Chapter

25
Pension Fund Operation

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Chapter Objectives
The Specific objectives of this chapter are to:

Describe the common types of private pension plans,

Explain how pension funds are managed.

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Background on Pension Fund Operations

Pension plans provide a savings plan for employees that can be used
for retirement. They receive premium from the employer and/or the
employee.
In aggregate, most of the contributions come from the employer.
Pension funds are major investors in stock, bonds, and various types
of loan packages.

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Background on Pension Fund Operations, cont..

Public Pension Funds:
Pubic pension funds can be either state, local or federal. The bestknown government pension fund is Social Security. In addition to
the system, all govt. employees and almost half non-govt. employees
participate in other pension funds.
Private Pension Plans:
Private pension plans are created by private agencies, including
industrial, labor, service, non profit, charitable, and educational
organization. Some pension funds are so large that they are major
investors in corporate securities.
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Background on Pension Fund Operations, cont..

Private pension funds can be classified by the way contributions are
received and benefits are paidDefined-Benefit Plan:
With a defined-benefit plan, contributions are dictated by the
benefits that will eventually be provided. When the value of pension
assets exceeds the current and future benefits owed to employees,
companies respond by reducing future contributions.
Alternatively, they may distribute the surplus amount to the firms
shareholders rather than the employees. Thus, the management of
the pension fund can have a direct impact on shareholders.
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Background on Pension Fund Operations, cont..

Defined- Contribution Plan:
In contrast, a defined-contribution plan provides benefits that are
determined by the accumulated contributions and the funds
investment performance.
With this plan, a firm knows with certainty the amount of funds to
contribute, whereas that amount is undetermined in defined-benefit
plan. The benefits to participants are uncertain.

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Background on Pension Fund Operations, cont..

Underfunded Pension:
The future pension obligations of a defined-benefit plan are
uncertain because the obligations are stated in terms of fixed
payments to retirees. These payments are dependent on salary levels,
retirement ages, and life expectancies. Even if future payment
obligations can be accurately predicted, the amount the plan needs
today will be uncertain because of the uncertain rate of return on
todays investments. The higher the future return on the plans
investments, the fewer the funds that must be invested today to
satisfy future payments.

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Pension Fund Management:

Regardless of the manner in which premiums are contributed, the
premiums received must be managed (invested) until needed to pay
benefits.
Private Pension portfolios are dominated by common stock. Public
pension portfolios are somewhat eventually invested in corporate
bonds, stocks, and other credit instruments.
Pension fund management can be classified according to the
strategy used to manage the portfolio.

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Pension Fund Management, cont..

With a matched funding strategy, investment decisions are made
with the objective of generating cash flows that match planned
outflow payments.
An alternative strategy is projective funding, which offers managers
more flexibility in constructing a pension portfolio that can benefit
from expected market and interest rate movements. Some pension
funds segment their portfolios, with part used for matched funding
and the rest for projective funding.

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Pension Fund Management, cont..

Management of Insured VS Trust Portfolios:
Some pension plans are managed by life insurance companies.
Contributions to such plans, called insured plans, are often used to
purchase annuity policies so that the life insurance companies can
provide benefits to employees upon retirement.
As, an alternative, some pension funds are managed by the trust
departments of financial institutions, such as commercial banks. The
trust department invests the contributions and pays benefits to
employees upon retirement. Although the day-to-day invest decisions
of the trust department are controlled by the managing institution, the
corporation owning the pension normally specifies general guidelines
that the institution should follow.
These guidelines might include
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Pension Fund Management, cont..

Management of Insured VS Trust Portfolios, cont..

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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Interaction Between Pension Funds and

other Financial Institutions
Types of Financial
Institution
Commercial Banks

Insurance Companies

Interaction with
Pension Funds
Commercial banks
sometimes manage
pension funds
Pension funds
commonly purchase
commercial loans
that are sold by
commercial banks in
the secondary
market.
Insurance companies
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Interaction Between Pension Funds and

other Financial Institutions, cont..
Types of Financial
Institution
Mutual Funds

Brokerage firms and

investment banking firm

Interaction with
Pension Funds
Some pension funds are
invested in various
mutual funds, which
allows them to achieve
diversification without
incurring excessive
transaction costs
Brokerage firms formally
execute securities
transactions for pension
funds
Brokerage firms offer
investment advice to A2 - 13

Interaction Between Pension Funds and

other Financial Institutions, cont..
Types of Financial
Institution
Brokerage firms and
investment banking
firm

Interaction with
Pension Funds
Investment banking
firms commonly act as
advisers on leveraged
buyouts in which
pension funds
participate
Investment banking
firms underwrite newly
issued stocks and
bonds that are
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Participation of Pension Funds in Financial

Markets
Financial
Markets

Participation by Pension Funds

Mortgage
Market

Pension portfolios frequently

contain some mortgages,
although the relative proportion
is low compared with bonds and
stocks.
Stock Market At least 30 % of a pension funds
portfolio is typically allocated to
stocks. In general, definescontribution plans usually have a

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Participation of Pension Funds in Financial

Markets
Financial Markets
Money Market

Participation by Pension Funds

Pension fund managers maintain a small
proportion of liquid money market
securities that can be liquidated when they
wish to increase investment in stocks,
bonds, or other alternatives

Bond Markets

At least 25% of a pension fund portfolio is

typically allocated to bonds. Portfolios of
defined-benefit plans usually have a higher
concentration of bonds than definedcontribution plans. Pension fund managers
frequently conduct transactions in the bond
market
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Participation of Pension Funds in Financial

Markets, cont..
Financial
Markets

Participation by Pension Funds

Mortgage
Market

Pension portfolios frequently

contain some mortgages,
although the relative proportion
is low compared with bonds and
stocks.
Stock Market At least 30 % of a pension funds
portfolio is typically allocated to
stocks. In general, definescontribution plans usually have a

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Participation of Pension Funds in Financial

Markets, cont..
Financial Markets

Participation by Pension
Funds

Future Market

Some pension funds use

future contracts on debt
securities and on bond
indexes to hedge the
exposure of their bond
holdings to interest rate
risk. In addition, some
pension funds use
futures on stock indexes
to hedge against market
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risk. Other pension

Participation of Pension Funds in Financial

Markets, cont..
Financial Markets

Participation by Pension Funds

Option Market

Some pension funds use stock

options to hedge against
movements of particular
stocks. They may also use
options on future contracts to
secure downside protection
against bond price
movements
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Participation of Pension Funds in Financial

Markets, cont..
Financial Markets

Participation by Pension Funds

Swap Markets

Pension funds commonly

engage in interest in interest
rate swap to hedge the
exposure of their bond and
mortgage portfolios to
interest rate risk.

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