Chapter 18

Pension Funds

Pensions
Definition: A pension plan is an asset pool that accumulates over an individuals working years and is paid out during the nonworking years. Developed as Americans began relying less on children for care during their later years. Also became popular as life expectancy increased.

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Types of Pensions
The pension fund industry comprises two distinct sectors.

1. Private pension funds: are those funds administered by a private corporation ( e.g. (insurance company, mutual fund).
Any pension plan set up by employers, groups, or individuals

2. Public pension funds: are those funds administered by a federal, state, or local government (e.g., Social Security).
Any pension plan set up by a government body for the general public.

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Insured versus Noninsured Pension funds:

Pension Plan

Document that governs the operations of a pension fund.

1. Insured pension fund: A pension fund administered by a life insurance company.
Pool of money invested in Insurance Company The assets purchased with the premiums from the Insurance Company.

Become the legal property of the insurance company managing the pension funds.
Because they bear the risk of Assets failure.
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Insured versus Noninsured Pension funds:

Non Inured pension funds: managed by a trust department of a financial institution appointed by the sponsoring business, participant, or union. Trustee invest the contributions and pay the retirement benefits in accordance with the terms of the pension fund. Invested by the sponsor but segregated and listed as a separate pools of assets on the trustees balance sheet.

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Insured versus Noninsured Pension funds:

The assets purchased from the noninsured pension funds are the legal property of the sponsoring corporation. Because non insured pension funds managers, by contrast, do not incur the risk associated with the asset value fluctuations. Thus the trustees overseeing the pension funds generally invest pension premiums received in more risky securities. Noninsured pension funds generally offer the potential for higher rates of return but are also more risky than insured pension funds.

However, the higher rates of return allow the employee to reduce contributions necessary to achieve a given amount of funds at retirement.
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Defined Benefit versus Defined contribution Pension Funds

Pensions funds can also be distinguished by the way contributions are made and benefits are paid. 1. Defined Benefit Pension fund : A plan where the employer promises the employee a specific benefit when they retire.
i. Flat benefit formula ii. Career average formula iii. Final pay formula iv. Fully funded v. Underfunded vi. Overfunded
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Flat benefit formula

Pays a flat amount for every year of employment.
Example: A employee with 20 years of service at a company is considering retirement at some point in the next 10 years. The employer uses a flat benefit formula by which the employee receives an annual benefit payment of $2000 times the number of years of service. For retirement now, in 5 years, and in 10 years, the employees annual retirement benefit payment is. 1. Retire now 2. Retire after 5 years $2000 x 20 = $40,000 $2000 x 25 = $ 50,000

3. Retire after 10 years

$2000 x 30 = $ 60,000

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Career average formula

Pension fund that pays retirement benefits based on the employees average salary over the entire period of employment.
Example: An employee with 20 years of service at a compnay is considering retirement some times in the next10 year. The employer uses a career average benefit formula by which the employee receives an annual benefit payment of 4 percent of his career average salary times the number of years of service. Fro retirement now, in 5 years, and in 10 years, the employees annual retirment benefit payment is: Average Salary 1. Retire Now 2. Retire in 5 years 3. Retire in 10 years $ 48000 $ 50000 $ 52,000 Retirement Benefit $ 48000 x .04 x 20 = $38,400 $ 50,000 x .04 x 25= $ 50,000 $52,000 x .04 x 30 = $ 63,000

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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 employees career times the number of years of services.
Example: An employee with 20 years of service at a company is considering retirement at some times in the next 10 years. The employer uses a final pay benefit formula by which the employee receives an annual benefit payment of 2.5 percent of her average salary during her last five years of service times her total years employed. For retirement now, in 5 years, and in 10 years, the employees (estimated) annual retirement benefit payment is:
Average salary Retire now Retire after 5 years $75,000 $ 80,000 Retirement Benefit $75,000 x .025 x 20 = $37500 $ 80,000 x .025 x 20 = $50,000

Retire in 10 years

$ 85,000

$ 85,000 x .025 x 20 = 63,750

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Defined Benefit versus Defined contribution Pension Funds (cont)

Under defined benefit pension funds, the employer should set aside sufficient funds to ensure that it can meet the promised payments.

Fully funded: when sufficient funds are available to meet payouts Overfunded: funds exceed the expected payout Underfunded: funds are not expected to meet the required benefit payouts
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Defined Benefit versus Defined contribution Pension Funds (cont)

Defined-Contribution Pension Plan: Pension fund in which the employer agrees to make a specified contribution to the pension fund during the employees working years.
So the final retirement benefit is based on
1. 2. Employer contribution Any additional employee contribution

3.

Gain or losses on the investments purchased by the fund with these contributions.

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Private Pension Plan Assets

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Social Security
Pay as you go system, where current funding is used (partially) to pay current benefits. Projected number of workers is falling while projected number of retirees is increasing, which will cause problems in years to come if not corrected.

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Social Security
Its difficult to measure the health of the social security system. Many factors are hard to predict, such as birth rates and the rate of immigration. Although it may not fail, itd be wise for you plan other sources for your retirement cash flows.

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Regulation of Pension Plans

A major U.S. Supreme Court decision in 1949 established that pension benefits were a legitimate part of collective bargaining. The number of plans increased from this as unions negotiated for such plans.

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Regulation of Pension Plans

Employee Retirement Income Security Act of 1974
Established guidelines for funding Allowed plan credit to transfer with employees Established vesting requirements to gain plan benefits Increased disclosure requirements Assigned regulatory oversight to the Department of Labor
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Regulation of Pension Plans

ERISA also established the Pension Benefit Guarantee Corporation to insure pension benefits if an underfunded pension plan is unable to meet its obligations.
Accounting makes it difficult to assess funding status of a plan May be in trouble as plans appear underfunded
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Regulation of Pension Plans

The next slide shows the annual payments made since 1980 to failed plan participants. In 2005, the PBGC said that the plan has never been under more stress

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Regulation of Pension Plans

Pension Protection Act of 2006 was passed to address the growing problem of failed pension plans. The act provides for stronger funding rules, greater transparency, and a strong pension insurance system.

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Regulation of Pension Plans

Pension Reform Act of 1978 authorized individual retirement accounts.
Enjoy a preferential tax treatment

Keogh plans are similar plans for selfemployed individuals

SIMPLE IRAs are simplified retirement plans for small businesses.

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The Future of Pension Funds

We can expect their growth and popularity as the average population continues to grow. Variety of pension fund offerings may increase as well. Pension funds may gain significant control of corporations as their stock holdings increase.
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Chapter Summary
Insurance Companies: the nature of the industry, including rationale and people employed in the industry, was presented. Fundamentals of Insurance: the seven fundamental ideas behind all insurance were listed and reviewed.

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Chapter Summary (cont.)

Growth and Organization of Insurance Companies: the changes in growth patterns over the last several decades was reviewed, including both assets and number of companies. Types of Insurance: the variety of insurance policies available covering life, health, etc., were presented.
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Chapter Summary (cont.)

Pensions: the general idea and growth in pension funds was presented. Types of Pensions: the various forms, from defined-benefit to defined-contribution, were reviewed and compared.

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Chapter Summary (cont.)

Regulation of Pension Plans: ERISA and other laws that govern pension funds was discussed. The Future of Pension Funds: we should expect their popularity, size, and power to continue to grow as the population ages.

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