PENSION FUNDS - Financial Institutions and Markets by Fabozzi

CHAPTER 9

PENSION FUNDS

INTRODUCTION TO PENSION FUNDS

A pension plan is a fund that is established for the payment of retirement benefits. Pension plans are set up by plan sponsors to pay retirement benefits. Monies are placed in the funds by the employer/employees and earnings compound tax-free until withdrawn at retirement. The key factor explaining pension fund growth is that the employer’s contributions and specified amount of the employee’s contributions, as well as the earnings of the fund assets, are tax exempt. In essence, a pension is a form of employee remuneration for which the employee is not taxed until funds are withdrawn.

TYPE OF PENSION PLANS

Defined Benefit Plan

In a defined benefit plan, payments are specified upon retirement by the sponsor. The amount available upon retirement becomes a function of the amount placed in the fund and years of service. The pension obligations are effectively the obligation of the plan sponsor, who assumes the risk of insufficient funding to meet contractual payments. Plan sponsors often buy annuities from insurance companies, thereby shifting the risk to these companies. Such plans are called insured benefit plans, though the phrase is a misnomer in that the benefits are guaranteed only so far as the insurance company can provide the funds.

The Pension Benefit Guaranty Corporation (PBGC), established under ERISA provides only for vested benefits payments in event of discontinuation by the plan sponsor. Defined benefit plans are expensive and hard to implement when few employees work for only one company over many years.

Benefits become vested when employees reach a certain age and complete enough years of service to meet minimum requirement for receiving benefits. In recent years, firms have not adopted defined benefit plans. Major firms that have them have been freezing their plans. This is because they are costly and firms have found that the plans hinder their competitiveness.

Defined Contribution Plans

In a defined contribution plan, the plan sponsor provide only for specified contributions to the fund. No guarantees are given as to the amount of benefits that will be available upon retirement. Thus the risk of poor performance is borne by the employee. Such plans are usually provided under Section 401 K of the Revenue Code, and the employee can usually direct what group will manage these funds. The fastest-growing sector of DCP is the 401k, 403(b) and 457. By end of 1999, over one trillion dollars had been placed in 401k. The largest public sponsor of a defined contribution plan is the Federal Retirement Thrift ($233 billion).

Hybrid Pension Plans

In an effort to offset the flaws of the defined contribution and benefit plans, a number of companies have started to select hybrid pension plans, wherein an employer contributes a certain amount each year. A pre-set minimal benefit level is specified, but if the plan does not meet this goal, the employee must make up the deficit.

A cash balance plan is basically a defined benefit that has some of the features of a defined contribution plan. A cash balance plan defines future pension benefits. Each participant in a cash balance plan has an account that is credited with a dollar amount that resembles an employer contribution and is generally determined as a percentage of pay. The plan usually provides benefits in the form of a lump-sum distribution as annuity. Interest is credited to the employee’s account at a rate specified in the plan and is unrelated to the investment earnings of the employer’s pension trust.

INVESTMENTS

Defined benefit plans allocate more than 65% of their funds to equities and fixed-income securities. Defined contribution plans favor insurance company GICs. Since some qualified pension funds are exempt from federal taxes they have little use for municipal bonds in their portfolio. There are no federal restrictions on foreign securities investments, although sponsors may deny management this privilege.

REGULATION

Because pension plans are crucial for U.S. workers, pension plans are regulated under the Employee Retirement Income Security Act of 1974 (ERISA). Its major provisions include:

1. Minimum funding standards: a plan sponsor must make to he pension plan; cannot “pay as you go”;

2. Fiduciary responsibility: must follow “prudent man” rule in investment practices;

3. Minimum vesting standards; for example that after five years of employment, a participant is entitled to 25% of accrued pension benefits.

4. Created PBGC for vested benefits funded by premiums under direct benefit plans.

MANAGERS OF PENSION FUNDS

A plan sponsor chooses one of the following to manage assets: (1) in-house staff, (2) outside money management firms, (3) combination of both. In addition to money managers, advisers called consultants provide other advisory services provided to pension plan sponsors. These include:

1.      Developing an investment policy and asset allocation;

2.      Providing actuarial advice;

3.      Designing benchmark performance measures;

4.      Monitoring performance;

5.      Providing specialized research.

DEFINED BENEFIT CRISIS

Today, there is a crisis facing defined benefit pension plans. At the end of 2003, corporate pension underfunding or deficit was close to $250 billion. Some estimates double this number. In essence, corporate and public plan sponsors have systematically underestimated pension liabilities. Pension funding is a cost that affects earnings. The returns on pension assets can be an earning if the projected return exceeds liabilities. This creates a perverse incentive to overstate projected returns and understate liabilities.  The bottom line is that the failure to properly value pension liabilities because of the use of an inappropriate discount rate and the impact it had on the allocation decision among major asset classes to justify a high forecast return on assets were the two major contributing factors to this financial crisis.

PENSION PROTECTION ACT OF 2006

The Pension Protection Act of 2006 (PPA) contains two major parts. The first part modifies ERISA in the following way:

1.      It required underfunded plans to pay additional premiums to the Pension Benefit Guaranty Corporation.

2.      It extended the requirement that companies that terminate their pension plans provide extra funding to the pension system.

3.      It closed loopholes that allowed underfunded plans to skip pension payments.

4.      It raised the caps on the amount that companies can contribute to their pension plans so they can contribute more during prosperous times.

5.      It required that companies measure their pension plan obligations more accurately.

6.      It prevented companies with underfunded pension plans from providing extra benefits to their workers without paying for these benefits up front.

The second part of the PPA relates primarily to individuals’ use of defined contribution plans. According to the PPA, employers can automatically enroll their employees in a defined contribution plan. It also permits employers to choose default options on behalf of the plan participants who do not make an election on how to invest their funds, and enables employers to obtain more investment advice for their employees by removing the fiduciary liability based on the perceived conflict of interest of self-interested investment advice provided by the employer.

ANSWERS TO QUESTIONS FOR CHAPTER 8

(Questions are in bold print followed by answers.)

1. What is a plan sponsor?

A plan sponsor is a corporation or public agency that establishes a retirement plan for its employees. Plan sponsors include private businesses, federal, state, and local governments, unions, not-for-profit organizations, and even individuals setting up plans for themselves.

2. How does a defined-benefit plan differ from a defined-contribution plan?

In a defined contribution plan, the sponsor and/or employees are responsible only for making specified (hence “defined”) contributions to the plan. There is no guarantee of what amount will be available upon retirement. Hence the employee bears the risk of whether he will have an adequate retirement income. Under a defined benefit plan the sponsor agrees to provide specified dollar payments to employees upon their retirement. The amount to be paid is usually determined by a formula, which considers length of time of employment and income level. Herein the employer takes the risk of having sufficient funding to meet future needs. Vested benefits are guaranteed by the Pension Benefit Guaranty Corporation (PBGC), wherein an employer contributes a certain amount each year. A pre-set minimal benefit level is specified, but if the plan does not meet this goal, the employee must make up the deficit.

3. Why have some corporations frozen their defined benefit plans?

Pension plans are too costly and some companies have found it difficult to compete with other firms.

4.

1. What is a cash balance plan?
2. Discuss the resemblance of a cash balance plan to a defined-benefit and a defined-contribution plan.

a.       A cash balance plan is basically a defined benefit that has some of the features of a defined contribution plan. It defines future pension benefits. Each participant in a cash balance plan has an account that is credited with a dollar amount that resembles an employer contribution and is generally determined as a percentage of pay. The plan usually provides benefits in the form of a lump-sum distribution as an annuity. Interest is credited to the employee’s account at a rate specified in the plan and is unrelated to the investment earnings of the employer’s pension trust.

b.      A cash balance plan is similar to defined benefits in the sense that benefits are fixed based on a formula. Investment responsibility is borne by the employer, and employees are automatically included in the plan. It is similar to defined contribution in the sense that assets are accumulated in an “account” for each employee and vested assets may be taken as a lump sum and rolled into an IRA.

5.

1. What is an insured pension plan?
2. What is the function of PBGC?

a.       An insured plan is one administered by an insurance company providing annuities upon retirement. Unless the PBGC is involved for defined benefits, there is no further insurance.

b.      The Pension Benefit Guaranty Corporation insures vested benefits under defined benefits plans in the event of corporate failures. It charges premiums for this service. Currently, the PBGC itself is close to insolvency due to fact that many corporate plans are under-funded and PBGC itself has little enforcement power. Also, many companies have dropped defined benefit plans in favor of defined contribution plans to save themselves premium payments and pass on the risks of providing adequate retirement income to the employees themselves.

6. What role do mutual funds play in 401(k) plans?

A 401k plan is a defined contribution plan. The employee can select a qualified plan in which to place his retirement contributions. These contributions are tax deferred as is the income generated by the fund. A mutual fund can qualify as a 401k plan, thus allowing it to generate tax-deferred earnings on behalf of the employee.

7. Can and do pension plans invest in foreign securities or tax-exempt securities?

U.S. pension funds are free to invest in foreign securities. However, plan sponsors may set local restrictions. It is also true for tax-exempt securities.

8.

1. What is the major legislation regulating pension funds?
2. Does the legislation require every corporation to establish a pension fund?

a.       Pension plans are regulated under the Employee Retirement Income Security Act of 1974 as amended. This legislation establishes the types of plans covered, funding and vesting requirements, and the PBGC.

b.      There is currently no legislation that requires a corporation to establish a pension plan. But if it does so, it must comply with ERISA regulations.

9. Discuss ERISA’s “prudent man” rule.

ERISA’s “prudent man role” establishes fiduciary standards for pension fund trustees and managers. The rule seeks to determine which investments are proper to make sure that the trustee takes the role seriously in acquiring and using the information pertinent to making an investment decision.

10. Who are plan sponsor consultants and what is their role?

In addition to money managers, advisors call plan sponsor as consultants they provide other advisory services to pension plan sponsors. Among the functions that consultants provide to plan sponsors include developing plan for investment policy, providing actuarial advice, designing benchmarks and measuring and monitoring the performance of the fund’s money managers.

11. In 2001, investor Warren Buffett had this to say about pension accounting: Unfortunately, the subject of pension [return] assumptions, critically important though it is, almost never comes up in corporate board meetings. . . . And now, of course, the need for discussion is paramount because these assumptions that are being made, with all eyes looking backward at the glories of the 1990s, are so extreme.

1. What does Mr. Buffett mean by the “pension return assumption”?
2. Why is the pension return assumption important in pension accounting in accordance with generally accepted accounting principles?
3. Why is the pension return assumption important in pension accounting in accordance with Internal Revenue rules?
4. Mr. Buffet went on to warn that too high an assumed return on pension assets risks litigation for a company’s chief financial officer, its board, and its auditors. Why?

a.       The assumptions that management or plan administrator uses to project pension fund growth rates, and amounts of assets and liabilities. 

b.      The assumptions determine whether plan assets can meet liabilities. Overly optimistic return lead to conclusions that liabilities will be met and that the fair value of the plan is positive.

c.       There are IRS regulations that determine the actual amount of funding required.

d.      Too high an assumed return on pension assets may mislead plan participants on the issue of plan solvency. Such deception may lead to litigation.