Chapter Eighteen

Pension Funds

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Pension Funds
Pension
Pensionfunds
funds(PFs)
(PFs)offer
offersavings
savingsplans
plansthrough
throughwhich
which
participants
participantsaccumulate
accumulatetax
taxdeferred
deferredsavings
savingsduring
duringtheir
their
working
workingyears
yearsbefore
beforewithdrawing
withdrawingthem
themin
intheir
theirretirement
retirement
years
years
funds
fundsinvested
investedare
areexempt
exemptfrom
fromcurrent
currenttaxation
taxation(i.e.,
(i.e.,during
during
working
workingyears)
years)
tax
taxpayments
paymentsare
arenot
notmade
madeuntil
untilfunds
fundsare
arewithdrawn
withdrawnby
bythe
the
participant
participant(i.e.,
(i.e.,during
duringretirement)
retirement)

PFs
PFswere
werefirst
firstestablished
establishedin
inthe
theU.S.
U.S.in
in1759
1759to
tobenefit
benefitthe
the
widows
widowsand
andchildren
childrenof
ofchurch
churchministers
ministers
The
Thefirst
firstcorporate
corporatePF
PFwas
wasestablished
establishedby
byAmerican
American
Express
ExpressCo.
Co.in
in1875
1875
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Pension Funds
By
By1940
1940approximately
approximately400
400PFs
PFsexisted
existed

most
mostwere
werefor
foremployees
employeesininthe
therailroad,
railroad,banking,
banking,and
andpublic
public
utilities
utilitiesindustries
industries

By
By2007
2007over
over700,000
700,000PFs
PFsexisted
existed

28.3%
28.3%of
ofU.S.
U.S.households
householdsfinancial
financialassets
assetswere
wereininPFs
PFs
compares
comparestotojust
justover
over5%
5%inin1950
1950

There
Thereare
aretwo
twodistinct
distinctPF
PFsectors
sectors

private
privatePFs
PFsare
arefunds
fundsadministered
administeredby
byprivate
privatecorporations
corporations(e.g.,
(e.g.,
insurance
insurancecompanies
companiesor
ormutual
mutualfunds)
funds)
public
publicPFs
PFsare
arefunds
fundsadministered
administeredby
byfederal,
federal,state,
state,or
orlocal
local
governments
governments(e.g.,
(e.g.,Social
SocialSecurity)
Security)

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Pension Funds

AApension
pensionplan
plangoverns
governsthe
theoperation
operationof
ofaapension
pensionfund
fund
Pension
Pensionfunds
fundsare
arebroadly
broadlyclassified
classifiedinto
intotwo
twocategories,
categories,
defined
definedbenefit
benefitplans
plansand
anddefined
definedcontribution
contributionplans
plans
AAdefined
definedbenefit
benefitPF
PFififaafund
fundin
inwhich
whichthe
theemployer
employeragrees
agreesto
to
provide
providethe
theemployee
employeewith
withaaspecific
specificcash
cashbenefit
benefitupon
upon
retirement
retirement

aaflat
flatbenefit
benefitformula
formulaPF
PFpays
paysaaflat
flatamount
amountfor
forevery
everyyear
yearof
of
employment
employment
aacareer
careeraverage
averageformula
formulaPF
PFpays
paysbenefits
benefitsbased
basedon
onthe
theemployees
employees
average
averagesalary
salaryover
overthe
theentire
entireperiod
periodof
ofemployment
employment
aafinal
finalpay
payformula
formulaPF
PFpays
paysbenefits
benefitsbased
basedon
onaapercentage
percentageof
ofthe
the
average
averagesalary
salaryduring
duringaaspecified
specifiednumber
numberof
ofyears
yearsatatthe
theend
endof
ofthe
the
employees
career
times
the
number
of
years
of
service
employees career times the number of years of service

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Pension Funds
Defined
Definedbenefit
benefitPFs
PFs(cont.)
(cont.)

aafully
fullyfunded
fundedPF
PFhas
hassufficient
sufficientfunds
fundsavailable
availabletotomeet
meetall
allfuture
future
payment
paymentobligations
obligations
an
anunderfunded
underfundedPF
PFdoes
doesnot
nothave
havesufficient
sufficientfunds
fundsavailable
availabletotomeet
meet
all
allfuture
futurepromised
promisedpayments
payments
an
anoverfunded
overfundedPF
PFhas
hasmore
morethan
thanenough
enoughfunds
fundsavailable
availabletotomeet
meetthe
the
required
future
payouts
required future payouts

AAdefined
definedcontribution
contributionPF
PFisisaafund
fundin
inwhich
whichthe
theemployer
employer
agrees
agreesto
tomake
makeaaspecified
specifiedcontribution
contributionto
tothe
thepension
pensionfund
fund
during
duringthe
theemployees
employeesworking
workingyears
years

fixed-income
fixed-incomefunds
fundsoffer
offeraaguaranteed
guaranteedrate
rateof
ofreturn
return
with
withvariable-income
variable-incomefunds,
funds,all
allprofits
profitsand
andlosses
losseson
onthe
theunderlying
underlying
securities
securitiesare
arepassed
passedthrough
throughtotothe
thefund
fundparticipants
participants

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Pension Funds
Pension
Pensionfunds
fundsmay
maybe
beeither
eitherinsured
insuredor
ornoninsured
noninsured

an
aninsured
insuredpension
pensionfund
fundisisaaPF
PFadministered
administeredby
byaalife
lifeinsurance
insurance
company
company
aanoninsured
noninsuredpension
pensionfund
fundisisaaPF
PFadministered
administeredby
byaafinancial
financial
institution
institutionother
otherthan
thanaalife
lifeinsurance
insurancecompany
company

Private
Privatepension
pensionfunds
fundsare
arecreated
createdby
byprivate
privateentities
entitiesand
and
administered
administeredby
byprivate
privatecorporations
corporations
$8.4
$8.4trillion
trillioninintotal
totalfinancial
financialassets
assetsinin2007
2007

McGraw-Hill/Irwin

insurance
insurancecompanies
companiesadminister
administer$2.5
$2.5trillion
trillion
mutual
mutualfunds
fundsadminister
administer$1.6
$1.6trillion
trillion
other
otherfinancial
financialinstitutions
institutions(e.g.,
(e.g.,banks)
banks)administer
administer$4.3
$4.3trillion
trillion

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Private Pension Funds

401(k)
401(k)and
and403(b)
403(b)plans
plansare
areemployer-sponsored
employer-sponsoredplans
plans
that
thatsupplement
supplementaafirms
firmsbasic
basicretirement
retirementplan
plan

allow
allowfor
forboth
bothemployer
employerand
andemployee
employeecontributions
contributions
401(k)
401(k)plans
plansare
areoffered
offeredtotoemployees
employeesof
oftaxable
taxablefirms
firms
403(b)
403(b)plans
plansare
areoffered
offeredtotoemployees
employeesof
oftax
taxexempt
exemptemployers
employers
contributions
contributionsare
aremade
madeon
onaapretax
pretaxbasis
basis
most
mostplans
plansare
aretransferable
transferableififthe
theemployee
employeechanges
changesjobs
jobs
participants
participantsgenerally
generallymake
maketheir
theirown
ownchoice
choiceof
ofthe
theallocation
allocationof
of
assets
assetsfrom
fromboth
bothemployee
employeeand
andemployer
employercontributions
contributions
younger
youngerparticipants
participantsgenerally
generallyinvest
investmore
moreininequities
equitieswhile
whileolder
older
participants
participantsgenerally
generallyinvest
investmore
moreininfixed-income
fixed-incomesecurities
securities

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Private Pension Funds

Individual
Individualretirement
retirementaccounts
accounts(IRAs)
(IRAs)are
areself
selfdirected
directed
retirement
retirementaccounts
accountsset
setup
upby
byemployees
employeeswho
whomay
mayalso
alsobe
be
covered
coveredby
byemployer-sponsored
employer-sponsoredpension
pensionplans
plans

contributions
contributionsare
aremade
madestrictly
strictlyby
bythe
theemployee
employee
first
firstintroduced
introducedinin1981
1981totosupplement
supplementemployer-sponsored
employer-sponsoredprograms
programs
as
asof
of2007
2007maximum
maximumcontributions
contributionsare
are$5,000
$5,000per
peryear
year

Roth
RothIRAs
IRAswere
wereintroduced
introducedin
in1998
1998

inin2008
2008they
theyallow
allowaamaximum
maximumof
of$5,000
$5,000yearly
yearlycontribution
contributionper
per
individual
individual
contributions
contributionsare
aretaxed
taxedininthe
theyear
yearof
ofcontributions,
contributions,while
while
withdrawals
are
tax-free
as
long
as
they
have
been
invested
withdrawals are tax-free as long as they have been investedatatleast
least
five
years
and
the
account
holder
is
at
least
59

years
old
five years and the account holder is at least 59 years old
only
onlyavailable
availabletotoindividuals
individualswith
withincome
incomeless
lessthan
than$116,000
$116,000per
peryear
year
(or
households
less
than
$169,000)
(or households less than $169,000)

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McGraw-Hill/Irwin

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Public Pension Funds

State
Stateor
orlocal
localgovernment
governmentpension
pensionfunds
funds

pay
payas
asyou
yougo
goininthat
thatcurrent
currentemployee
employeecontributions
contributionsfund
fund
current
currentretiree
retireebenefits
benefits
because
becauseof
ofan
anincreasing
increasingnumber
numberof
ofretirees
retireesrelative
relativetotoworkers,
workers,
some
somefunds
fundscurrent
currentpayments
paymentsexceed
exceedcurrent
currentcontributions
contributions

Federal
Federalgovernment
governmentpension
pensionfunds
funds

civil
civilservice
servicefunds
fundscover
coverall
allfederal
federalemployees
employeesnot
notininthe
thearmed
armed
forces
forces
such
suchemployees
employeesare
arenot
notcovered
coveredby
bySocial
SocialSecurity
Security

aamilitary
militarypensions
pensionsfund
fundcovers
coverscareer
careermilitary
militarypersonnel
personnel

McGraw-Hill/Irwin

military
militarypersonnel
personnelare
arealso
alsocovered
coveredby
bySocial
SocialSecurity
Security
military
militarypersonnel
personnelare
areeligible
eligibleafter
after20
20years
yearsofofmilitary
militaryservice
service

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Public Pension Funds

Social
SocialSecurity,
Security,aka
akaOld
OldAge
Ageand
andSurvivors
SurvivorsInsurance
InsuranceFund
Fund
provides
providesbenefits
benefitstotoalmost
almostall
allemployees
employeesand
andself-employed
self-employed
individuals
individualsininthe
theU.S.
U.S.
established
establishedinin1935
1935totoprovide
provideaaminimum
minimumlevel
levelof
ofretirement
retirementincome
income
totoall
allretirees
retirees
funded
fundedon
onaapay
payas
asyou
yougo
gobasis
basis
historically,
historically,contributions
contributionshave
haveexceeded
exceededdisbursements
disbursements

FICA
FICAcontributions
contributionsare
are7.65%
7.65%of
ofthe
thefirst
first$102,000
$102,000earned
earnedinin2008
2008
(which
(whichisisalso
alsomatched
matchedby
byan
anemployer
employercontribution
contributionof
of7.65%)
7.65%)
self
selfemployed
employedindividuals
individualspay
paythe
thefull
full15.30%
15.30%

disbursements
disbursementsare
areexpected
expectedtotoexceed
exceedcontributions
contributionsby
by2018
2018
system
systemisisexpected
expectedtotobe
bebankrupt
bankruptby
by2042
2042

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Public Pension Funds

State
Stateand
andlocal
localPFs
PFs

equities
equitiesand
andequity
equityMFs
MFsrepresent
represent73.59%
73.59%of
oftotal
totalassets
assetsinin2007
2007
compares
comparestoto23.32%
23.32%inin1975
1975

U.S.
U.S.government
governmentsecurities
securitiesand
andbonds
bondsrepresent
represent22.42%
22.42%of
ofassets
assets
held
in
2007
held in 2007
compares
comparestoto66.03%
66.03%inin1975
1975

Social
SocialSecurity
Security

contributions
contributionsare
areinvested
investedininrelatively
relativelylow
lowrisk
riskand
andlow-return
low-return
U.S.
U.S.Treasury
Treasurysecurities
securities
coupled
coupledwith
withslow
slowpopulation
populationgrowth
growthand
andan
anincreasing
increasingretirement
retirement
population,
population,the
thelong-term
long-termviability
viabilityof
ofSocial
SocialSecurity
Securityisisinin
question
question

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Public Pension Funds

Social
SocialSecurity
Securitywas
wasrestructured
restructuredin
inthe
themid
mid1990s
1990s

required
requiredcontributions
contributionswere
wereincreased
increased
benefits
benefitswere
weredecreased
decreased

full
fullretirement
retirementage
ageisisnow
now65
65
full
fullretirement
retirementage
agewill
willbe
beincreased
increasedtoto67
67ininphases
phases
dollar
dollaramount
amountofofincome
incomesubject
subjecttotoFICA
FICAincreases
increasesevery
everyyear
year

Future
Futurechanges
changesto
toSocial
SocialSecurity
Securityare
areslow
slowto
tooccur
occur

increasing
increasingcontributions
contributionsand
anddecreasing
decreasingbenefits
benefitsare
areunpopular
unpopular
with
withthe
thepublic
publicand
andare
arethus
thusunpopular
unpopularwith
withpoliticians
politiciansseeking
seeking
election
electionor
orre-election
re-election
the
thewar
waron
onterrorism
terrorismand
andan
aneconomic
economicdownturn
downturnininthe
theU.S.
U.S.have
have
shifted
shiftedthe
thenational
nationalspotlight
spotlightaway
awayfrom
fromSocial
SocialSecurity
Security

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Pension Fund Regulation

The
The Employee
Employee Retirement
Retirement Income
Income Security
SecurityAct
Act
(ERISA)
(ERISA) of
of 1974
1974 focused
focused on
on five
five areas
areas of
ofreform
reform
pension
pensionplan
planfunding
funding
vesting
vestingof
ofbenefits
benefits
fiduciary
fiduciaryresponsibilities
responsibilitiesof
offund
fundadministrators
administrators
pension
pensionfund
fundtransferability
transferability
pension
pensionfund
fundinsurance
insurance

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Pension Fund Regulation

Funding
Funding

prior
priortotoERISA,
ERISA,regulation
regulationdid
didnot
notrequire
requirePFs
PFstotobe
beadequately
adequately
funded
funded
ERISA
ERISAestablished
establishedguidelines
guidelinesfor
forfunding
fundingand
andset
setpenalties
penaltiesfor
for
fund
funddeficiencies
deficiencies
contributions
contributionsmust
mustbe
besufficient
sufficienttotomeet
meetall
allannual
annualcosts
costsand
and
expenses
expenses
PFs
PFsmust
mustfund
fundany
anyunfunded
unfundedhistorical
historicalliabilities
liabilitiesover
overaa30-year
30-year
period
period
any
anynew
newunderfunding
underfundingmust
mustbe
befunded
fundedover
overaa15-year
15-yearperiod
period
has
hasled
ledmany
manydefined
definedbenefit
benefitplans
planstotoswitch
switchover
overtotoaadefined
defined
contribution
contributionstructure
structure

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Pension Fund Regulation

Vesting
Vestingof
ofbenefits
benefits

aavested
vestedemployee
employeeisisan
anemployee
employeewho
whoisiseligible
eligibletotoreceive
receivepension
pension
benefits
benefitsbecause
becausehe
heor
orshe
shehas
hasworked
workedfor
foraastated
statedperiod
periodof
oftime
time
prior
priortotoERISA
ERISAvesting
vestingcould
couldtake
takeup
uptoto25
25years
years
ERISA
ERISAset
setthe
themaximum
maximumvesting
vestingperiod
periodatat10
10years
years

Fiduciary
Fiduciaryresponsibility
responsibility

aaPF
PFfiduciary
fiduciaryisisaatrustee
trusteeor
orinvestment
investmentadvisor
advisorthat
thatmanages
managesaaPF
PF
ERISA
ERISArequires
requiresthat
thatPF
PFcontributions
contributionsbe
beinvested
investedwith
withthe
thesame
same
diligence,
diligence,skill,
skill,and
andcare
careas
asaaprudent
prudentperson
person
the
thesole
soleobjective
objectiveof
ofPF
PFmanagement
managementisistotoprovide
providethe
thepromised
promised
benefits
benefitstotothe
theplan
planparticipants
participants

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2009, The McGraw-Hill Companies, All Rights

Pension Fund Regulation

Transferability
Transferability

ERISA
ERISAallows
allowsemployees
employeestototransfer
transferpension
pensioncredits
creditsfrom
fromone
one
employer
employertotoanother
anotherwhen
whenswitching
switchingjobs
jobs

Insurance
Insurance

ERISA
ERISAestablished
establishedthe
thePension
PensionBenefit
BenefitGuarantee
GuaranteeCorporation
Corporation
(PBGC)
(PBGC)
PBGC
PBGCinsures
insuresparticipants
participantsof
ofdefined
definedbenefit
benefitpension
pensionplans
plans
employers
employerspaid
paid$1
$1ininpremiums
premiumsper
peremployee
employeewhen
whenPBGC
PBGCwas
was
created
createdinin1974
1974
premium
premiumraised
raisedtoto$2.60
$2.60per
peremployee
employeeinin1979
1979
premium
premiumraised
raisedtoto$8.50
$8.50per
peremployee
employeeinin1987
1987along
alongwith
withthe
the
addition
additionof
ofaavariable-rate
variable-ratepremium
premiumof
ofup
uptoto$50
$50per
peremployee
employeefor
for
employers
employerswith
withunderfunded
underfundedplans
plans

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Pension Fund Regulation

Insurance
Insurance(cont.)
(cont.)

by
by1991
1991Congress
Congresshad
hadraised
raisedthe
thepremiums
premiumstotoup
uptoto$72
$72per
per
employee
employeefor
forfirms
firmswith
withunderfunded
underfundedplans
plansand
and$19
$19per
peremployee
employee
for
forfull
fullfunded
fundedplans
plans
even
evenso,
so,ERISA
ERISAhas
hasgenerally
generallyoperated
operatedatataadeficit
deficit
the
theRetirement
RetirementProtection
ProtectionAct
Actof
of1994
1994attempted
attemptedtotostrengthen
strengthen
the
thePBGC
PBGC

the
the$72
$72premium
premiumcap
capwas
wasphased
phasedout
outas
asapproximately
approximately80%
80%of
of
underfunded
plans
paid
the
maximum
underfunded plans paid the maximum

by
by2000
2000the
thePBGC
PBGCoperated
operatedatataarecord
recordsurplus
surplusof
of$9.7
$9.7billion
billion
however,
however,large
largebankruptcies
bankruptciesininthe
theearly
early2000s
2000sresulted
resultedininthe
the
agency
agencyposting
postingaa$23.3
$23.3billion
billiondeficit
deficitand
andaacall
callfor
foradditional
additional
reform
reforminin2005
2005

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Pension Fund Regulation

The
ThePension
PensionProtection
ProtectionAct
Actof
of2006
2006
increased
increasedannual
annualpremiums
premiumsfrom
from$19
$19to
to$30
$30per
peremployee
employee
for
forfully
fullyfunded
fundedfirms
firms
implemented
implementedautomatic
automaticpremium
premiumincreases
increasesevery
everyyear
year
thereafter
thereafter
underfunded
underfundedplans
plansnow
nowpay
pay$9
$9per
per$1,000
$1,000of
ofunderfunding
underfunding
gives
givescompanies
companiesonly
only55years
yearsto
tomake
makeup
upshortfalls
shortfallsin
intheir
their
defined
definedbenefit
benefitpension
pensionplans
plans
requires
requirescompanies
companiesto
totell
tellinvestors
investorsand
andemployees
employeeswell
well
before
beforeplans
plansbecome
becomesignificantly
significantlyunderfunded
underfunded

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Global Issues
Pension
Pensionsystems
systemsvary
varywidely
widelyin
inEurope
Europe

the
theU.K.,
U.K.,the
theNetherlands,
Netherlands,Ireland,
Ireland,Denmark,
Denmark,and
andSwitzerland
Switzerlandall
all
have
haveaatradition
traditionof
ofstatestate-(or
(orpublic-)
public-)funded
fundedpension
pensionschemes
schemes
Spain,
Spain,Portugal,
Portugal,and
andItaly
Italyhave
haveless
lessdeveloped
developedpension
pensionsystems
systems
France
Franceuses
usesaapay-as-you-go
pay-as-you-gosystem
system
the
thelink
linkbetween
betweencontributions
contributionsand
andbenefits
benefitsisisweak
weakininFrance
Franceand
and
Germany,
Germany,but
butstrong
strongininSweden,
Sweden,Italy,
Italy,the
theU.K.,
U.K.,and
andChile
Chile

Reform
Reformaround
aroundthe
theglobe
globehas
hasincluded
includedbenefit
benefitreduction,
reduction,
measures
measuresto
toencourage
encouragelater
laterretirement,
retirement,and
andexpansions
expansionsof
of
private
privatefunding
fundingfor
forgovernment
governmentpensions
pensions
The
Theprimarily
primarilyprivate
privatestate
statepension
pensionsystem
systemof
ofChile
Chilehas
hasbeen
been
copied
copiedby
byatatleast
leastthirteen
thirteenother
otherLatin
LatinAmerican
Americancountries
countries
McGraw-Hill/Irwin

18-20

2009, The McGraw-Hill Companies, All Rights