Pension funds

8-1McGraw-Hill/IrwinChapter EighteenPension Funds18-2McGraw-Hill/IrwinPension FundsPension funds (PFs) offer savings plans through which participants accumulate tax deferred savings during their working years before withdrawing them in their retirement yearsfunds invested are exempt from current taxation (i.e., during working years)tax payments are not made until funds are withdrawn by the participant (i.e., during retirement)PFs were first established in the U.S. in 1759 to benefit the widows and children of church ministersThe first corporate PF was established by American Express Co. in 187518-3McGraw-Hill/IrwinPension FundsBy 1940 approximately 400 PFs existedmost were for employees in the railroad, banking, and public utilities industriesBy 2007 over 700,000 PFs existed28.3% of U.S. households’ financial assets were in PFscompares to just over 5% in 1950There are two distinct PF sectorsprivate PFs are funds administered by private corporations (e.g., insurance companies or mutual funds)public PFs are funds administered by federal, state, or local governments (e.g., Social Security)18-4McGraw-Hill/IrwinPension FundsA pension plan governs the operation of a pension fundPension funds are broadly classified into two categories, defined benefit plans and defined contribution plansA defined benefit PF if a fund in which the employer agrees to provide the employee with a specific cash benefit upon retirementa flat benefit formula PF pays a flat amount for every year of employmenta career average formula PF pays benefits based on the employee’s average salary over the entire period of employmenta final pay formula PF pays benefits based on a percentage of the average salary during a specified number of years at the end of the employee’s career times the number of years of service18-5McGraw-Hill/IrwinPension FundsDefined benefit PFs (cont.) a fully funded PF has sufficient funds available to meet all future payment obligationsan underfunded PF does not have sufficient funds available to meet all future promised paymentsan overfunded PF has more than enough funds available to meet the required future payoutsA defined contribution PF is a fund in which the employer agrees to make a specified contribution to the pension fund during the employee’s working yearsfixed-income funds offer a guaranteed rate of returnwith variable-income funds, all profits and losses on the underlying securities are passed through to the fund participants18-6McGraw-Hill/IrwinPension FundsPension funds may be either insured or noninsuredan insured pension fund is a PF administered by a life insurance companya noninsured pension fund is a PF administered by a financial institution other than a life insurance companyPrivate pension funds are created by private entities and administered by private corporations$8.4 trillion in total financial assets in 2007insurance companies administer $2.5 trillionmutual funds administer $1.6 trillionother financial institutions (e.g., banks) administer $4.3 trillion18-7McGraw-Hill/IrwinPrivate Pension Funds401(k) and 403(b) plans are employer-sponsored plans that supplement a firm’s basic retirement planallow for both employer and employee contributions401(k) plans are offered to employees of taxable firms403(b) plans are offered to employees of tax exempt employerscontributions are made on a pretax basismost plans are transferable if the employee changes jobsparticipants generally make their own choice of the allocation of assets from both employee and employer contributionsyounger participants generally invest more in equities while older participants generally invest more in fixed-income securities18-8McGraw-Hill/IrwinPrivate Pension FundsIndividual retirement accounts (IRAs) are self directed retirement accounts set up by employees who may also be covered by employer-sponsored pension planscontributions are made strictly by the employeefirst introduced in 1981 to supplement employer-sponsored programsas of 2007 maximum contributions are $5,000 per yearRoth IRAs were introduced in 1998in 2008 they allow a maximum of $5,000 yearly contribution per individualcontributions are taxed in the year of contributions, while withdrawals are tax-free as long as they have been invested at least five years and the account holder is at least 59 ½ years oldonly available to individuals with income less than $116,000 per year (or households less than $169,000)18-9McGraw-Hill/Irwin 18-10McGraw-Hill/IrwinPublic Pension FundsState or local government pension funds“pay as you go” in that current employee contributions fund current retiree benefitsbecause of an increasing number of retirees relative to workers, some funds’ current payments exceed current contributionsFederal government pension fundscivil service funds cover all federal employees not in the armed forcessuch employees are not covered by Social Securitya military pensions fund covers career military personnelmilitary personnel are also covered by Social Securitymilitary personnel are eligible after 20 years of military service18-11McGraw-Hill/IrwinPublic Pension FundsSocial Security, aka Old Age and Survivors Insurance Fundprovides benefits to almost all employees and self-employed individuals in the U.S.established in 1935 to provide a minimum level of retirement income to all retireesfunded on a “pay as you go” basishistorically, contributions have exceeded disbursementsFICA contributions are 7.65% of the first $102,000 earned in 2008 (which is also matched by an employer contribution of 7.65%)self employed individuals pay the full 15.30%disbursements are expected to exceed contributions by 2018system is expected to be bankrupt by 204218-12McGraw-Hill/IrwinPublic Pension FundsState and local PFsequities and equity MFs represent 73.59% of total assets in 2007compares to 23.32% in 1975U.S. government securities and bonds represent 22.42% of assets held in 2007compares to 66.03% in 1975Social Securitycontributions are invested in relatively low risk and low-return U.S. Treasury securitiescoupled with slow population growth and an increasing retirement population, the long-term viability of Social Security is in question18-13McGraw-Hill/IrwinPublic Pension FundsSocial Security was restructured in the mid 1990srequired contributions were increasedbenefits were decreasedfull retirement age is now 65full retirement age will be increased to 67 in phasesdollar amount of income subject to FICA increases every yearFuture changes to Social Security are slow to occurincreasing contributions and decreasing benefits are unpopular with the public and are thus unpopular with politicians seeking election or re-electionthe war on terrorism and an economic downturn in the U.S. have shifted the national spotlight away from Social Security18-14McGraw-Hill/IrwinPension Fund RegulationThe Employee Retirement Income Security Act (ERISA) of 1974 focused on five areas of reformpension plan fundingvesting of benefitsfiduciary responsibilities of fund administratorspension fund transferabilitypension fund insurance18-15McGraw-Hill/IrwinPension Fund RegulationFundingprior to ERISA, regulation did not require PFs to be adequately fundedERISA established guidelines for funding and set penalties for fund deficienciescontributions must be sufficient to meet all annual costs and expensesPFs must fund any unfunded historical liabilities over a 30-year periodany new underfunding must be funded over a 15-year periodhas led many defined benefit plans to switch over to a defined contribution structure18-16McGraw-Hill/IrwinPension Fund RegulationVesting of benefitsa vested employee is an employee who is eligible to receive pension benefits because he or she has worked for a stated period of timeprior to ERISA vesting could take up to 25 yearsERISA set the maximum vesting period at 10 yearsFiduciary responsibilitya PF fiduciary is a trustee or investment advisor that manages a PFERISA requires that PF contributions be invested with the same diligence, skill, and care as a “prudent person”the sole objective of PF management is to provide the promised benefits to the plan participants18-17McGraw-Hill/IrwinPension Fund RegulationTransferabilityERISA allows employees to transfer pension credits from one employer to another when switching jobsInsuranceERISA established the Pension Benefit Guarantee Corporation (PBGC)PBGC insures participants of defined benefit pension plansemployers paid $1 in premiums per employee when PBGC was created in 1974premium raised to $2.60 per employee in 1979premium raised to $8.50 per employee in 1987 along with the addition of a variable-rate premium of up to $50 per employee for employers with underfunded plans18-18McGraw-Hill/IrwinPension Fund RegulationInsurance (cont.)by 1991 Congress had raised the premiums to up to $72 per employee for firms with underfunded plans and $19 per employee for full funded planseven so, ERISA has generally operated at a deficitthe Retirement Protection Act of 1994 attempted to strengthen the PBGCthe $72 premium cap was phased out as approximately 80% of underfunded plans paid the maximumby 2000 the PBGC operated at a record surplus of $9.7 billionhowever, large bankruptcies in the early 2000s resulted in the agency posting a $23.3 billion deficit and a call for additional reform in 200518-19McGraw-Hill/IrwinPension Fund RegulationThe Pension Protection Act of 2006increased annual premiums from $19 to $30 per employee for fully funded firmsimplemented automatic premium increases every year thereafterunderfunded plans now pay $9 per $1,000 of underfundinggives companies only 5 years to make up shortfalls in their defined benefit pension plansrequires companies to tell investors and employees well before plans become significantly underfunded18-20McGraw-Hill/IrwinGlobal IssuesPension systems vary widely in Europethe U.K., the Netherlands, Ireland, Denmark, and Switzerland all have a tradition of state- (or public-) funded pension schemesSpain, Portugal, and Italy have less developed pension systemsFrance uses a pay-as-you-go systemthe link between contributions and benefits is weak in France and Germany, but strong in Sweden, Italy, the U.K., and ChileReform around the globe has included benefit reduction, measures to encourage later retirement, and expansions of private funding for government pensionsThe primarily private state pension system of Chile has been copied by at least thirteen other Latin American countries