Chapter 26
Pension Fund Operations
Outline
Types of Pension Plans
Defined-Benefit Plans
Defined-Contribution Plans
Comparing Pension Plans
Pension Fund Participation in Financial Markets
Regulation of Private Pension Plans
Vesting of Private Pension Plans
Transferability of Private Pension Plans
Tax Benefits of Private Pension Plans
Insurance on Private Pension Plans
Underfunded Private Defined-Benefit Pensions
Underfunded Public Defined-Benefit Pensions
Overestimated Rate of Return
Political Motivation
Possible Solutions to Underfunded Pensions
Corruption of Defined-Benefit Pension Funds
Bribes to Trustees
Payment of Excessive Benefits
Ineffective Oversight by Trustees
Pension Fund Management
Asset Allocation of Pension Funds
Influence of Management Compensation on Risk
Management of Portfolio Risk
Matched Versus Projective Funding Strategy
Performance of Pension Funds
Pension Fund’s Stock Portfolio Performance
Pension Fund’s Bond Portfolio Performance
Performance Evaluation
Performance of Pension Portfolio Managers
Chapter 26: Pension Fund Operations ❖ 2
Key Concepts
1. Explain the difference between defined-benefit and defined –contribution plans.
2. Explain how pension funds are regulated.
3. Describe how pension funds participate in financial markets.
4. Describe how potential incentives of politicians and pension portfolio managers can adversely affect
pension funds.
POINT/COUNTER-POINT:
Should Pension Fund Managers be More Involved with Corporate
Governance?
POINT: No. Pension fund managers should focus more on assessing stock valuations and determining
COUNTER-POINT: Yes. To the extent that pension funds can use governance to improve the
WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own
opinion.
Questions
1. Private versus Public Pension Funds. Explain the general difference between the portfolio
composition of private pension funds and public pension funds.
2. Defined-Benefit versus Defined-Contribution Plan. Describe a defined-benefit pension plan.
Describe a defined-contribution plan, and explain why it differs from a defined-benefit plan.
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3. Pension Fund Participation in Financial Markets. Explain how pension funds participate in
financial markets.
4. Governance by Pension Funds. Explain how the governance over corporations by a pension fund
can help to enhance the performance of the pension fund.
5. Pension Plan’s Vesting Schedule. Explain the meaning of a pension plan’s vesting
schedule.
6. ERISA. Explain how ERISA affects employees who change employers.
7. Tax Benefits of Pension Plans. Explain how pension plans provide tax benefits.
8. Guidelines for a Trust. What type of general guidelines may be specified for a trust that is managing
a pension fund?
9. Management of Pension Portfolios. Explain the general difference in the composition of pension
portfolios managed by trusts versus those managed by insurance companies. Why does this difference
occur?
10. PBGC. What is the main purpose of the Pension Benefit Guarantee Corporation (PBGC)?
11. Exposure of Pension Funds to Interest Rate Risk. Why might pension funds be exposed to interest
rate risk? How can pension funds reduce their exposure to interest rate risk?
12. Pension Fund Agency Problems. The objective of the pension fund manager for McCanna, Inc. is
not the same as the objective of McCanna’s employees participating in the pension plan. Why?
13. Estimated Rate of Return and Underfunding. Explain how some government defined-benefit plans
have become underfunded as a result of overestimating their rate of return on investment.
14. Potential Impact of Underfunded Public Pension Fund on Debt. Explain how an underfunded
public pension fund can affect the debt rating of a city or state.
15. Potential Corruption of Pension Fund Trustees. Explain the potential for corruption when a trustee
has the power to determine who will manage a pension fund.
ANSWER: The decision by one person or a few people overseeing the pension fund to allow a
CRITICAL THINKING QUESTION
Aligning Incentives of Pension Funds. Consider a state pension fund that needs to generate a series of
fixed payments for its retirees. Yet, assume that its compensation for its portfolio managers is tied to the
return earned on the investments each year. Write a short essay that explains how the compensation plan
might lead to investment strategies that do not serve the needs of the retirees.
ANSWER
Interpreting Financial News
Interpret the following statements made by Wall Street analysts and portfolio managers.
a. “The city is now broke because of its pensions.”
Chapter 26: Pension Fund Operations ❖ 6
b. “Defined-contribution plans would prevent politicians from buying votes in a state.”
c. “Public pension funds govern corporations but also need to govern themselves. .”
Managing in Financial Markets
As a consultant to a state’s underfunded pension fund, you have been asked to search for solutions to
prevent underfunding in the future.
a. One explanation for the underfunding of the defined-benefit plan is that the economy was weak
recently, and financial markets were weak, and this was the cause of the underfunding. If so, the
underfunding may not be a problem in the future. Do you think this explanation is sufficient, such
that there is no need to search for an alternative solution. Explain.
b. One possible solution is for the state’s defined-benefit plan to be converted into a defined-
contribution plan. Explain why this could be a viable solution to the problem.
c. Some state workers prefer to be on a defined-benefit plan because they will likely make poor
investments if they are forced to manage their own funds (if they had a defined-contribution
plan). Is that a sufficient reason to force a state to remain on a defined-benefit plan ?
Flow of Funds Exercise
How Pension Funds Facilitate the Flow of Funds
Carson Company has a defined-benefit pension plan in which it offers generous benefits to its employees
upon retirement.
Chapter 26: Pension Fund Operations ❖ 7
a. Explain the role of the portfolio managers who manage the pension fund. What is their primary
role?
retirement benefits.
The bonds could generate more predictable returns, which may be useful when attempting to
c. Explain how investment decisions on the pension fund would change if the defined-benefit plan
was changed to be a defined-contribution plan.
The defined-contribution plan would contribute to the employee’s retirement, but allow the
Solutions to Integrative Problem for Part 7
Assessing the Influence of Economic Conditions Across a Financial Conglomerate’s Units
1. The objective of this case is to force students to compare asset portfolios across units of the
Default Risk
In comparing the effects of the recession, assess the composition of each unit’s asset portfolio.
Regarding default risk, most units will be adversely affected, but some are more exposed than
others. For example, finance company assets may be subject to a higher default rate than the other
Interest Rate Risk
Regarding interest rate risk, the institutions that are more exposed to interest rate movements may
benefit from the likely interest rate movements. As the recession begins, there will likely be a
Chapter 26: Pension Fund Operations ❖ 8
decline in the demand for funds, causing a decline in interest rates. Institutions that have debt
Effect on Brokerage Firms and Investment Banking Firms
A brokerage firm’s performance is mostly affected by its volume of brokerage transactions rather
Summary
Overall, insurance companies and mutual funds holding a large proportion of highly rated long–
term bonds may perform better than most other financial institutions during the recession. They
would benefit from their exposure to interest rate risk without being heavily exposed to default
risk.
2. It is expensive and inefficient for each unit to have its own economists to provide forecasts. In
addition, economists among units conduct redundant analyses and then may even create