Pension funds

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Pension funds

  1. 1. Chapter 18PensionFunds
  2. 2. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 22-2Pensions• Definition: A pension plan is an asset pool thataccumulates over an individual’s working yearsand is paid out during the nonworking years.• Developed as Americans began relying less onchildren for care during their later years.• Also became popular as lifeexpectancy increased.
  3. 3. Types of Pensions• The pension fund industry comprises two distinct sectors.1. Private pension funds: are those funds administered bya private corporation ( e.g. (insurance company, mutualfund). Any pension plan set up by employers, groups, or individuals1. Public pension funds: are those funds administered bya federal, state, or local government (e.g., SocialSecurity). Any pension plan set up by a government body for the generalpublic.Copyright © 2009 Pearson Prentice Hall. All rights reserved. 22-3
  4. 4. Insured versus Noninsured Pension funds:Pension PlanDocument that governs the operations of a pensionfund.1.Insured pension fund: A pension fundadministered by a life insurance company.• Pool of money invested in Insurance Company• The assets purchased with the premiums from the InsuranceCompany.• Become the legal property of the insurance companymanaging the pension funds.• Because they bear the risk of Assets failure.Copyright © 2009 Pearson Prentice Hall. All rights reserved. 22-4
  5. 5. Insured versus Noninsured Pension funds:• Non Inured pension funds: managed by a trustdepartment of a financial institution appointed bythe sponsoring business, participant, or union.• Trustee invest the contributions and pay theretirement benefits in accordance with the termsof the pension fund.• Invested by the sponsor but segregated andlisted as a separate pools of assets on thetrustees balance sheet.Copyright © 2009 Pearson Prentice Hall. All rights reserved. 22-5
  6. 6. Insured versus Noninsured Pension funds:• The assets purchased from the noninsured pension fundsare the legal property of the sponsoring corporation.• Because non insured pension funds managers, bycontrast, do not incur the risk associated with the assetvalue fluctuations. Thus the trustees overseeing thepension funds generally invest pension premiumsreceived in more risky securities.• Noninsured pension funds generally offer the potential forhigher rates of return but are also more risky than insuredpension funds.• However, the higher rates of return allow the employee toreduce contributions necessary to achieve a givenamount of funds at retirement.Copyright © 2009 Pearson Prentice Hall. All rights reserved. 22-6
  7. 7. Defined Benefit versus Definedcontribution Pension Funds• Pensions funds can also be distinguished by the waycontributions are made and benefits are paid.1. Defined Benefit Pension fund : A plan where theemployer promises the employee a specific benefit whenthey retire.i. Flat benefit formulaii. Career average formulaiii. Final pay formulaiv. Fully fundedv. Underfundedvi. OverfundedCopyright © 2009 Pearson Prentice Hall. All rights reserved. 22-7
  8. 8. Flat benefit formula• Pays a flat amount for every year of employment.Example:A employee with 20 years of service at a company is consideringretirement at some point in the next 10 years. The employer uses aflat benefit formula by which the employee receives an annual benefitpayment of $2000 times the number of years of service. Forretirement now, in 5 years, and in 10 years, the employees annualretirement benefit payment is.1. Retire now $2000 x 20 = $40,0002. Retire after 5 years $2000 x 25 = $ 50,0003. Retire after 10 years $2000 x 30 = $ 60,000Copyright © 2009 Pearson Prentice Hall. All rights reserved. 22-8
  9. 9. Career average formula• Pension fund that pays retirement benefits based on theemployee’s average salary over the entire period ofemployment.Example: An employee with 20 years of service at a compnay is consideringretirement some times in the next10 year. The employer uses a careeraverage benefit formula by which the employee receives an annual benefitpayment of 4 percent of his career average salary times the number of yearsof service. Fro retirement now, in 5 years, and in 10 years, the employee’sannual retirment benefit payment is:Average Salary Retirement Benefit1. Retire Now $ 48000 $ 48000 x .04 x 20 = $38,4002. Retire in 5 years $ 50000 $ 50,000 x .04 x 25= $ 50,0003. Retire in 10 years $ 52,000 $52,000 x .04 x 30 = $ 63,000Copyright © 2009 Pearson Prentice Hall. All rights reserved. 22-9
  10. 10. Final Pay Formula• Pays a retirement benefit based on a percentage of the averagesalary during a specified number of years at the end of theemployees career times the number of years of services.Example: An employee with 20 years of service at a company is consideringretirement at some times in the next 10 years. The employer uses a final paybenefit formula by which the employee receives an annual benefit payment of2.5 percent of her average salary during her last five years of service timesher total years employed. For retirement now, in 5 years, and in 10 years, theemployee’s (estimated) annual retirement benefit payment is:Average salary Retirement BenefitRetire now $75,000 $75,000 x .025 x 20 = $37500Retire after 5 years $ 80,000 $ 80,000 x .025 x 20 = $50,000Retire in 10 years $ 85,000 $ 85,000 x .025 x 20 = 63,750Copyright © 2009 Pearson Prentice Hall. All rights reserved. 22-10
  11. 11. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 22-11Defined Benefit versus Definedcontribution Pension Funds (cont)• Under defined benefit pension funds, the employer shouldset aside sufficient funds to ensure that it can meet thepromised payments.– Fully funded: when sufficient funds areavailable to meet payouts– Overfunded: funds exceed theexpected payout– Underfunded: funds are not expected to meetthe required benefit payouts
  12. 12. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 22-12Defined Benefit versus Definedcontribution Pension Funds (cont)• Defined-Contribution Pension Plan: Pensionfund in which the employer agrees to make aspecified contribution to the pension fund duringthe employee’s working years.• So the final retirement benefit is based on1. Employer contribution2. Any additional employee contribution3. Gain or losses on the investments purchased by the fund with thesecontributions.
  13. 13. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 22-13Private Pension Plan Assets
  14. 14. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 22-14Social Security• Pay as you go system, where currentfunding is used (partially) to paycurrent benefits.• Projected number of workers is falling whileprojected number of retirees is increasing,which will cause problems in years to comeif not corrected.
  15. 15. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 22-15Social Security• It’s difficult to measure the health of thesocial security system. Many factors arehard to predict, such as birth rates and therate of immigration. Although it may notfail, it’d be wise for you plan other sourcesfor your retirement cash flows.
  16. 16. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 22-16Regulation of Pension PlansA major U.S. Supreme Court decision in1949 established that pension benefitswere a legitimate part of collectivebargaining. The number of plansincreased from this as unions negotiatedforsuch plans.
  17. 17. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 22-17Regulation of Pension Plans• Employee Retirement Income Security Actof 1974– Established guidelines for funding– Allowed plan credit to transfer with employees– Established vesting requirements to gainplan benefits– Increased disclosure requirements– Assigned regulatory oversight to theDepartment of Labor
  18. 18. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 22-18Regulation of Pension Plans• ERISA also established the PensionBenefit Guarantee Corporation to insurepension benefits if an underfunded pensionplan is unable to meet its obligations.– Accounting makes it difficult to assess fundingstatus of a plan– May be in trouble as plans appearunderfunded
  19. 19. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 22-19Regulation of Pension Plans• The next slide shows the annual paymentsmade since 1980 to failed plan participants.In 2005, the PBGC said that the plan hasnever been under more stress…
  20. 20. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 22-20Regulation of Pension Plans• Pension Protection Act of 2006 waspassed to address the growing problem offailed pension plans. The act provides forstronger funding rules, greatertransparency, and a strong pensioninsurance system.
  21. 21. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 22-21Regulation of Pension Plans• Pension Reform Act of 1978 authorizedindividual retirement accounts.– Enjoy a preferential tax treatment– Keogh plans are similar plans for self-employed individuals– SIMPLE IRAs are simplified retirement plansfor small businesses.
  22. 22. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 22-22The Future of Pension Funds• We can expect their growth and popularityas the average population continuesto grow.• Variety of pension fund offerings mayincrease as well.• Pension funds may gain significantcontrol of corporations as their stockholdings increase.
  23. 23. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 22-23Chapter Summary• Insurance Companies: the nature of theindustry, including rationale and peopleemployed in the industry, was presented.• Fundamentals of Insurance: the sevenfundamental ideas behind all insurancewere listed and reviewed.
  24. 24. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 22-24Chapter Summary (cont.)• Growth and Organization of InsuranceCompanies: the changes in growthpatterns over the last several decades wasreviewed, including both assets andnumberof companies.• Types of Insurance: the variety ofinsurance policies available covering life,health, etc., were presented.
  25. 25. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 22-25Chapter Summary (cont.)• Pensions: the general idea and growth inpension funds was presented.• Types of Pensions: the various forms, fromdefined-benefit to defined-contribution,were reviewed and compared.
  26. 26. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 22-26Chapter Summary (cont.)• Regulation of Pension Plans: ERISA andother laws that govern pension fundswas discussed.• The Future of Pension Funds: we shouldexpect their popularity, size, and power tocontinue to grow as the population ages.
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