Chapter 18 - Pension Funds

SOLUTIONS MANUAL
Chapter Eighteen
Answers to Chapter 18
Questions:
1. Private pension funds are created by the private entities (e.g., manufacturing, mining, or
transportation firms) and are administered by private corporations (financial institutions). Public
pension funds are those funds administered by a federal, state, or local government (e.g., ocial
ecurity).
!. Pension plans administered by life insurance companies (almost "# percent of the industry=s
assets) are termed insured pension plans. $he distinction is due not necessarily to the type of
administrator, but to the classification of assets in %hich pension fund contributions are invested.
pecifically, there is no separate pool of assets. &ather the funds are invested in the general asset
accounts of the insurance company. $he portion of the insurance company=s assets devoted to
the pension fund is reported in the liability section under pension reserves. 'oninsured pension
plans (administered by mutual funds and other financial institutions) are managed by a trustee
appointed by the sponsoring business, participant, or union. $rustees invest the contributions and
pay the retirement benefits in accordance %ith the terms of the pension plan.
". (n a defined benefit pension plan, the employer (or plan sponsor) agrees to provide the
employee a specific cash benefit upon retirement, based on a formula that considers such factors
as years of employment and salary during employment. $he formula is generally one of three
types) flat-benefit, career-average, or final-pay formula.
*ith a defined contribution pension plan the employer (or plan sponsor) does not commit to
provide a specified retirement income. &ather, the employer contributes a specified amount to
the pension fund during the employee=s %or+ing years. $he final retirement benefit is then
based on the total employer contributions, any additional employee contributions, and any
investment gains or losses.
,. $he three types of formulas used to determine pension benefits for defined benefit pension
funds are flat-benefit formula, career-average formula, and final-pay formula. - flat benefit
formula pays a flat amount for every year of employment. $%o variations of career-average
formulas e.ist/ both base retirement benefits on the average salary over the entire period of
employment. 0nder one formula retirees earn benefits based on a percentage of their average
salary during the entire period they belonged to the pension plan. 0nder the alternate formula,
the retirement benefit is e1ual to a percentage of the average salary times the number of years
employed. - 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 employee=s career times the number
of years of service.
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Chapter 18 - Pension Funds
2. 3efined contribution plans are increasingly dominating the private pension fund mar+et.
(ndeed, many defined benefit funds are converting to defined contribution funds. Figure 18-1
sho%s that as e1uity mar+et values fell in !##1 and in !##8 (during the financial crisis), pension
fund asset values, particularly for defined contribution funds, fell as %ell. -s the economy
recovered and e1uity mar+et values increased in the mid- then late-!###s, so did the value of
pension funds assets. Figure 18-! sho%s that from 144# through !#1#, defined benefit funds
actually e.perienced a reduction in assets held, %hile defined contribution funds sa% a
continuous increase in ne% asset investments. 5ne reason for this shift is that defined
contribution funds do not re1uire the employer to guarantee retirement benefits and thus
managers do not need to monitor the funds6 performance once the re1uired contribution are
made. $hus, employees must bare more of the responsibility for monitoring fund performance.
7. Figure 18-" sho%s the gro%th in ,#1(+) plans in the 144#s and !###s) from 8"82 billion in
144# to 8!,48! billion in !##9, and 8!,74" billion in !#1#. (n !#1# there %ere over 21,###
,#1(+) plans and over !# million participants.
9. (ndividual retirement accounts are self-directed retirement accounts set up by employees %ho
are also covered by employer sponsored pension plans. Contributions to (&-s are made strictly
by the employee. - :eogh account is retirement account available to self-employed individuals.
Contributions by the individual may be deposited in ta. deferred accounts administered by a life
insurance company, a ban+, or other financial institution. imilar to ,#1(+) plans the participant
in a :eogh account is given some discretion in ho% the funds are invested.
8. ;ost state and local government pension funds are funded on a Apay as you go@ basis,
meaning that contributions collected from current employee=s are the source of payments to the
current retirees. -s result of the increasing number of retirees relative to %or+ers, some of these
pension funds (e.g., 'e% <or+ City) have e.perienced a situation in %hich contributions have not
been high enough to cover the increases in re1uired benefit payments (or the pension funds are
underfunded).
(n the late !###s, 0.. states faced a total shortfall of at least 81 trillion in their funding of
employees= pensions and retirement benefits, and their financial problems %ere only gro%ing.
(llinois %as in the %orst shape, %ith only 2, percent of its pension obligations funded in fiscal
year (>une) !##8?%ith the do%nturn in the stoc+ mar+et bet%een >uly !##8 and !#1#, the gap is
even %ider. 3uring the !###s, many states contributed only the minimum funds to the pension
plans. (n !###, states %ere only re1uired to pay 8!9 billion total into their funds. @y fiscal !##8,
that amount had more than doubled to a 87, billion deposit. -s stoc+ mar+et returns fell and the
0.. economy entered a steep recession, state revenues fell dramatically. 0nder these
circumstances, the minimum contributions made in Agood timesB %ere insufficient to +eep up
%ith promised payouts. (n fiscal !###, half of the 2# states had fully funded their pension
systems. @y fiscal !##8 only four states?Florida, 'e% <or+, *ashington, and *isconsin?%ere
able to cover their costs. $he gro%ing bill from promised pension payouts coming due to states
could have significant conse1uences for ta.payers/ resulting in higher ta.es, less money for
public services, and lo%er state bond ratings.
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Chapter 18 - Pension Funds
4. Civil service funds cover all federal employees %ho are not members of the armed forces.
$his group is not covered by ocial ecurity. imilar to private pension funds the federal
government is the main contributor to the fund, but participants may contribute as %ell. (n
addition to ocial ecurity, career military personnel receive retirements benefits from a federal
government-sponsored military pension fund. Contributions to the fund are made by the federal
government and participants are eligible for benefits after !# years of military service.
Cmployees of the nation=s railroad system are eligible to participate in federal railroad pension
system. 5riginated in the 14"#s, contributions are made by railroad employers, employees, and
the federal government. $he largest federal government pension fund is ocial ecurity. -lso
+no%n as the 5ld -ge and urvivors (nsurance Fund, ocial ecurity provides retirement
benefits to almost all employees in the 0.. ocial ecurity %as established in 14"2 %ith the
obDective of providing minimum retirement income security to all retirees.
1#. Financial assets held by pension funds totaled 8!,,." billion in 1492 and 82,771., billion in
!#1# (a !,!19 percent increase in "2 years). (n !#1#, 77.,9 percent of pension fund contributions
%ere in corporate e1uities or mutual funds shares. $his compares to ,,.71 percent in 1492. (n
fact, pension funds are the largest institutional investor in the stoc+ mar+et. Certainly the
booming stoc+ mar+ets of the 144#s are one reason for the s%itch to e1uities.
11. Figure 18-, sho%s the distinction in private pension plan financial asset investments for
defined benefit and defined contribution plans. 3efined benefit plans have "8.9" percent of their
funds invested in 0.. government securities and bonds compared to defined contributions plans
%ith 9.2" percent. -lso, defined benefit plans have ",.8" percent of their assets invested in
corporate e1uities compared to "#.87 percent for defined contribution plans. (n contrast, defined
contribution plans have ,7.,1 percent of their funds invested in mutual fund shares compared to
1,.#9 percent for defined benefit plans.
3efined benefit pension plans offer employees a promised payout, %hile defined contribution
plans do not. $he promise of guaranteed retirement payments is li+ely a maDor reason for the
larger percentage of investments in fi.ed payout securities by defined benefit plans. 3efined
contribution plans do not offer a guaranteed retirement payout. $hus, administrators invest more
of the funds in ris+y e1uities and mutual fund shares.
1!. C&(- %as passed %hen many %or+ers %ho had contributed to pension funds for years %ere
failing to receive their pension benefits. C&(- charged the 3epartment of Eabor %ith the Dob of
overseeing pension funds.
18-"
Chapter 18 - Pension Funds
1". $he principal features of C&(- involve funding, vesting of benefits, fiduciary responsibility,
transferability, and insurance.
Funding) Prior to C&(- there %ere no statutory re1uirements forcing defined fund benefit
administrators to ade1uately fund their plans. C&(- established guidelines for funding and set
penalties for fund deficiencies.
Festing of @enefits) Fre1uently, %hile employers start contributing to an employee6s pension
fund as soon as the employee is eligible to participate, benefits may not be paid to the employee
until he or she has %or+ed for the employer for a stated period of time (or until the employee is
vested). C&(- re1uires that the plan must have minimum vesting re1uirements and set a
ma.imum vesting period of ten years.
Fiduciary &esponsibilities) - pension plan fiduciary is a trustee or investment advisor charged
%ith the management of the pension plan. C&(- set standards governing the management of a
pension plan. pecifically, C&(- re1uired that pension plan contributions be invested %ith the
same diligence, s+ill, and prudence as a prudent person in li+e circumstances (the so-called
prudent-man rule). Plan assets are re1uired to be managed %ith the sole obDective of providing
the promised benefits to participants. $o ensure a fund operates in this manner C&(- increased
the re1uirement for pension plans to report on the current status of investments in the pension
plan.
$ransferability) C&(- allo%ed employees to transfer pension credits from one employer plan to
another %hen s%itching Dobs.
(nsurance) C&(- established the Pension @enefit Guarantee Corporation (P@GC), an insurance
fund for pension plan participants similar to the F3(C. $he P@GC insures participants of defined
benefit plans if the proceeds from the plan are unable to meet its promised pension obligations.
Probe!s:
1. -nnual benefits %ill be
<ears %or+ed -nnual benefit
!2 8!,2## . !2 H 87!,2##
!8 8!,2## . !8 H 89#,###
"# 8!,2## . "# H 892,###
!. -nnual benefits %ill be
<ears %or+ed -nnual benefit
"# 87#,### . .#2 . "# H 84#,###
"" 87!,2## . .#2 . "" H 81#",1!2
"2 87,,### . .#2 . "2 H 811!,###
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Chapter 18 - Pension Funds
". CICCE Problem) Payment H 82#,###
Payment H 827,1#2
Payment H 872,788
Payment H 898,8##
Payment H 88!,8,9
,. CICCE Problem) Payment H 8,#,###
Payment H 8,,,88,
Payment H 82!,221
Payment H 87#,7,#
Payment H 877,!99
2. -nnual benefits %ill be
<ears %or+ed -nnual benefit
19 8,#,### . .#" . 19 H 8!#,,##
!# 8,9,### . .#" . !# H 8!8,!##
!! 82#,### . .#" . !! H 8"",###
7. <our annual investment is
Cmployee6s contribution H 87#,### . .1! H 89,!##
$a. avings H 89,!## . ."1 H 8!,!"!
Cmployee6s cost 8,,478
Cmployer6s match H 87#,### . .2# . .#2 H 81,2##
$otal ,#1(+) investment at year start 88,9##
<our one-year return is
1-year earnings H 88,9## . .1# H 889#
$otal ,#1(+) investment at year-end 84,29#
Cmployee6s 1-year return H (84,29# - 8,,478)J8,,478 H 4!.7"K
9. -ssuming the employee=s salary, ta. rate, and ,#1(+) yield remains constant over a !2-year
career, %hen the employee retires the ,#1(+) %ill be %orth
88,9## LM(1N.1#)
!2
-1OJ.1#P H 8822,714
5r on a financial calculator, P;$ H 8,9##, ( H 1#, n H !2, HQ CP$ FF H 822,714
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