CHAPTER

Pension Fund
25 Operations
Chapter Objectives

 Describe the different types of private

pension funds and the terminology of
pension funds
 Describe the pension management styles
 Explain how pension funds can become
underfunded and overfunded
Pension Fund Terminology Summary

Public
Publicvs.
vs. Trusteed
Trusteedvs.
vs.
Private
Private Insured
Insured

Under
Under Defined
Defined
Funded
Fundedvs.
vs. Benefit
Benefitvs.
vs.
Over
Over Contribution
Contribution
 Pension Fund Developments

 Pension plans are a recent development

 From defined benefit to defined contribution
pensions
 Pension funds have become a major capital
market participant
Background on Pension Funds

 Public pension funds

 Social security
 State and local governments
 Manypublic pensions are funded on a pay-as-
you-go system
 Pension fund is unfunded
 Depends on current cash flows of entity to support
pensioners
 Many public pension plans are fully funded
Types of Private Pension Plans

 Pension funds are commonly categorized as defined-benefit or

defined-contribution plans depending on how contributions are
made and on the level of benefits provided.
 Defined-benefit plan
 Annual contributions are determined by the benefits
“defined” in the plan paid at retirement
 If value of pension assets exceeds (over funded) current and
future benefits owed, employer may
 Reduce future contributions
 Distribute surplus to shareholders
Types of Private Pension Plans

 Defined-contribution plan
 Provides benefits determined by the accumulated
contributions and the fund’s investment
performance
 Firm knows with certainty the amount of the
contribution
 Provides uncertain benefits to participants
Types of Private Pension Plans

Under-funded Pension Plan

 Future pension obligations of a defined-benefit plan

are uncertain because obligations are fixed payments
to retirees and payments depend on salary level,
retirement ages and life expectancies
 High risk investments might be used to generate higher
returns with varied results
Types of Private Pension Plans

Over-funded Pension Plan

 When investment returns for defined-benefit plans

perform better than expected, there are funds in
excess of the amount needed to meet obligations
 A portion of the surplus can be credited to the
income statement of a corporation
Pension Regulations

 Regulations vary depending on the type of

plan - defined benefit more regulated
 Criticism of plans led to regulation
 Some plans were underfunded and could not pay
the benefits they promised
 Employees did not benefit when plans had excess
earnings but received reduced benefits when plans
performance faltered
Pension Regulations

 Accounting regulations
 Allow companies to more quickly recognize gains
and losses
 May increase the volatility of funds’ returns
 Rules may affect portfolio composition
 Underfunded plans shown as a liability on the
balance sheet
Pension Fund Management

 Management of “insured” portfolios

 Some plans are managed by life insurance
companies
 Insured plans purchase pension policies so the life
insurance company can provide benefits to the
employees upon retirement
 Retirement benefits are “assured” by credit
strength of life insurance company
Pension Fund Management

 Management of trusteed portfolios

To set up a pension fund, a sponsor corporation
establishes a trust pension fund through a
commercial bank’s trust department or an insured
pension fund through an insurance company.
 Managed by the trust department of a financial
institution
Pension Fund Management

 Differencesbetween trust department and

insured portfolios
 Trusts offer higher returns with higher risk via
investment in stocks
 Mortgages are more important in insurance
company portfolios
 Both invest in bonds
Pension Fund Management

 Management of private versus public

pensions
 Private business vs. state, municipal pensions
 Private pension portfolios dominated by common
stock
 Public pension portfolios more evenly invested in
stock, bonds and other credit instruments
Other Issues

 Interaction with other financial institutions

 Participation in financial markets
 Foreign investment by pension funds
 Several funds allocate a portion of investments to
foreign stocks and bonds
 Exhibit: 25.9 & 25.10
Pension Fund Terminology Summary

Public
Publicvs.
vs. Trusteed
Trusteedvs.
vs.
Private
Private Insured
Insured

Under Defined
Defined
Under
Funded Benefit
Benefitvs.
vs.
Fundedvs.
vs.
Over Contribution
Contribution
Over