ASSET MANAGEMENT

PENSION FUNDS.

Introduction.

What is a Pension Plan/Fund?

This is an investment plan set up by an employer to provide for employees’

retirement. It requires an employer to make contributions to a pool of funds set
aside for workers future benefit. The pool of funds is invested on the employees’
behalf and the earnings on the investments generate income to the worker upon
retirement. In addition to an employer’s required contributions, some pension plans
have a voluntary investment component. A Pension plan may allow a worker to
contribute part of his current income from wages into an investment plan to help
fund retirement.

The employer may also match a portion of the worker’s annual contributions up to
a specific percentage amount.

Simply put:

Pension funds are collective investment undertakings that manage employee

savings and retirement. Their primary objective is to provide pensioners who
have reached retirement age with income in the form of a lifetime pension or
capital.

At the core of pension fund operations are three types of activity:

(1) Premium collection.

(2) Investment of sums collected.
(3) Payment of benefits.

Main Types of Pension Plans.

There are two types of pension plans:

(1) Defined Benefit plan.

(2) Defined contribution plan.

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Defined Benefit Plan.

In a defined-benefit plan, the employer guarantees that the employee receives a

definite amount of benefit upon retirement, regardless of the performance of the
underlying investment pool. The employer is liable for a specific flow of pension
payments to the retiree (the amount (shs) is determined by a formula usually based
on earnings and years of service) and if the assets in the pension plan are not
sufficient to pay the benefits, the company is liable for the remainder of the
payment.

Defined-Contribution Plans.

In a defined contribution plan,the employee makes specific plan contributions for

the worker usually matching to varying degrees of contributions made by the
employees.

The final benefit received by the employee depends on the plans investment
performance.

The Company’s liability to pay a specific benefit ends when the contributions are
made.

Pension Funds can also be categorized as Public and Private Pension Funds.

In a Public Pension Fund, contributions paid by the assets are designed to pay
pensions for retirees.

A Private Pension Fund is often individual and voluntary, allowing working people
to set up their own retirement. They save during their working lives to insure their
old age. The contributions received are the subject of financial investments. The
return on these investments depends primarily on market developments.

ROLE OF PENSION FUNDS.

As we develop through our lifetime, we have an expectation that a time will come
when we will be able to retire after years of working. As we come to retire we will
often experience a reduction in income and eventually when we stop working no
income at all. Therefore we must secure our means of financial stability and

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security after retirement, which will enable us to continue living the life we were
living prior to retirement.

Specifically:

(1) Pension funds maintain contentment and morale of the staff. It assures them
of their future financial stability in turn means a more healthy staff and
greater productivity.
(2) Pension Funds attract and keep competent employees. This is an advantage
to the employer.
(3) Pension Funds are there to support employees and give them a decent
standard of living when commencing retirement. To maintain the same
standard of living after retirement.
(4) Pension Funds can provide protection and financial support to defendants in
the event of a member’s death.
(5) Pension Funds exist to encourage growth and investment due to state tax
relief on pensions.

ROLE OF PENSIONS IN ECONOMIC DEVELOPMENT.

(1) Increasing the generation of longterm savings.

(2) Lengthening the maturity profile of public and private debt due to the long-
term nature of pension management.
(3) Stimulating Financial Innovation and new products such as asset backed
securities and Infrastructure bonds.
(4) Improving market integrity through professionalism, activism and influence
of institutional investors.
(5) Transfer of knowledge due to international service provision to pensions
sector.
(6) Lastly they are Financial Intermediaries i.e. collecting (pooling) funds from
units of surplus (savers) to the consumers (investors) of funds. This way they
bring about economic growth.

(II) PENSION FUND MANAGEMENT.

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Regardless of the manner in which funds are contributed to a pension plan, the
funds received must be managed (invested) until needed to pay benefits. Private
pension portfolios are dominated by common stock.

Public Pension Portfolios are somewhat evenly invested in corporate Bonds,

Stock and other credit instruments.

Pension Fund Management can be classified according to the strategy used to

manage the portfolio. With a Matched funding strategy, investment decisions are
made with the objective of generating cash flows that match planned outflow
payments.

An alternative strategy is Projective Funding, which offers Managers more

flexibility in constructing a pension portfolio that can benefit from expected market
and interest rate movements.

Some Pension funds segment their portfolios with part being used for matched
funding and the rest for projective funding.

An informal method of matched funding is to invest in long-term bonds to fund

long-term liabilities and intermediate bonds (Maturities of 5 -10 years) to fund
intermediate liabilities. The appeal of matching is the assurance that future
liabilities are covered regardless of market movements that match future payouts.

For example, portfolio managers required to use matched funding would need to
avoid callable bonds (Callable or redeemable bonds are bonds that can be
redeemed or paid off by the issuer prior to the bonds' maturity date) because
these bonds could potentially be retired before maturity. This requirement
precludes consideration of many high yield bonds. In addition each liability
payout may require a separate investment to which it can be perfectly
matched; this would require several small investments and increase the
pension fund’s transaction costs.
Pension funds that are willing to accept market returns on bonds can purchase
bond index portfolios that have been created by investment companies.
(III).PENSIONS FINANCE –COMMON TERMS.

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1.Plan’s current liability.
Refers to the value of the Pension’s that current and past employees have
earned so far by their work for the company. Also known as Accrued
Benefit Obligation (ABO)

2. Accrued Liabilty for Past Service.

Refers to the sum of the Pension Plan’s current liability and its liability in
respect of future salary increases.

3.Future Service Liability.

Refers to the amount that employees are likely to accumulate (entitlements)

as they continue to work for the company.

4.Normal Cost(s).

Suppose that the assets in a pension plan/fund were sufficient to cover the
accrued liability for past service. In this case there would be no unfunded
liability and the company would simply need to pay into the Pensions fund
each year the value of any extra premiums that have been earned during the
year. These regular contributions are generally referred to as normal costs.

5.Pension Vesting.

Refers to the process by which an employee with a qualified retirement plan

and /or stock option becomes entitled to the benefits of ownership, even if
he/she no longer works at the company providing the retirement plan or
stock option.

Vesting occurs after employee has worked at the company for a certain
number of years. Once vesting occurs, the benefits of the plan or stock
option cannot be revoked.

Put differently,

It is used in reference to retirement plan benefits. When an employee accrues

non-forfeitable rights over employer-provided stock incentives or employer
contributions made to the employee’s qualified retirement plan account or
pension plan.
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6.Actuarial Gains or Losses.

Actuarial gain or loss refers to an increase or a decrease in the projections

used to value a corporation’s defined benefit pension plan obligations.

The Actuarial assumptions of a plan are directly affected by the discount rate
used to calculate the present value of benefit payments and the expected rate
of return on plan assets.

7.Accumulated Benefit Obligation (ABO).

Accumulated Benefit Obligation (ABO) is the approximate amount of a

company’s Pension Plan liability at a single point in time.ABO is estimated
based on the assumption that the Pension plan is to be terminated
immediately; it does not consider any future salary increases. This differs
from the Projected Benefit Obligation (PBO) which assumes that the
pension plan is ongoing and thus accounts for future salary increases.

(a) Accumulated benefit obligation (ABO) is equal to the present value of

the future amount that a Pension plan expects to pay an individual during
their retirement.
(b) Companies are required to measure and report their Pension liabilities
and the performance of their Pension Plan.
(c) If the accumulated benefit obligation (ABO) is above the Pension plan’s
assets, then the plan is underfunded.
If the ABO is below the Pension plan’s assets, then the plan is
overfunded.
(d) Underfunded or overfunded status can be affected by the discount rate
used as well as the expected rate of return on the plan’s invested assets.

8. Unamortized experience losses.

Refers to losses that result from the difference between expectations and
experience.(In a pension plan).

9.Contributions for Future Service.

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 Refers to contributions that the firm plans to make to cover future service by
current employees. This is stated at its present value

10.Unamortized supplental liabilities.

Refers to liability for improved pension benefits.

(IV)FUNDED/FULLY FUNDED, UNDER FUNDED AND UNFUNDED

PENSION PLANS.

(a) Fully Funded Pension Plan.

Fully Funded is a description of a Pension plan that has sufficient assets to

provide for all the accrued benefits it owes and can thus meet its future
obligations.

In order to be fully funded, the Pension Plan must be able to make all the
anticipated payments to both current and prospective pensioners.

A Pension Fund’s administrator/Manager is able to predict the amount of

fund’s that will be needed on yearly basis.

The funding status is generally determined by the plan’s actuaries. This can
help determine the financial health of the Pension plan. Fully funded can be
contrasted with an underfunded Pension which does not have enough current
assets to fund its obligations.

(b)Underfunded Pension Plan.

An underfunded Pension plan is a company sponsored retirement plan that
has more liabilities than assets. In other words, the money needed to cover
current and future retirements is not readily available. This means there is no
assurance that future retirees will receive the Pensions they were promised
or that current retirees will continue to get their previously established
distribution amount.
An underfunded pension plan may be contrasted with a fully funded or
overfunded Pension Plan.

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 What leads/can lead to underfunding?
 There may be a decline in the value of securities in the Pension
Fund.
 The actuary may revise upward his or her assumption about the
rate of salary inflation.
 The Union may negotiate increased Pensions.

On the hand id the investments perform better than expected, the value of the
Pension assets, may be greater than the accrued liability. Such a Pension plan
is said to be overfunded.

Implications.

If the plan is underfunded, it is worried that the company may not have enough
Money to pay Pensions as they become due. Therefore The Regulator
(Retirement Benefits Authority), requires companies with underfunded plans to
slowly make good the deficiency.

If the plan is overfunded, the government is concerned that companies are

simply using the plan to postpone paying taxes.(Pension contributions are tax-
deductible).Therefore such companies are not permitted to make further
deductible pension contributions until the overfunding has been eliminated.

(c) Unfunded Pension Plan.

An unfunded plan is an employer managed retirement plan that uses the
employer’s current income to fund pension payments as they become
necessary.
 Unfunded pension plans do not have any assets set aside meaning that
retirement benefits are usually paid directly from employer
contributions.
 Also called pay-as-you-go plans, these retirement accounts can be set
up by companies or governments.

(V) Actuarial Gains or Losses.

Actuarial gain or loss refers to an increase or decrease in the Projections used to

value a corporation’s defined benefit pension plan obligations.

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The actuarial assumptions of a plan are directly affected by the discount rate used
to calculate the present value of benefit payments and the expected rate of return
on plan assets.

(VI) Pension Plan Costs/Expenses.

Procedures are set out for calculating the Pension expense deducted from
each year’s reported income. This has four components.

(1) Interest Cost.

The Company starts the year with debt-like pension liability. Its cost is
the interest rate times the pension liability.
(2) Service Cost.
In addition, employees earn other benefits during the year. The expense
of these extra benefits is known as service Cost.
(3) Amortization of Deficit.
If the company has accumulated pension deficit, it will also need to pay it
over time.
(4) Expected Investment Return.
Expenses 1,2and 3 above are partly offset by the return that the company
expects to earn on the pension assets.
The net expense is equal to:
(Interest Cost + Service Cost + Amortization of Plan deficit) –
Expected Investment return = Net Pension expense.

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