1.1.1.1.1Chapter Eighteen
Pension Funds
1.1.1.2 I. Chapter Outline
1. Pension Funds Defined: Chapter Overview
2. Size, Structure and Composition of the Industry
a. Defined Benefit Versus Defined Contribution Pension Funds
b. Insured Versus Noninsured Pension Funds
c. Private Pension Funds
d. Public Pension Funds
3. Financial Asset Investments and Recent Trends
a. Private Pension Funds
b. Public Pension Funds
4. Regulation of Pension Funds
5. Global Issues
Appendix 18A: Calculation of Growth in IRA Value During an Individual’s Working Years,
available on Connect or from your McGraw-Hill representative
II. Learning Goals
1. Describe the difference between a private pension fund and a public pension fund
2. Distinguish between and calculate the benefits from a defined benefit and a defined
contribution pension fund
3. Identify the characteristics and calculate the benefits from the different types of private
pension funds
4. Identify the different types of public pension funds
5. Examine the main regulations governing pension funds
6. Review the major issues for pension funds in the global markets
1.1.1.3 III. Chapter in Perspective
Pension funds allow people to transfer wealth through time while avoiding taxation on their
investment earnings during their working years. The primary purpose of pensions is to provide
retirement income for individuals. Traditionally most pension funds have paid set benefits to
retirees based on their wage during their tenure with the company and years of service. Today
more and more individuals are covered by plans that do not pay a set amount at retirement, rather
their retirement benefits will normally be an annuitized payment based on the terminal value of
their wealth in the plan. The value of their plan holdings depends upon the amounts paid in and
the earnings on the funds invested.
1.1.1.4 IV. Key Concepts and Definitions to Communicate to Students
Private pension funds Defined benefit pension plan
Public pension funds Defined contribution plan
Pension plan Flat benefit formula
Insured pension plan Career-average formula
Noninsured pension plan Final-pay formula
Social Security reform Fully funded
403(b) 401(k)
Roth IRA IRA
ERISA Vesting
Keogh plan PBGC
Qualified plan
1.1.1.5 V. Teaching Notes
1. Pension Funds Defined: Chapter Overview
Over 680,000 pension funds exist today. In 2013 U.S. households had about 34% of their
financial assets invested in pension funds. Private pension funds are administered by a private
corporation. Public pension funds are administered by either the federal government or a
municipality. Pension fund assets in 2013 were $18,736.60 billion, and private pension funds
comprised 56% of the total. The financial crisis reduced global pension assets from $25 trillion
to $20 trillion. U.S. retirement accounts fell by $2 trillion, causing many to postpone retirement
and reduce spending to save more. At the end of 2008 company sponsored pension plans were
underfunded by $400 billion.
2. Size, Structure and Composition of the Industry
a. Defined Benefit Versus Defined Contribution Pension Funds
Defined Benefit Plans
Traditionally most plans have been defined benefit plans. In this type of plan the sponsor
agrees to pay employees a set (defined) benefit upon retirement according to some
formula that usually incorporates the employee’s working wages and/or years of service.
There are three types:
Flat benefit: This type plan pays a flat amount for every year of employment. For
example, a retiree may receive $2,000 per year of service times the number of years of
service as an annual retirement benefit.
Career-Average Formula:
Flat percentage: Under this type plan the retiree receives a flat percentage of their average
salary over their entire work period.
Percentage of average salary adjusted for number of years working: With this plan the
retiree receives a given percentage of their average salary during their career with the
firm times the number of years employed. The percentage may or may not increase with
years of service.
Final-Pay Formula: Under this formula the retiree receives a percentage of their average
salary during the last three to five years of working for the firm times the number of years of
service.
E.G.: An employee works 20 years for a firm. His average salary over his entire career with the
firm was $65,000. His average salary over the last five years was $75,000.
Annual retirement benefit for various defined benefit plans:
Flat benefit of $2,000 per year worked: $2,000 20 years = $40,000
Career average, flat percentage of 60% of average salary: $65,000 0.60 = $39,000
Career average, flat percentage amount of 4% of average salary adjusted by years of service:
$65,000 0.04 20 years = $52,000
Final pay: A flat percentage amount of 4% of the last five years of salary adjusted for years of
service: $75,000 0.04 20 years = $60,000
The final pay formula usually results in the highest benefit. Some plans will take the average of
the five highest years of pay instead of the final pay. This variation generally provides benefits
similar to the final pay formula because pay rarely decreases with seniority.
Defined benefit plans may be
Overfunded or fully funded: The plan has assets greater than (overfunded) or equal to (fully
funded) the present value of expected future payouts.
Underfunded: The plan has some assets held as a reserve against expected future payouts
but does not have an amount equal to the present value of expected future liabilities. Social
Security is underfunded.
Unfunded: The plan has no assets held as a reserve against expected future retirement
benefits.
Pension plans are not required to be fully funded but there are minimum funding requirements
and penalties for excessive underfunding.
Teaching Tip: Changes in actuarial assumptions can improve the corporate plan sponsor’s current
earnings. For instance, if interest rates rise, pension fund contributions (expenses) may be
reduced because the corporate sponsor can now assume that the fund’s assets will generate
higher earnings growth. Ford Motor Co. reduced pension expenses in 1981 and GM did the
same in 1990 by assuming that the fund would earn higher interest rates.
The plan sponsor bears the interest rate and price risk in a defined benefit plan because the
sponsor is liable for all promised pension fund payments, but the earnings rate on the assets is
not guaranteed.
Defined Contribution
A defined contribution plan shifts the risk of poor investment earnings onto the covered
employees. The employer does not guarantee or define the retirement benefit. If an investor’s
retirement occurs during a protracted recession, their retirement income could be substantially
reduced, particularly if their portfolio had significant equity exposure.
Teaching Tip: The SEC’s Savings and Investing Campaign (see www.sec.gov) indicates that the
majority of Americans are still not well informed about investment risk and returns and are
underinvested in stocks. A quick rule of thumb is that an individual should invest (100 – their
age) percent of their portfolio in stocks. Less well informed individuals are usually
uncomfortable with this level of risk.
In a defined contribution plan the plan sponsor (employer) typically pays a fixed amount into an
individual’s retirement plan, usually along with employee contributions. The employee has some
limited choice about where the funds are invested. The choices may include a GIC and several
mutual funds. Fixed income funds often guarantee a minimum rate of return. Investors may
seek higher returns in riskier investments, including equities. Fundholders receive all investment
profits (less management fees).
b. Insured Versus Noninsured Pension Funds
A pension plan governs the operations of the pension fund. Insured pension plans are
normally administered by life insurance firms and these plans constitute about 27% of industry
assets. Insured plans do not have segregated assets backing the plan. Pension fund contributions
are instead commingled with an insurer’s policy premiums and jointly invested in securities. The
amount owed to the pension fund is recorded as a liability called pension fund reserves. The
pension fund’s assets are thus owned by the insurance company.
Noninsured pension plans are typically administered by a trust department of a financial
institution such as a bank or mutual fund that is appointed by the plan sponsor. The assets of the
noninsured fund are owned by the plan sponsor and are listed as separate assets on the trustee’s
balance sheet. In either case the plan sponsor sets the guidelines for the plan such as the benefit
formula or matching contributions, etc.
Noninsured pension funds tend to invest in riskier assets and earn higher rates of return than
insured pension funds. This occurs because the insurance firm is at risk of declining values of
pension fund assets, but the trustee making the investments of a noninsured plan is not at risk
from declining asset values because the assets belong to the sponsor. Nevertheless, the prudent
person rule (see below) constrains managers of both types of funds to limit the riskiness of
pension fund investments.
c. Private Pension Funds
In terms of number of plans and number of participants, defined contribution plans are
increasingly becoming the dominant form of private pension plans. Total assets in defined
contribution plans have generally exceeded total assets of defined benefit plans since about 1996.
Note that the shift from defined benefit to defined contribution plans shifts the risk of investment
performance onto the employee. The financial crisis reduced retirement investments in
aggregate in the U.S. by $2 trillion. The losses forced many Americans to postpone retirement
and reduce current spending in order to save more. In 2013 total assets of private pension funds
were $10,423.80 billion, about 27.1% of which were administered by life insurers, 25% by
mutual funds and the rest by other financial institutions including banks.
Teaching Tip: Why one should not count on Social Security as the sole source of retirement
income:
Social security AND a pension typically provide only a part of your pre-retirement income.
SS has only limited inflation protection.
Working after retirement can reduce SS benefits.
SS benefits can be taxed.
Under current projections SS is underfunded and although it is unlikely, it could conceivably
go broke. (Nobody believed the S&L industry and the FSLIC would go broke until the crisis
occurred.)
Many people today will have the opportunity to invest in a 401(k) plan. These plans had grown
to $3,790 billion by 2013. There were more than 64,000 plans with over 20 million participants.
401(k) plans are employer sponsored retirement plans. 403(b) plans are similar plans offered by
tax exempt employers such as hospitals, university’s and other educational institutions.
Teaching Tip: In a 401(k) the employee has some choices about how much to contribute to their
retirement plan and where it will be invested. Typically, the company supplements your
investment by contributing a fixed percentage of whatever the employee pays in to the plan. The
maximum employer contribution is currently 25% of the employee’s salary or $16,500 per year,
whichever is less. The maximum total contribution is the lesser of $49,000 or 100% of
compensation. The Economic Growth and Tax Reconciliation Act of 2001 (EGTRRA) allows
greater 401(k) contributions through time. All contributions are TAX-DEDUCTIBLE, and all
interest earned accrues TAX FREE until withdrawal.1 The fixed dollar amount maximums are
indexed to inflation and increase each year. Current figures can be found at
www.retirementplanners.com. There are tax penalties for withdrawal of funds prior to age 59 ½,
although various exceptions exist. See below.
Teaching Tip: Refer to the defined benefit plan information above and find the level of annual
contribution to a 401(k) plan that would be needed to generate a retirement benefit equal to the
$60,000 per year retirement benefit of the final pay plan given the following information:
The employer matches by paying 40% of the first 6% of the employee’s contributions. (The
employee could contribute more, but it would not be matched.)
The employee expects to earn 12% per year on all funds invested.
The employee has 20 years of work remaining and will live 25 years after retirement.
Solution:
Step 1: Required PV at retirement age =
12.
)12.1(1
*000,60$
25
= $470,588
Step 2: Required annual contribution to the plan:
1A new provision of the EGTRRA 2001 allows investors (effective 2006) to choose “Roth IRA”
treatment for their 401(k) contributions. These contributions will not be deductible, but
withdrawals will not be taxed. Certain conditions apply.
12.
112.1
*ionContribut588,470$
20
; Total Contribution = $6,531
Assuming this amount is not more than 6%, the employer pays 40% of the employee’s
contribution. $6,531 = (0.40 employee contribution) + employee contribution, or the
employee’s required annual contribution is $4,665 and the employer contributes $1,866.
Note that the eroding effects of inflation on purchasing power have not been included in this
example. The $60,000 should be increased at the inflation rate over the working period and the
withdrawals should increase with inflation during the retirement period. It is also reasonable to
assume that contributions will rise over time as well.
The effect of the rate of return on employee’s required contribution:
If the plan earns only 9% the required annual employee’s contribution is $8,228. A major equity
component is often needed in retirement portfolios to get the required contributions down to a
reasonable level.
The effect of work time on employee’s required contribution:
If the plan earns 12% but the employee has only 15 years of work time remaining the required
annual employee’s contribution is $9,016. Encourage your students to begin funding their
retirement as soon as they graduate.
Individual retirement accounts (IRAs)
IRAs are investment vehicles designed to provide supplemental retirement income. The
maximum annual contribution in 2013 and 2014 to an IRA is $5,500 per year ($10,000 per
household) subject to income limits in 2011.2 IRA contributions may be tax deductible
depending on the investor’s income and whether the individual has a retirement plan at work. If
the household has an adjusted gross income (AGI) of $188,000 or less and neither spouse is
covered by an employer plan then contributions are at least partially tax deductible. As of 2013
there were over $5.7 trillion invested in IRAs.
Teaching Tip: The following applies to IRAs, 401k and 403bs: Withdrawals before age 59½ may
face a 10% tax penalty although many exceptions now exist; check current tax law. The typical
tax penalty for early withdrawal is a 10% surcharge tax plus all withdrawals are taxed as
ordinary income. Various hardship exceptions exist for medical conditions, disability and in
some cases even home purchases. To ensure taxes are paid, in most cases 20% of the amount
withdrawn must be withheld by the plan sponsor to ensure payment of taxes. Certain states, like
Virginia, apply an additional 10% withholding. Withdrawals must begin at or before age 70½ to
avoid a tax penalty. Withdrawals of deductible contributions and their earnings are taxable upon
2The EGTRRA 2001 allows for increases in IRA contributions through time The amount will be
increased by the cost of living increases and it will adjust in $500 increments. In addition this
act allows people age 50 and over to make additional contributions up to $5,000 more in a 401(k)
and $1,000 in an IRA beginning in the year 2006. Details are available at
www.retirementplanners.com or at www.irs.gov.
withdrawal.
A separate type of IRA, the Roth IRA, also exists. Contributions to the Roth IRA are not tax
deductible, but the withdrawals are generally not taxed. Investors who believe they will be in a
substantially lower tax bracket when they retire may find a Roth IRA to be more beneficial. The
$5,000 ($10,000 per household) annual contribution limit applies to both types IRAs in total and
Roth IRAs are available only to individuals with maximum income of $129,000 or $191,000 per
household. In both type IRAs excessive contributions and their earnings face a stiff tax penalty.
There are now Roth versions of 401(k) and 403(b) plans.
Teaching Tip: Why does the government decry the low savings rate in the U.S. and then institute
low maximum annual investment amounts in an IRA?
Simplified Employee Pensions (SEPs), formerly known as Keogh accounts, are for
self-employed individuals and corporations. Maximum contributions are the lesser of 25% of
your self-employment income, or $52,000, per year as of 2014. A money purchase plan (or
money sharing plan) requires fixed contributions be made by the employer each year. A profit
sharing plan allows the employer to vary the contributions year to year. Money sharing plans
allow for greater pension contributions and may be used when the employer wants to shelter
more income. Both are qualified plans.
Teaching Tip: The term qualified plan refers to whether or not the plan qualifies for full tax
benefits such as immediate employer tax deductions for plan contributions. Unqualified plans
have fewer regulations such as who must be covered and less stringent vesting requirements, but
they do not provide the same tax benefits to the employer.
d. Public Pension Funds
In 2013 public pension fund assets comprised about $8.31 trillion, about double the 2010 value.
State and local government pension funds are typically unfunded (pay as you go) where there are
no reserves held to back future liabilities. Current inflows are used to meet current payment
requirements. Many state and local plans may have a difficult time meeting projected
obligations in the years to come. In some states the plans have become critically underfunded.
Illinois and many other states have large funding deficits. According to the Pew Trust, states
were underfunded by as much as $1.38 trillion in 2010. Illinois is now facing reduced benefit
increases, older retirement ages and caps on salary in determining pension benefits. Over the
2000s the required payments needed by states to fund their obligations more than doubled as
they overpromised pension benefits and as stock prices declined reducing the value of pension
investments. In 2010 only Wisconsin had fully funded its pension plan. Connecticut, Illinois,
Kentucky and Rhode Island had the worst levels of funding (under 55%). States had only about
5% of funds needed to pay health care and other non-pension benefits obligations. Seventeen
states had not set aside any money for health payments and only seven states had funded at least
25% of projected non-pension outlays. Data source, www.pewtrusts.org.
The federal government has a separate plan for federal government workers including
Congressmen and the military.3 The best known federal pension fund is the Old Age and
Survivors Insurance Fund or better known as simply “Social Security.” Social Security (SS)
was created in 1935 as a result of the Depression to provide subsistence funds to retirees. The
President at the time, Franklin Roosevelt, intended that the plan would always be maintained on
a fiscally sound basis. Social Security taxes (FICA on your wage statement) are 7.65% of the
first $115,500 earned, and employers also make contributions to get the tax rate up to 15.30%.
Self-employed individuals contribute 15.30%. In 2010 Social Security receipts were not
sufficient to pay obligations for the first time. The fund has sufficient IOUs from the Treasury to
prevent bankruptcy until the year 2033, although these projections vary with the economy.
Note: Data from the following is drawn from the sources listed at the end.
Teaching Tip: In 1960 there were 5 workers per retiree, there are currently slightly over 3 and in
2035 there are projected to be only 2 workers per retiree. In 2004 SS ran a $151 billion surplus
but it is projected to begin running ever increasing deficits in 2018. The surplus is invested in
U.S. Treasury bonds which will mature when baby boomers retire and should allow SS to pay
currently promised benefits until 2033 depending on estimates. The trust fund is currently about
$1.5 trillion but is underfunded over the next 75 years by as much as $3.7 trillion. That is a large
amount even to Congress. Moreover, Medicare and Medicaid face substantially more serious
funding problems. (See Article #4)
An analysis of the numbers indicates that the longer we wait to fix the problem the greater the
burdens will be on taxpayers and/or retirees. Ignoring privatization for the moment, the
alternatives are to increase payroll taxes now, wait and increase taxes more later, increase the
amount of income on which payroll taxes are collected, raise the retirement age, tax more SS
payments, and/or cut benefits. If we raise payroll taxes now, only a modest 15% increase from
the current payroll tax level would be required. If we wait however, payroll tax rates of 30% or
more will be required.4 Other than cutting benefits or raising taxes, several other proposals have
been made to shore up the Social Security fund, including raising the minimum age to collect full
benefits, encouraging workers to redirect some of their payroll taxes to private investments with
associated reductions in Social Security benefits, and changing how benefits are indexed to
inflation. It is likely that some combination of these changes will be implemented.
President Bush proposed partial privatization of the Social Security system. Various ideas
were considered, some would have allowed people to divert a part of their payroll tax (usually
4%) to private accounts, other plans would require the full payroll tax be paid into Social
Security but would have allowed supplemental amounts to go to private accounts. The
President’s idea assumed benefits were likely to be cut, so the potentially higher earnings on
private accounts could be used to more than make up for losses from the reduced SS benefits. It
is important to understand however that privatization is a separable issue from fixing the SS
system. Bush argued that increasing ownership of retirement accounts would encourage people
to become more fully engaged in the economic system. Presumably this would have provided
people with incentives to work harder and have a greater interest in how the economy performs,
3Probably a guaranteed method to ensure the continue viability of Social Security would be to
include Congressional pensions in Social Security!
4 This figure assumes that no other changes are made of course, data are drawn from Article #4)
and of course encourage them to manage their retirement on their own. Studies by the SEC show
that too many people do not invest enough for retirement and that people do not invest a
sufficient amount in equities although younger people now invest more in equities. From a
macro perspective, history is on Bush’s side in this argument; economies with greater levels of
ownership do tend to perform at higher levels over time. In a basic sense this is just the old
capitalism versus socialism argument in a different form.
Problems with privatization:
Privatization can be quite costly in the short run if the payroll tax were to be diverted to private
accounts. Also, given the diminishing marginal value of wealth coupled with the fact that the
poor are the least likely to take advantage of private accounts (and according to the studies, may
receive the least benefit from them) arguments can be made that privatization adds risk to those
who are least able to bear it and profit from it. In terms of age, the figures I have seen indicate
that privatization provides significant benefits for those born in the 1990s or later. Those in this
age group probably should be advised that it is too risky for them to count on SS as their sole or
main form of retirement income.
SS is currently progressive, i.e. the poorer benefit disproportionately more than the wealthy.
Moving to privatization reduces the opportunity to use SS in this way. In short, those who
believe the government should be heavily involved in income redistribution will probably not
like privatization because moving to private accounts and fostering the idea of ownership begins
to limit the flexibility of government to use SS for redistribution purposes. Those who believe
that they can do better on their own and that they should be allowed to keep their money will
tend to favor privatization (typically younger, better educated people fit this category).
It is not clear as of this writing what form of adjustment will be made to ensure the viability of
the Social Security fund. What is clear is that the least palatable alternative is to do nothing.
Doing nothing raises the required tax levels to unacceptable amounts and/or causes benefit cuts
to be onerously large. If the government attempts to borrow the necessary amounts to continue
to fund current benefits, the pressure on the value of the dollar will likely become enormous with
debt owed to foreigners rising to unprecedented levels. Already the U.S owes to foreigners an
amount equal to about 25% of its annual GDP. How large can this number get before painful
macro adjustments occur?