Chapter 26
Pension Fund Operations
Outline
Types of Pension Plans
Pension Fund Participation in Financial Markets
Governance by Pension Funds
Regulation of Private Pension Plans
Vesting of Private Pension Plans
Underfunded Public Defined-Benefit Pensions
Overestimated Rate of Return
Corruption of Defined-Benefit Pension Funds
Bribes to Trustees
Pension Fund Management
Asset Allocation of Pension Funds
Matched Versus Projective Funding Strategy
Performance of Pension Funds
Pension Fund’s Stock Portfolio Performance
Chapter 26: Pension Fund Operations ❖ 2
Key Concepts
2. Explain how pension funds are regulated.
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
which stocks are undervalued or overvalued. If pension funds own stocks of firms that perform poorly,
COUNTER-POINT: Yes. To the extent that pension funds can use governance to improve the
performance of the firms in which they invest, they can improve the fund performance. In this way, they
also improve the returns to the pension recipients.
WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own
opinion.
ANSWER: There is a possible compromise. Pension funds can use most of their time to focus on making
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 how it differs from a defined-benefit plan.
ANSWER: A defined-benefit plan requires contributions that are dictated by the benefits that will
Chapter 26: Pension Fund Operations ❖ 3
3. Pension Fund Participation in Financial Markets. Explain how pension funds participate in
financial markets.
ANSWER: Because pension fund portfolios are normally dominated by stocks and bonds, the
4. Governance by Pension Funds. Explain how a pension fund’s governance over corporations can
help to enhance the performance of the pension fund.
ANSWER: As pension funds exert some governance to ensure that the managers and board members
5. Pension Plan’s Vesting Schedule. Explain how a pension plan’s vesting schedule works and
what its purpose is.
ANSWER: A pension plan’s vesting schedule represents the time at which rights to assets that have
accumulated in the employee’s pension fund cannot be taken away. Employees whose employment
6. ERISA. Explain how ERISA affects employees who change employers.
ANSWER: Employees that changed employers could transfer any vested amount into the pension
7. Tax Benefits of Pension Plans. Explain how pension plans provide tax benefits.
ANSWER: First, a portion of the income earned by the employee is contributed to the employee’s
Chapter 26: Pension Fund Operations ❖ 4
8. Guidelines for a Trust. What type of general guidelines may be specified for a trust that is managing
a pension fund?
ANSWER: Guidelines may include the percentage of the portfolio allocated to stocks or bonds, a
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?
ANSWER: Pension portfolios managed by trusts offer potentially higher returns than insured plans
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?
ANSWER: Pension funds commonly invest in bonds, so if interest rates rise, the valuation of these
12. Pension Fund Investment Performance Evaluation. McCanna Inc. has hired an investment
company to manage its pension fund, which is invested in a stock portfolio and bond portfolio.
Explain how McCanna can evaluate the performance of the investment company in managing its
pension fund money.
ANSSWER: A pension fund’s performance can be evaluated by comparison to a passive
strategy benchmark representing the same mix of securities. For example, assume that an
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.
ANSWER: Many government agencies assumed that they would earn a high rate of return on their
Chapter 26: Pension Fund Operations ❖ 5
Chapter 26: Pension Fund Operations ❖ 6
14. Potential Impact of an Underfunded Public Pension Fund on Debt. Explain how an underfunded
public pension fund can affect the debt rating of a city or state.
ANSWER: Underfunded pensions can cause large budget deficits. The credit rating agencies
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
particular investment company to manage the pension fund’s money can generate millions of dollars
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
If portfolio managers are compensated based on the return on investment, they may be tempted to make
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.”
The city’s employees were granted large pension payments in the future, which underfunded.
Chapter 26: Pension Fund Operations ❖ 7
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. .”
Pension fund portfolio managers are major investors in corporations and therefore can govern
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.
A weak economy can occur again in the future, and underfunding might occur again as a result.
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.
The defined-contribution plan would require that the state set aside the proper funds for
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 (as they would with a defined-
contribution plan). Is that a sufficient reason to force a state to remain on a defined-benefit plan?
Students can weigh the tradeoffs, but most students would likely say that just as the state should
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 ❖ 8
a. Explain the role of the portfolio managers who manage the pension fund. What is their primary
role?
Their role is to generate sufficient returns on the portfolio so that retirement payments can be
b. Explain the tradeoff between investing in bonds versus in stock for the purpose of providing
future retirement benefits.
The bonds could generate more predictable returns, which may be useful when attempting to
uncertain and could possibly cause the pension fund to be underfunded.
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
financial conglomerate and consider how each asset portfolio is exposed to default risk and
interest rate risk. An overall comparison can only be made once these types of exposure are
evaluated.
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 ❖ 9
decline in the demand for funds, causing a decline in interest rates. Institutions that have debt
securities with fixed interest rates can benefit from the decline in market interest rates, since the
In addition, savings institutions that concentrate on variable-rate mortgages would not benefit
from the expected movement in interest rates.
Mutual funds concentrating on securities such as long-term bonds and mortgages could benefit
from the decline in interest rates, while money market mutual funds would not benefit.
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
contradictory forecasts. Thus, one unit may be altering its asset portfolio in anticipation of higher
interest rates while another alters its asset portfolio in anticipation of lower interest rates. The