Pension funds

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 22-2
Pensions
• Definition: A pension plan is an asset pool that
accumulates over an individual’s working years
and is paid out during the nonworking years.
• Developed as Americans began relying less on
children for care during their later years.
• Also became popular as life
expectancy increased.

Types of Pensions
• The pension fund industry comprises two distinct sectors.
1. Private pension funds: are those funds administered by
a private corporation ( e.g. (insurance company, mutual
fund).
 Any pension plan set up by employers, groups, or individuals
1. Public pension funds: are those funds administered by
a federal, state, or local government (e.g., Social
Security).
 Any pension plan set up by a government body for the general
public.

Insured versus Noninsured Pension funds:
Pension Plan
Document that governs the operations of a pension
fund.
1.Insured pension fund: A pension fund
administered by a life insurance company.
• Pool of money invested in Insurance Company
• The assets purchased with the premiums from the Insurance
Company.
• Become the legal property of the insurance company
managing the pension funds.
• Because they bear the risk of Assets failure.

• Non Inured pension funds: managed by a trust
department of a financial institution appointed by
the sponsoring business, participant, or union.
• Trustee invest the contributions and pay the
retirement benefits in accordance with the terms
of the pension fund.
• Invested by the sponsor but segregated and
listed as a separate pools of assets on the
trustees balance sheet.

• The assets purchased from the noninsured pension funds
are the legal property of the sponsoring corporation.
• Because non insured pension funds managers, by
contrast, do not incur the risk associated with the asset
value fluctuations. Thus the trustees overseeing the
pension funds generally invest pension premiums
received in more risky securities.
• Noninsured pension funds generally offer the potential for
higher rates of return but are also more risky than insured
pension funds.
• However, the higher rates of return allow the employee to
reduce contributions necessary to achieve a given
amount of funds at retirement.

Defined Benefit versus Defined
contribution Pension Funds
• Pensions funds can also be distinguished by the way
contributions are made and benefits are paid.
1. Defined Benefit Pension fund : A plan where the
employer promises the employee a specific benefit when
they retire.
i. Flat benefit formula
ii. Career average formula
iii. Final pay formula
iv. Fully funded
v. Underfunded
vi. Overfunded

Flat benefit formula
• Pays a flat amount for every year of employment.
Example:
A employee with 20 years of service at a company is considering
retirement at some point in the next 10 years. The employer uses a
flat benefit formula by which the employee receives an annual benefit
payment of $2000 times the number of years of service. For
retirement now, in 5 years, and in 10 years, the employees annual
retirement benefit payment is.
1. Retire now $2000 x 20 = $40,000
2. Retire after 5 years $2000 x 25 = $ 50,000
3. Retire after 10 years $2000 x 30 = $ 60,000

Career average formula
• Pension fund that pays retirement benefits based on the
employee’s average salary over the entire period of
employment.
Example: An employee with 20 years of service at a compnay is considering
retirement some times in the next10 year. The employer uses a career
average benefit formula by which the employee receives an annual benefit
payment of 4 percent of his career average salary times the number of years
of service. Fro retirement now, in 5 years, and in 10 years, the employee’s
annual retirment benefit payment is:
Average Salary Retirement Benefit
1. Retire Now $ 48000 $ 48000 x .04 x 20 = $38,400
2. Retire in 5 years $ 50000 $ 50,000 x .04 x 25= $ 50,000
3. Retire in 10 years $ 52,000 $52,000 x .04 x 30 = $ 63,000

Final Pay Formula
• Pays a retirement benefit based on a percentage of the average
salary during a specified number of years at the end of the
employees career times the number of years of services.
Example: An employee with 20 years of service at a company is considering
retirement at some times in the next 10 years. The employer uses a final pay
benefit formula by which the employee receives an annual benefit payment of
2.5 percent of her average salary during her last five years of service times
her total years employed. For retirement now, in 5 years, and in 10 years, the
employee’s (estimated) annual retirement benefit payment is:
Average salary Retirement Benefit
Retire now $75,000 $75,000 x .025 x 20 = $37500
Retire after 5 years $ 80,000 $ 80,000 x .025 x 20 = $50,000
Retire in 10 years $ 85,000 $ 85,000 x .025 x 20 = 63,750

contribution Pension Funds (cont)
• Under defined benefit pension funds, the employer should
set aside sufficient funds to ensure that it can meet the
promised payments.
– Fully funded: when sufficient funds are
available to meet payouts
– Overfunded: funds exceed the
expected payout
– Underfunded: funds are not expected to meet
the required benefit payouts

contribution Pension Funds (cont)
• Defined-Contribution Pension Plan: Pension
fund in which the employer agrees to make a
specified contribution to the pension fund during
the employee’s working years.
• So the final retirement benefit is based on
1. Employer contribution
2. Any additional employee contribution
3. Gain or losses on the investments purchased by the fund with these
contributions.

Private Pension Plan Assets

Social Security
• Pay as you go system, where current
funding is used (partially) to pay
current benefits.
• Projected number of workers is falling while
projected number of retirees is increasing,
which will cause problems in years to come
if not corrected.

Social Security
• It’s difficult to measure the health of the
social security system. Many factors are
hard to predict, such as birth rates and the
rate of immigration. Although it may not
fail, it’d be wise for you plan other sources
for your retirement cash flows.

Regulation of Pension Plans
A major U.S. Supreme Court decision in
1949 established that pension benefits
were a legitimate part of collective
bargaining. The number of plans
increased from this as unions negotiated
for
such plans.

• Employee Retirement Income Security Act
of 1974
– Established guidelines for funding
– Allowed plan credit to transfer with employees
– Established vesting requirements to gain
plan benefits
– Increased disclosure requirements
– Assigned regulatory oversight to the
Department of Labor

• ERISA also established the Pension
Benefit Guarantee Corporation to insure
pension benefits if an underfunded pension
plan is unable to meet its obligations.
– Accounting makes it difficult to assess funding
status of a plan
– May be in trouble as plans appear
underfunded

• The next slide shows the annual payments
made since 1980 to failed plan participants.
In 2005, the PBGC said that the plan has
never been under more stress…

• Pension Protection Act of 2006 was
passed to address the growing problem of
failed pension plans. The act provides for
stronger funding rules, greater
transparency, and a strong pension
insurance system.

• Pension Reform Act of 1978 authorized
individual retirement accounts.
– Enjoy a preferential tax treatment
– Keogh plans are similar plans for self-
employed individuals
– SIMPLE IRAs are simplified retirement plans
for small businesses.

The Future of Pension Funds
• We can expect their growth and popularity
as the average population continues
to grow.
• Variety of pension fund offerings may
increase as well.
• Pension funds may gain significant
control of corporations as their stock
holdings increase.

Chapter Summary
• Insurance Companies: the nature of the
industry, including rationale and people
employed in the industry, was presented.
• Fundamentals of Insurance: the seven
fundamental ideas behind all insurance
were listed and reviewed.

Chapter Summary (cont.)
• Growth and Organization of Insurance
Companies: the changes in growth
patterns over the last several decades was
reviewed, including both assets and
number
of companies.
• Types of Insurance: the variety of
insurance policies available covering life,
health, etc., were presented.

• Pensions: the general idea and growth in
pension funds was presented.
• Types of Pensions: the various forms, from
defined-benefit to defined-contribution,
were reviewed and compared.

• Regulation of Pension Plans: ERISA and
other laws that govern pension funds
was discussed.
• The Future of Pension Funds: we should
expect their popularity, size, and power to
continue to grow as the population ages.

Pension funds

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