Answers to Chapter 18
Questions:
1. Private pension funds are created by the private entities (e.g., manufacturing, mining, or transportation firms) and
2. Pension plans administered by life insurance companies (27 percent of the industry=s assets) are termed insured
pension plans. The distinction is due not necessarily to the type of administrator, but to the classification of assets in
3. In a defined benefit pension plan, the employer (or plan sponsor) agrees to provide the employee a specific cash
4. The three types of formulas used to determine pension benefits for defined benefit pension funds are flat-benefit
formula, career-average formula, and final-pay formula. A flat benefit formula pays a flat amount for every year of
5. Defined contribution plans are increasingly dominating the private pension fund market. Indeed, many defined
benefit funds are converting to defined contribution funds. Figure 18-1 shows that as equity market values fell in
2001 and in 2008 (during the financial crisis), pension fund asset values, particularly for defined contribution funds,
7. Individual retirement accounts are self-directed retirement accounts set up by employees who are also covered by
employer sponsored pension plans. Contributions to IRAs are made strictly by the employee. A Keogh account is
8. Most state and local government pension funds are funded on a Apay as you go@ basis, meaning that
contributions collected from current employee=s are the source of payments to the current retirees. As result of the
increasing number of retirees relative to workers, some of these pension funds (e.g., the state of Illinois) have
9. Civil service funds cover all federal employees who are not members of the armed forces. This group is not
covered by Social Security. Similar to private pension funds the federal government is the main contributor to the
fund, but participants may contribute as well. In addition to Social Security, career military personnel receive
10. Financial assets held by pension funds totaled $244.3 billion in 1975 and $7,231.4 billion in 2013. In 2013,
11. Figure 18-4 shows the distinction in private pension plan financial asset investments for defined benefit and
defined contribution plans. Defined benefit plans have 24.56 percent of their funds invested in U.S. government
securities and bonds compared to defined contributions plans with 6.68 percent. Also, defined benefit plans have
12. Social Security contributions are invested in relatively low-risk, low-return Treasury securities. This, along with
the fact that the growth of the population is slowing and the percentage of the population in retirement is increasing,
has led to questions regarding the long-term viability of the Social Security fund (and the Social Security system in
14. The principal features of ERISA involve funding, vesting of benefits, fiduciary responsibility, transferability, and
insurance.
Vesting of Benefits: Frequently, while employers start contributing to an employee=s pension fund as soon as the
Fiduciary Responsibilities: A pension plan fiduciary is a trustee or investment advisor charged with the management
Insurance: ERISA established the Pension Benefit Guarantee Corporation (PBGC), an insurance fund for pension
15. Reforms of pension systems in other countries have included benefit reductions, measures to encourage later
retirement, and expansions of private funding for government pensions. For example, in many countries reforms
include raising the age at which a person is eligible for pension benefits. This type of reform recognizes increased
The European debt crisis forced many countries to reform their pension systems. For example, France’s
parliament approved a bill that increased the retirement age from 60 to 62. As part of the bailout plan organized by
the International Monetary Fund, Greece made changes that increased the retirement age and cut automatic bonuses
Problems:
1. Annual benefits will be
2. Annual benefits will be
3. For retirement now, in 5 years, and in 10 years, the employee’s (estimated) annual retirement benefit payment is:
6. Annual benefits will be
7. Your annual investment is
8. Assuming the employee=s salary, tax rate, and 401(k) yield remains constant over a 25-year career, when the
employee retires the 401(k) will be worth
9. Your annual investment is
Your one-year return is
10. Assuming the employee=s salary, tax rate, and 401(k) yield remains constant over a 15-year career, when the
employee retires the 401(k) will be worth
11. The terminal value of the 401(k) plan, assuming all returns and contributions remain constant (at $16,500) over
the twenty years, will be:
Option 1:
Option 2:
Option 3:
16,500 (0.4){[(1 + 0.12)20 – 1]/0.12} + 16,500 (0.5){[(1 + 0.05)20 – 1]/0.05} + 16,500 (0.1){[(1 + 0.03)20 – 1]/0.03} = $792,676