Financial Markets and Institutions

12th Edition
by Jeff Madura

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 26 Pension Fund Operations
Chapter Objectives

• Distinguish between defined-benefit versus defined

contribution pension plans.
• Explain how pension funds participate in financial markets.
• Discuss the regulation of private pension plans.
• Discuss underfunding of public pension plans.
• Discuss corruption and defined-benefit plans.
• Explain how pension funds are managed.
• Explain the key factors that influence the performance of
pension portfolios.
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2
 Background on Pension Funds (1 of 2)

• Pension plans provide savings for employees that can be used

for retirement. They serve as a key source of income for
employees upon retirement.
• Pension plans set aside money that is to be distributed to
employees upon retirement, and invest the money in financial
markets until it is to be distributed.
• Pension plans serve as major institutional investors.

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 Background on Pension Funds (2 of 2)

Public versus Private Pension Funds

• Public Pension Funds
• Can be either state, local, or federal.
• The best-known government pension fund is Social Security.
• Many public pension plans are funded on a pay-as-you-go
basis.
• Private Pension Plans
• Created by private agencies, including industrial, labor,
service, nonprofit, charitable, and educational organizations.

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 Types of Pension Plans (1 of 2)

Defined-Benefit versus Defined-Contribution Plans

• Defined-Benefit Plans
• Contributions are dictated by the benefits that will eventually be
provided.
• The future pension obligations of a defined benefit plan are
uncertain because the obligations are stated in terms of fixed
payments to retirees.
• The amount the plan needs today will be uncertain because of the
uncertain rate of return on today’s investments.

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 Types of Pension Plans (2 of 2)

Defined-Benefit versus Defined-Contribution Plans

(cont.)
• Defined-Contribution Plans
• Provides benefits that are determined by the accumulated
contributions and the fund’s investment performance.
• Some firms match a portion of the contribution made by their
employees.
• With this type of plan, a firm knows with certainty the amount
of funds to contribute, whereas that amount is undetermined in
a defined-benefit plan.
• The benefits to the participants are uncertain.
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 Pension Fund Participation in Financial Markets (1 of 2)

• Pension funds are major participants in financial markets. Many

of the investments by pension funds in the financial markets
finance economic growth. (Exhibit 26.1)
• Managers of pension funds instruct securities firms on the type
and amount of investment instruments to purchase. (Exhibit
26.2)
• Pension fund managers participate in various financial markets,
including the stock and bond market, money and mortgage
markets, and futures and options markets. (Exhibit 26.3)
• Pension funds can exert a degree of governance over
corporations because of their large purchases of stocks and
corporate bonds.

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 Pension Fund Participation in Financial Markets (2 of 2)

Governance by Pension Funds

• Pension funds can exert a degree of governance over
corporations because of their large purchases of stocks and
corporate bonds.

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 Exhibit 26.1 How Pension Funds Finance Economic
Growth

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 Exhibit 26.2 Interaction between Pension Funds and
Other Financial Institutions

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 Exhibit 26.3 Participation of Pension Funds in
Financial Markets

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 Regulation of Private Pension Plans (1 of 5)

• Private pension plans are created to serve

employees in the private sector and are
governed by federal regulations.
• A sponsor corporation may establish a trust
pension fund through a commercial bank’s trust
department or an insured pension fund through
an insurance company.
• Plans must comply with the Internal Revenue
Service tax rules that apply to pension fund
income.

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 Regulation of Private Pension Plans (2 of 5)

Vesting of Private Pension Plans

• A vesting schedule represents the time at which rights to assets
that have accumulated in the employee’s pension fund cannot be
taken away.
• ERISA
• Defined-contribution plans are subject to guidelines specified by
the Employee Retirement Income Security Act (ERISA) of
1974 (also called the Pension Reform Act) and its 1989
revisions.
• Requires that any contributions be invested in a prudent
manner.

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 Regulation of Private Pension Plans (3 of 5)

Transferability of Private Pension Plans

• ERISA allows employees changing employers to transfer any
vested amount into the private pension plan of their new employer
or to invest it in an Individual Retirement Account (IRA).
• With either alternative, taxes on the vested amount are still
deferred until retirement when the funds become available.

Tax Benefits of Private Pension Plans

• Benefits provided by the plan must be proportionately equal
relative to income, so that employees earning lower wages receive
equal treatment.

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 Regulation of Private Pension Plans (4 of 5)

Insurance on Private Pension Plans

The Pension Benefit Guaranty Corporation
• ERISA established the Pension Benefit Guaranty Corporation
(PBGC) to provide insurance on pension plans.
• Guarantees that participants of defined-benefit pension plans will
receive their benefits upon retirement.

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 Regulation of Private Pension Plans (5 of 5)

Underfunded Private Defined-Benefit Pensions

• Implementation of Pension Protection Act to
Prevent Underfunding
• Pension Protection Act of 2006
• If a company’s defined-benefit pension plan is
underfunded, the Pension Protection Act of 2006 requires
the company to increase its contributions to the pension
plan so that it will be fully funded within 7 years.

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 Underfunded Public Defined-Benefit Pension Plans (1 of 2)

Overestimated Rate of Return

• The trend of underfunded public defined-benefit pension plans
could have adverse consequences in the long run, because the
agencies will have to raise taxes or cut government services
later to make up for the underfunding.
Political Motivation
• Governments do not set aside sufficient funding for their
pension plans because they prefer to spend more funds on other
government services.
• Some hope to correct their budget deficit caused by
underfunded pensions by issuing debt.

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 Underfunded Public Defined-Benefit Pension Plans (2 of 2)

Possible Solutions to Underfunded Pensions

• Use aggressive investment management strategy for the pension
fund.
• Revise the required pension contributions or benefits.
• Increase taxes or reduce other government services.
• Make government officials accountable for underfunded pensions.
• Shift from defined-benefit to defined-contribution plans.

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 Corruption of Defined-Benefit Pension Funds (1 of 2)

Agency problems can occur, whereby the trustees make

decisions that are mostly intended to benefit themselves at
the expense of the participants that they represent.

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 Corruption of Defined-Benefit Pension Funds (2 of 2)

Bribes to Trustees
• Trustees should not be subject to potential conflicts of interest.
Payment of Excessive Benefits
• Trustees should not engage in actions that favor particular
pension participants or are simply inappropriate.
Ineffective Oversight by Trustees
• Sometimes trustees of public pension funds are hired for
political reasons and do not have the financial qualifications to
adequately oversee the management of the pension funds.

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 Pension Fund Management (1 of 6)

Management of Insured versus Trust Portfolios

Although the day-to-day investment decisions controlled by the
managing institution, the corporation owning the pension normally
specifies general guidelines:
• The percentage of the portfolio that should be used for stocks or bonds
• A desired minimum rate of return on the overall portfolio
• The maximum amount to be invested in real estate
• The minimum acceptable quality ratings for bonds
• The maximum amount to be invested in any one industry
• The average maturity of bonds held in the portfolio
• The maximum amount to be invested in options
• The minimum size of companies in which to invest

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 Pension Fund Management (2 of 6)

Asset Allocation of Pension Funds

Portfolio managers change the asset allocation of the pension
fund over time in response to the investment environment.
• Private pension portfolios are dominated by common stock.
• Public pension portfolios evenly invested in corporate bonds,
stock, and other credit instruments.
• Pension funds also invest in private equity funds, which use the
money to purchase majority or entire stakes in businesses.

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 Pension Fund Management (3 of 6)

Influence of Managerial Compensation on Risk

Portfolio managers have an incentive to take more risk than is
appropriate under these conditions:
• If they are rewarded if the portfolio performs very well.
• If they are not penalized if the portfolio performs poorly.
• Some state governments have imposed restrictions on the types of
investments that their pension fund managers can pursue.

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 Pension Fund Management (4 of 6)

Management of Portfolio Risk

• Pension fund managers often struggle with the decision of
whether to pursue investments with high expected return that
have high risk.
Hedging Risk
• Pension fund portfolio managers are very concerned about
interest rate risk and stock market risk.

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 Pension Fund Management (5 of 6)

Passive Investment Strategy

• Pension funds could consider using a passive
management strategy such as investing in indexed mutual
funds, which would perform as well as market
benchmarks that represent the general stock market, bond
market, and real estate market.
• Pension funds that are willing to accept market returns on bonds
can purchase bond index portfolios that have been created by
investment companies.
• Equity portfolio indexes that mirror the stock market are also
available for passive portfolio managers.

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 Pension Fund Management (6 of 6)

Matched versus Projective Funding Strategies

• Pension fund management can be classified according to the
strategy used to manage the portfolio.
• Matched funding: investment decisions are made with
the objective of generating cash flows that match planned
outflow payments.
• Projective funding: offers managers more flexibility in
constructing a pension portfolio that can benefit from
expected market and interest rate movements.

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 Performance of Pension Funds (1 of 4)

Pension Fund’s Stock Portfolio Performance

• Change in Market Conditions
• The stock portfolio’s performance is usually closely related
to market conditions.
• Change in Management Abilities
• Stock portfolio performance can vary among pension funds
in a particular time period because of differences in
management abilities.

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 Performance of Pension Funds (2 of 4)

Pension Fund’s Bond Portfolio Performance

• Impact of Change in the Risk-Free Rate
The prices of bonds tend to be inversely related to changes in the risk-
free interest rate.
• Impact of Change in the Risk Premium
The prices of bonds tend to be inversely related to changes in the risk
premiums required by investors who purchase bonds.
• Impact of Management Abilities
The performance levels of bond portfolios can vary as a result of
differences in management abilities.

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 Performance of Pension Funds (3 of 4)

Performance Evaluation
• If a manager has the flexibility to adjust the relative
proportion of stocks versus bonds, the portfolio performance
should be compared to a benchmark representing a passive
strategy.
• Any difference between the performance of the pension
portfolio and the benchmark portfolio would result from:
• The manager’s shift in the relative proportion of bonds versus
stocks.
• The composition of bonds and stocks within the respective
portfolios.

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 Performance of Pension Funds (4 of 4)

Performance of Pension Portfolio Managers

• Many pension funds hire several portfolio managers to
manage the assets.
• The general objective of portfolio managers is to make
investments that will earn a large enough return to adequately
meet future payment obligations.

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 SUMMARY (1 of 4)

• For defined-benefit pension plans, the benefits are dictated by a

formula that is typically based on the employee’s salary level and
number of years of employment. For defined-contribution pension
plans, the benefits are determined by the accumulated contributions
and the returns on the pension fund investments.
• Pension funds participate in financial markets by investing in
securities such as stocks and bonds. Many pension funds’
investments require the brokerage services of securities firms. Some
pension funds have taken active roles in governance over
corporations.

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 SUMMARY (2 of 4)

• Private pension plans are subject to vesting rules and are

monitored by the Pension Benefit Guaranty Corporation.
• Many defined-benefit pension plans are underfunded. One of
the reasons for the underfunding is that some employers have
used an overly optimistic rate of return assumption. Some
public pension funds are underfunded because the government
agencies have granted generous retiree benefits, but without
requiring sufficient contributions to cover those future benefits
when employees retire. Consequently, they have to correct the
deficiency by raising taxes or cutting government services.

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 SUMMARY (3 of 4)

• Corruption including bribery and political favors has contributed to

the underfunding problem for many defined-benefit public pension
plans.
• Pension funds can use a matched funding strategy, in which
investment decisions are made with the objective of generating
cash flows that match planned outflow payments. Alternatively,
pension funds can use a projective funding strategy, which attempts
to capitalize on expected market or interest rate movements.

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 SUMMARY (4 of 4)

• The valuation and performance of pension fund portfolios are

highly influenced by market conditions. However, the
valuation of some pension portfolios are more exposed to risk
than others. The pension portfolio can suffer losses during
weak market conditions. Pension fund managers have an
influence on the pension portfolio performance, especially
when they have the flexibility to adjust the relative proportion
of stocks versus bonds in the portfolio.

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