This chapter provides an introduction to pension fund management. The key concepts covered are listed below.

Most companies, and almost all government units, have some type of employee pension plan. The management of these plans is important to employees, who use pensions for post-retirement income, and to stockholders, who bear the costs of pension plans.

Pension funds are big business, totaling over $12 trillion in assets.

There are four basic types of pension plans: (1) de ned contribution plans,

(2) de ned bene t plans, (3) pro t sharing plans, and (4) cash balance plans.

Under a de ned contribution plan, companies agree to make speci c payments into a retirement fund, perhaps 10% of an employees salary, and then retirees receive bene ts based on the total amount contributed and the

investment performance of the fund.

Under a de ned bene t plan, the employer agrees to give retirees a

speci cally de ned bene t, such as $500 per month or 50% of their nal

years salary.

In a pro t sharing plan, companies make contributions into an employee-

owned account, but the size of the payments depends on corporate pro ts.

A cash balance plan is a de ned bene t plan that has some of the popular features of a de ned contribution plan. Employees accrue speci c, observable amounts in their accounts, and they can move these accounts if they leave the

company.

If an employee has the right to receive pension bene ts even if he or she leaves

the company, the bene ts are said to be vested. Congress has set limits on the amount of time it takes employees to become vested.

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A portable pension plan can be carried from one employer to another. De ned contribution plans are portable because the contributions and fund earnings effectively belong to the employee. Also, unions manage the pension funds in some industries, enabling employees with de ned bene t plans to move among rms in that industry without losing bene ts.

Under de ned contribution or pro t sharing plans, the rms obligations are satis ed when the required contributions are made. However, under a de ned bene t plan, companies must cover all promised bene ts. If the present value of expected retirement bene ts equals the assets in the fund, the plan is said to be fully funded. If fund assets exceed the present value of expected bene ts, the fund is overfunded. If assets are less than the present value of expected bene ts, the plan is underfunded.

The discount rate used to determine the present value of future bene ts under a de ned bene t plan is called the actuarial rate of return. This rate is also the expected rate of return on the funds assets.

The Employee Retirement Income Security Act of 1974 (ERISA) is the basic federal law governing the structure and administration of corporate pension plans.

The Pension Bene t Guarantee Corporation (PBGC) was established by ERISA to insure corporate de ned bene t pension funds. Funds used by the PBGC come from fund sponsors, and these funds are used to make payments to retirees whose sponsoring rms subsequently go bankrupt and had under- funded plans at the time of bankruptcy. However, taxpayers will have to pay if the PBGC does not have suf cient funds to cover its payments to bankrupt rms retirees.

The different types of pension plans have different risks to both rms and employees. In general, a de ned bene t plan is the riskiest for the sponsoring organization but the least risky from the standpoint of employees.

Assuming a company has a de ned bene t plan, it must develop the funds funding strategy: (1) how quickly should any unfunded liability be reduced, and (2) what actuarial rate of return should be assumed?

A de ned bene t plans investment strategy must answer this question: Given the assumed actuarial rate of return, how should the portfolio be struc- tured so as to minimize the risk of not achieving the target return?

The performance of pension fund managers can be assessed in two ways: (1) The funds beta can be estimated, and the return can be plotted on the Security Market Line (SML). (2) The funds historical performance can be compared with the performance of other funds with similar investment objectives.

Pension fund managers use asset allocation models to help evaluate funding and investment strategies.

During the major bull market of the 1990s, many de ned bene t plans became overfunded. Some corporate sponsors terminated their overfunded plans, used part of the proceeds to buy annuities to cover the plans liabilities, and then reclaimed the remainder.

Retiree health bene ts have become a major problem for employers for two reasons: (1) these costs are escalating faster than in ation, and (2) a recent Financial Accounting Standards Board (FASB) ruling forced companies to accrue the retiree health care liability rather than merely expense the cash ows as they occur.

Q1-Suppose you formed your own company several years ago and now intend to offer your employees a pension plan. What are the advantages and disadvantages to the rm of a de ned bene t plan? A defned contribution plan?

Q2 -Describe how the type of pension fund used by a company in uences each of the following:

1 The likelihood of age discrimination in hiring

2The likelihood of gender discrimination in hiring

3Employee training costs

4The likelihood that union leaders will be exible if a company faces a

changed economic environmentsuch as those faced by the airline, steel, and auto industries in recent years