ACFI330 - Banking and the financial system: Pension funds

What is a pension fund?

A savings plan through which fund participants accumulate tax-deferred savings during their working years before withdrawing them in retirement years.

What are the two main tax advantages of pension funds?

• Funds originally invested are exempt from current taxation

• Tax payments are not made until funds are withdrawn (during retirement)

How has pension fund participation changed in the US since 1940?

Pension funds grew from only 400 in 1940 to over 740,000 currently. US households had 20% of financial assets in pension funds in 2021, compared to just over 5% in 1950.

What are the two distinct sectors of the pension fund industry?

• Private pension funds - administered by private corporations (mutual funds and insurance companies)

• Public pension funds - administered by federal, state, or local government (e.g., Social Security in US, State Pension in UK)

Who are the main providers of private pension funds?

Mutual funds and insurance companies

What are the two main types of private pension funds?

Defined benefit funds and defined contribution funds

What is a defined benefit pension fund?

A fund where the employer agrees to provide the employee with a specific cash benefit upon retirement, based on a formula considering years of employment and salary during employment.

What are the three formulas used in defined benefit plans?

• Flat benefit formula - pays a flat amount for every year of employment

• Career average formula - pays benefits based on employee's average salary over entire employment period

• Final pay formula - pays benefits based on percentage of average salary during specified number of years at end of career times number of years of service

Which defined benefit formula typically produces the biggest retirement benefit increases?

The final pay formula usually produces the biggest retirement benefit increases as years of service increase.

Why does the final pay formula provide better protection against inflation?

Because benefit payments are based on the employee's career-end salary, which is generally the highest and often reflects current levels of price and wage inflation.

Calculate retirement benefit using flat benefit formula: Employee with 20 years of service, $2,000 per year of service

: $2,000 × 20 = $40,000 annual retirement benefit

Calculate retirement benefit using career average formula: Employee with 20 years service, $48,000 average salary, 4% benefit rate

$48,000 × 0.04 × 20 = $38,400 annual retirement benefit

Calculate retirement benefit using final pay formula: Employee with 20 years service, $75,000 average salary in last 5 years, 2.5% benefit rate

$75,000 × 0.025 × 20 = $37,500 annual retirement benefit

What is a fully funded pension plan?

A plan that has sufficient funds available to meet all future payment obligations.

What is an underfunded pension fund?

A fund that does not have sufficient funds available to meet all future promised payments. The plan has some assets as reserves but not an amount equal to the present value of expected future liabilities.

Are pension plans required to be fully funded?

No, pension plans are not required to be fully funded, but there are minimum funding requirements and penalties for excessive underfunding.

Who bears the interest rate and price risk in a defined benefit plan?

The plan sponsor (employer) bears the risk because the sponsor is liable for all promised pension fund payments, but the earnings rate on the assets is not guaranteed.

What is a defined contribution pension fund?

A fund in which the employer agrees to make a specified contribution to the pension fund during the employee's working years, but does not commit to providing a specified retirement income.

How does risk differ between defined benefit and defined contribution plans?

• Defined benefit: Employer bears the risk of poor investment earnings

• Defined contribution: Employee bears the risk of poor investment earnings

What is the trade-off for employees in defined contribution plans?

Higher potential returns relative to defined benefit funds, but employees must accept increased risk of uncertain payouts.

What are fixed-income funds in DC plans?

Funds that typically offer a guaranteed minimum rate of return, with the possibility of higher returns if fund assets earn above minimum rates.

What are variable-income funds in DC plans?

Funds where all investment profits and losses are passed through to fund participants. Fundholders receive all investment profits (less management fees).

What risk do DC plan participants face if retiring during a recession?

Their retirement income could be substantially reduced, particularly if their portfolio had significant equity exposure.

What is a 401(k) plan?

An employer-sponsored defined contribution plan that supplements a firm's basic retirement plan, allowing for both employer and employee contributions.

What are the key features of 401(k) plans?

• Contributions made on pre-tax basis (reduce taxable salary)

• Most plans are transferable if employee changes jobs

• Participants generally make their own asset allocation choices

• Younger participants invest more in equities, older participants in fixed-income securities

Calculate 401(k) return: Employee contributes 10% of $75,000 salary, company matches 40% of first 6% of salary, employee in 31% tax bracket, 8% expected return. What is the employee's one-year return?

• Employee gross contribution: $7,500

• Tax savings: $2,325

• Employee net contribution: $5,175

• Employer contribution: $1,800

• Total investment: $9,300

• One-year earnings (8%): $744

• Year-end value: $10,044 One-year return: ($10,044 - $5,175)/$5,175 = 94.09%

In the previous example, what would the 401(k) be worth after 20 years with same conditions?

$9,300 × [(1.08²⁰ - 1)/0.08] = $425,586

How does asset allocation differ by age in DC plans?

• Younger participants (20s-40s): Invest mainly in equities (76.7% - 84.3% in equities)

• Older participants (50s-60s): More in fixed income and GIC funds (56.2% - 66.2% in equities)

What is a Guaranteed Investment Contract (GIC)?

A long-term liability issued by insurance companies that guarantees not only a rate of interest over a given period but also the annuity rate on a beneficiary's contract.

What are target date funds?

Funds that rebalance their portfolios to become less focused on growth (equities) and more focused on income (bonds) as the fund approaches the target date.

How has the private pension fund market shifted between DB and DC plans?

• DB plans decreased from more than 100,000 in 1990 to fewer than 50,000 in 2020

• DC plans increased from approximately 600,000 to over 700,000 in the same period

• As of 2020, more than 90% of private pension plans are DC plans

Why have employers shifted from DB to DC plans?

DC funds do not require the employer to guarantee retirement benefits, shifting investment risk to employees.

What massive shift in risk resulted from the DB to DC transition?

A massive shift in the risk of retirement benefits from employers to employees. In DB plans, employees don't bear risk of low returns or outliving income. In DC plans, investment risk is assumed by each employee.

What potential consequences face employees with DC plans who experience poor returns?

May need to postpone retirement, work longer than planned, take second jobs, or downsize lifestyle.

How have private pension plans shifted their equity holdings?

Shifted assets out of direct ownership of equities into mutual funds. However, pension funds remain the largest institutional investor in the US stock market.

What percentage of pension fund assets were in equities in 2021 vs 1975?

72.05% in 2021 compared to 44.61% in 1975

How do DB and DC funds differ in government securities holdings (2021)?

• DB funds: 30.95% in US government securities and corporate/foreign bonds

• DC funds: 5.23% in same categories

How do DB and DC funds differ in corporate equities holdings (2021)?

• DB funds: 41.93% in corporate equities

• DC funds: 26.49% in corporate equities

What percentage of 401(k) assets are in mutual funds?

Approximately 62% of 401(k) plan assets are invested in mutual funds (as of 2021).

What are public pension funds?

Pension funds sponsored by federal, state, or local governments (e.g., Social Security in US, State Pension in UK).

How are most public pension funds structured?

They are typically unfunded (pay-as-you-go plans) where there are no reserves held to back future liabilities. Current inflows are used to meet current payment requirements.

What problem affects many public pension funds?

Underfunding due to an increasing number of retirees relative to workers.

What were the only three US states able to cover their pension liabilities in fiscal year 2017?

South Dakota, Tennessee, and Wisconsin

What measures can governments use to tackle pension underfunding?

• Increase taxation

• Raise the retirement age

• Tax more of the pension benefit payments

• Cut benefits

What are the main areas of pension fund regulation?

• Pension plan funding

• Vesting of benefits

• Fiduciary responsibilities

• Pension fund transferability

• Pension fund insurance

What is required regarding pension plan funding?

• Guidelines for funding and penalties for deficiencies

• Contributions must be sufficient to meet all annual costs and expenses

• Unfunded historical liabilities or new underfunding must be funded over a certain period

What is vesting?

How long until an employee owns any employer contributions to the employee's pension plan. A vested employee is eligible to receive pension benefits because they have worked for a stated period of time.

What is a pension plan fiduciary?

A trustee or investment advisor charged with management of the pension fund.

What is the prudent-person rule?

Regulations require that pension fund contributions be invested with the same diligence, skill, and care as a "prudent person" in like circumstances.

What is the sole objective requirement for pension fund management?

Fund assets are required to be managed with the sole objective of providing the promised benefits to participants.

What is pension fund transferability?

Allowing employees to transfer pension credits from one employer to another when switching jobs.

What is pension fund insurance?

An insurance fund for pension fund participants similar to the FDIC (protects participants if their pension fund fails).

How do pension systems vary in Europe?

• UK, Netherlands, Ireland, Denmark, Switzerland: tradition of state/public-funded schemes

• Spain, Portugal, Italy: less developed systems

• France: uses pay-as-you-go system

How can pension systems be distinguished across countries?

By the extent to which a person's contributions are linked to the benefits they receive in retirement.

Where is the link between contributions and benefits weak vs strong?

• Weak link: France and Germany

• Strong link: Sweden, Italy, UK, and Chile

What reforms have occurred in pension systems globally?

• Benefit reductions

• Measures to encourage later retirement

• Expansions of private funding for government pensions

What is a pension plan?

The document that governs the operations of a pension fund.

What does it mean for a pension to be tax-deferred?

Taxes on contributions and earnings are not paid until withdrawal (during retirement), allowing investments to grow tax-free during accumulation years.

What are the three types of defined contribution plan types shown in the data?

• 401(k) plans (largest, ~71% of DC assets in 2021)

• 403(b) plans (~17% of DC assets)

• Other plans (~12% of DC assets)

What is meant by "pension fund assets held in mutual funds"?

Rather than directly purchasing stocks and bonds, pension funds invest in mutual fund shares that hold diversified portfolios. This percentage has grown from 33% in 1996 to 62% in 2021 for 401(k) plans.

Why might a young employee prefer a DC plan over a DB plan?

Younger employees may prefer DC plans because:

• Greater portability when changing jobs

• Potential for higher returns through equity investments

• More control over investment decisions

• Benefit from longer time horizon for compound growth

Why might an older employee prefer a DB plan over a DC plan?

Older employees may prefer DB plans because:

• Guaranteed retirement income (no investment risk)

• Protection from market downturns near retirement

• No risk of outliving retirement income

• Typically higher benefits for long-service employees (especially final pay formulas)

What happens to a DC plan participant who retires during a market crash?

Their retirement account value could be substantially reduced, potentially forcing them to:

• Delay retirement

• Accept a lower standard of living

• Continue working longer than planned

• Take a second job

• Deplete savings faster than anticipated

How does inflation affect different DB formulas?

• Final pay formula: Best protection (based on end-of-career salary reflecting current inflation)

• Career average formula: Moderate protection (averages across all years)

• Flat benefit formula: Worst protection (fixed dollar amount per year of service)

Why are many public pension funds underfunded?

• Increasing number of retirees relative to workers (demographic shift)

• Pay-as-you-go structure (no reserves built up)

• Longer life expectancies

• Lower birth rates (fewer workers contributing)

• Potential investment underperformance

What was the total value of private pension fund assets in 2021?

13,314.5 billion ($13.3 trillion)

How did corporate equities holdings change from 1975 to 2021?

Increased from $108.0 billion (43.48%) in 1975 to $4,093.3 billion (30.74%) in 2021

How did mutual fund holdings change from 1975 to 2021?

Increased from $2.8 billion (1.13%) in 1975 to $5,500.5 billion (41.31%) in 2021

What percentage of total assets do DB funds hold in mutual funds vs corporate equities?

• Mutual funds: 11.84%

• Corporate equities: 41.93%

What percentage of total assets do DC funds hold in mutual funds vs corporate equities?

• Mutual funds: 52.51%

• Corporate equities: 26.49%

An employee earning $100,000 contributes 8% to a 401(k). The employer matches 50% of the first 5% of salary. Employee is in 28% tax bracket. Calculate the total year-start investment.

1. Employee contribution: $100,000 × 0.08 = $8,000

2. Employer match on first 5%: $100,000 × 0.05 × 0.50 = $2,500

3. Total year-start investment: $8,000 + $2,500 = $10,500

Using the scenario in Q71, if the fund earns 7% for the year, what is the employee's return on their net contribution?

1. Tax savings: $8,000 × 0.28 = $2,240

2. Net employee contribution: $8,000 - $2,240 = $5,760

3. Year-end value: $10,500 × 1.07 = $11,235

4. Employee return: ($11,235 - $5,760)/$5,760 = 95.05%

Calculate the annual benefit for an employee with 25 years of service using a career average formula with $55,000 average salary and 3.5% benefit rate.

$55,000 × 0.035 × 25 = $48,125 annual retirement benefit

An employee has worked 15 years, earns $80,000, and the average of their last 5 years' salary is $75,000. Using a final pay formula of 2% per year of service, calculate their annual retirement benefit.

$75,000 × 0.02 × 15 = $22,500 annual retirement benefit

A flat benefit formula pays $1,500 per year of service. Compare retirement benefits for retiring now (20 years) vs. in 8 years (28 years).

• Now: $1,500 × 20 = $30,000

• In 8 years: $1,500 × 28 = $42,000

• Difference: $12,000 annual benefit increase

Why has there been a shift from DB to DC plans?

• Employer perspective: Reduces financial risk and long-term liabilities

• Cost: DB plans more expensive to maintain (especially final pay formulas)

• Risk transfer: Shifts investment risk to employees

• Regulatory: Less complex compliance requirements for DC plans

• Workforce mobility: DC plans more portable for modern workforce

What are the societal implications of the shift from DB to DC plans?

• Increased retirement income inequality (based on investment success)

• Potential for inadequate retirement savings

• Employees may work longer before retiring

• Greater financial literacy burden on employees

• Reduced retirement security for average workers

• Potential increased demand on social safety nets

How do target date funds address the risk profile needs of DC participants?

They automatically rebalance from growth-focused (equities) to income-focused (bonds) as the target retirement date approaches, matching the typical risk tolerance decline with age without requiring active participant management.

What advantages does the final pay formula have for employees despite being more costly for employers?

• Inflation protection (based on career-end salary)

• Rewards loyalty (benefits long-service employees most)

• Typically produces highest retirement benefits

• Reflects peak earning years

• Often includes recent salary increases

Why might pension funds invest heavily in mutual funds rather than directly in securities?

• Professional management

• Instant diversification

• Reduced transaction costs

• Simplified administration

• Access to specialized strategies

• Easier rebalancing

• Better for smaller pension funds