxes or cut government
services later to make up for the underfunding.
Political Motivation
• Governments do not set aside sufficient funding for their
pension plans because they prefer to spend more funds on
other government services.
• Some hope to correct their budget deficit caused by
underfunded pensions by issuing debt.

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 Underfunded Public Defined-Benefit
Pension Plans (2 of 4)

Possible Solutions to Underfunded Pensions

• Issue Bonds — Some governments might attempt to
correct their budget deficits caused by underfunded
pensions by issuing debt.
• Use aggressive investment management strategy for
the pension fund — In some cases, a pension plan that
is underfunded may attempt to correct its funding
deficiency by implementing a more aggressive
investment strategy to increase its return on investments.

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 Underfunded Public Defined-Benefit
Pension Plans (3 of 4)

• Revise the Required Pension Contributions or

Benefits — Some government agencies have attempted
to solve the problems caused by underfunded pensions
by increasing the retirement age at which employees can
start receiving their pensions, requiring employees to
contribute a larger proportion of their salary to the
pension fund, or reducing the retirement benefits to
employees.
• Increase Taxes or Reduce Other Government
Services — Some government agencies have
considered raising taxes or cutting services to resolve the
pension underfunding problem.Make government

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 Underfunded Public Defined-Benefit
Pension Plans (4 of 4)

• Hold Government Officials Accountable for

Underfunded Pensions — Government officials who
used pension money for political favors or other reasons
instead of allocating the money toward pension funds
have rarely been held accountable for the problems they
caused.Shift from defined-benefit to defined-contribution
plans.
• Shift from Defined-Benefit to Defined-Contribution
Plans — The pension underfunding problem is possible
only with defined-benefit plans and not with defined
contribution plans, because the money to be allocated in
defined-contribution plans is immediately set aside for
employees in each pay period.

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 Corruption of Defined-Benefit Pension
Funds (1 of 2)

Agency problems can occur, whereby the trustees make

decisions that are mostly intended to benefit themselves at
the expense of the participants that they represent.

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 Corruption of Defined-Benefit Pension
Funds (2 of 2)

Bribes to Trustees
• Trustees should not be subject to potential conflicts of
interest.
Payment of Excessive Benefits
• Trustees should not engage in actions that favor particular
pension participants or are simply inappropriate.

Ineffective Oversight by Trustees

• Sometimes trustees of public pension funds are hired for
political reasons and do not have the financial
qualifications to adequately oversee the management of
the pension funds.

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 Pension Fund Management (1 of 5)

Management of Insured versus Trust Portfolios

Although the day-to-day investment decisions controlled by
the managing institution, the corporation owning the
pension normally specifies general guidelines:
• The percentage of the portfolio that should be used for
stocks or bonds
• A desired minimum rate of return on the overall portfolio
• The maximum amount to be invested in real estate
• The minimum acceptable quality ratings for bonds
• The maximum amount to be invested in any one industry
• The average maturity of bonds held in the portfolio
• The maximum amount to be invested in options
• The minimum size of companies in which to invest

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 Pension Fund Management (2 of 5)

Asset Allocation of Pension Funds

Portfolio managers change the asset allocation of the
pension fund over time in response to the investment
environment.

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 Pension Fund Management (3 of 5)

Asset Allocation of Pension Funds (continued)

• Return versus Risk
• In determining their asset allocation, pension fund
managers have to balance return against risk.
• Hedging Pension Fund Portfolio Risk
• Pension fund portfolio managers are very concerned about
interest rate risk and stock market risk.

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 Pension Fund Management (4 of 5)

Asset Allocation of Pension Funds (continued)

• Passive Investment Strategy
• Pension funds could consider using a passive management
strategy such as investing in indexed mutual funds, which
would perform as well as market benchmarks that represent
the general stock market, bond market, and real estate
market.
• Pension funds that are willing to accept market returns on
bonds can purchase bond index portfolios that have been
created by investment companies.
• Equity portfolio indexes that mirror the stock market are
also available for passive portfolio managers.

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 Pension Fund Management (5 of 5)

Matched versus Projective Funding Strategies

• Pension fund management can be classified according to
the strategy used to manage the portfolio.
• Matched funding: investment decisions are made with the
objective of generating cash flows that match planned
outflow payments.
• Projective funding: offers managers more flexibility in
constructing a pension portfolio that can benefit from
expected market and interest rate movements.

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 Performance of Pension Funds (1 of 3)

Pension Fund’s Stock Portfolio Performance

• Change in Market Conditions
• The stock portfolio’s performance is usually closely related
to market conditions.
• Change in Management Abilities
• Stock portfolio performance can vary among pension funds
in a particular time period because of differences in
management abilities.

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 Performance of Pension Funds (2 of 3)

Pension Fund’s Bond Portfolio Performance

• Impact of Change in the Risk-Free Rate
The prices of bonds tend to be inversely related to changes in
the risk-free interest rate.
• Impact of Change in the Risk Premium
The prices of bonds tend to be inversely related to changes in
the risk premiums required by investors who purchase bonds.

• Impact of Management Abilities

The performance levels of bond portfolios can vary as a result
of differences in management abilities.

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 Performance of Pension Funds (3 of 3)

Evaluation of Pension Fund Performance

• A pension fund’s performance can be evaluated by
comparing it to a passive strategy benchmark
representing the same mix of securities.
• Research on Pension Portfolio — Performance Some
research has found that managed pension portfolios
perform no better than market indexes. During the credit
crisis, some pension portfolios actually performed much
worse than benchmark market indexes because their
managers invested heavily in risky mortgages and
mortgage-backed securities.

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 SUMMARY (1 of 4)

• 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. Some pension funds have
taken active roles in governance over corporations.

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 SUMMARY (2 of 4)

• Private pension plans are subject to vesting rules and are

monitored by the Pension Benefit Guaranty Corporation.
• Many defined-benefit pension plans are underfunded.
One of the reasons for the underfunding is that some
employers have used an overly optimistic rate of return
assumption. Some public pension funds are underfunded
because the government agencies have granted
generous retiree benefits, but without requiring sufficient
contributions to cover those future benefits when
employees retire. Consequently, they have to correct the
deficiency by raising taxes or cutting government
services.

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 SUMMARY (3 of 4)

• Corruption including bribery and political favors has

contributed to the underfunding problem for many
defined-benefit public pension plans.
• Some pension funds use a matched funding strategy, in
which investment decisions are made with the objective
of generating cash flows that match planned outflow
payments. Other pension funds use a projective funding
strategy, which attempts to capitalize on expected market
or interest rate movements.

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 SUMMARY (4 of 4)

• The valuation and performance of pension fund portfolios

are highly influenced by market conditions. However,
some pension portfolios are more exposed to risk than
others. Notably, pension portfolios can suffer losses
during weak market conditions. Pension fund managers
have an influence on the pension portfolio performance,
especially when they have the flexibility to adjust the
relative proportion of stocks versus bonds in the portfolio.

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