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Pension Fund Operation25 ChapterA2 - #Chapter ObjectivesThe Specific objectives of this chapter are to:

Describe the common types of private pension plans, Explain how pension funds are managed. A2 - #Background on Pension Fund OperationsPension 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. A2 - #Background on Pension Fund Operations, cont..Public Pension Funds:Pubic pension funds can be either state, local or federal. The best-known 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. A2 - #Background on Pension Fund Operations, cont..Private pension funds can be classified by the way contributions are received and benefits are paid-

Defined-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.

A2 - #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. A2 - #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.A2 - #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. A2 - #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.

A2 - #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

A2 - #Pension Fund Management, cont..Management of Insured VS Trust Portfolios, cont..

The percentage of the portfolio that should be used for stocks or bondsA desired minimum rate of return on the overall portfolioThe maximum amount to be invested in real estateThe minimum acceptable quality ratings for bondsThe maximum amount to be invested in any one industryThe average maturity of bonds held in the portfolioThe maximum amount to be invested in optionsThe minimum size of companies in which to invest

A2 - #Interaction Between Pension Funds and other Financial Institutions Types of Financial Institution Interaction with Pension FundsCommercial Banks Commercial banks sometimes manage pension fundsPension funds commonly purchase commercial loans that are sold by commercial banks in the secondary market. Insurance Companies Insurance companies sometimes create annuities for pension funds A2 - #Interaction Between Pension Funds and other Financial Institutions, cont.. Types of Financial Institution Interaction with Pension Funds Mutual Funds Some pension funds are invested in various mutual funds, which allows them to achieve diversification without incurring excessive transaction costs Brokerage firms and investment banking firm Brokerage firms formally execute securities transactions for pension fundsBrokerage firms offer investment advice to pension portfolio managersA2 - #Interaction Between Pension Funds and other Financial Institutions, cont.. Types of Financial Institution Interaction with Pension Funds Brokerage firms and investment banking firm Investment banking firms commonly act as advisers on leveraged buyouts in which pension funds participateInvestment banking firms underwrite newly issued stocks and bonds that are purchased by pension funds A2 - #Participation of Pension Funds in Financial Markets Financial Markets

Participation by Pension FundsMortgage MarketPension portfolios frequently contain some mortgages, although the relative proportion is low compared with bonds and stocks.Stock MarketAt least 30 % of a pension funds portfolio is typically allocated to stocks. In general, defines-contribution plans usually have a higher concentration of stocks than defined-benefit plans A2 - #Participation of Pension Funds in Financial Markets Financial MarketsParticipation by Pension FundsMoney MarketPension 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 alternativesBond MarketsAt 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 defined-contribution plans. Pension fund managers frequently conduct transactions in the bond marketA2 - #Participation of Pension Funds in Financial Markets, cont..Financial Markets

Participation by Pension FundsMortgage MarketPension portfolios frequently contain some mortgages, although the relative proportion is low compared with bonds and stocks.Stock MarketAt least 30 % of a pension funds portfolio is typically allocated to stocks. In general, defines-contribution plans usually have a higher concentration of stocks than defined-benefit plans A2 - #Participation of Pension Funds in Financial Markets, cont..Financial MarketsParticipation by Pension Funds

Future MarketSome 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 risk. Other pension funds use future contracts for speculative purposes.A2 - #Participation of Pension Funds in Financial Markets, cont..Financial Markets

Participation by Pension Funds

Option MarketSome 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 movementsA2 - #Participation of Pension Funds in Financial Markets, cont..Financial Markets

Participation by Pension Funds

Swap MarketsPension funds commonly engage in interest in interest rate swap to hedge the exposure of their bond and mortgage portfolios to interest rate risk. A2 - #