In performing the financial intermediation function of asset transformation, pension funds provide the public with another kind of protection: regular income payments during retirement. Employers, unions, or private individuals can set up pension plans, which acquire funds through contributions paid in by the plan's participants. As we can see in Table 1, pension plans both public and private have grown in importance, with their share of total financial intermediary assets rising from 13% at the end of 1970 to 23.6% at the end of 2005. Federal tax policy has been a major factor behind the rapid growth of pension funds because employer contributions to employee pension plans are tax-deductible. Furthermore, tax policy has also encouraged employee contributions to pension funds by making them tax-deductible as well and enabling self-employed individuals to open up their own tax-sheltered pension plans, Keogh plans, and individual retirement accounts (IRAs).

Because the benefits paid out of the pension fund each year are highly predictable, pension funds invest in long-term securities, with the bulk of their asset holdings in bonds, stocks, and long-term mortgages. The key management issues for pension funds revolve around asset management: Pension fund managers try to hold assets with high expected returns and reduce risk through diversification. They also use techniques we discussed in Chapter 9 to manage credit and interest-rate risk. The investment strategies of pension plans have changed radically over time. In the aftermath of World War II, most pension fund assets were held in government bonds, with less than 1% held in stock. However, the strong performance of stocks in the 1950s and 1960s afforded pension plans higher returns, causing them to shift their portfolios into stocks, which currently account for approximately two-thirds of their assets. As a result, pension plans now have a much stronger presence in the stock market: In the early 1950s, they held on the order of 1% of corporate stock outstanding; currently they hold on the order of 19%. Pension funds, along with mutual funds, are now the dominant players in the stock market.

Although the purpose of all pension plans is the same, they can differ in a number of attributes. First is the method by which payments are made: If the benefits are determined by the contributions into the plan and their earnings, the pension is a defined-contribution plan; if future income payments (benefits) are set in advance, the pension is a defined-benefit plan. In the case of a defined-benefit plan, a further attribute is related to how the plan is funded. A defined-benefit plan is fully funded if the contributions into the plan and their earnings over the years are sufficient to pay out the defined benefits when they come due. If the contributions and earnings are not sufficient, the plan is underfunded. For example, if Jane Brown contributes $100 per year into her pension plan and the interest rate is 10%, after ten years the contributions and their earnings would be worth $1,753.2 If the defined benefit on her pension plan pays her $1,753 or less after ten years, the plan is fully funded because her contributions and earnings will fully pay for this payment. But if the defined benefit is $2,000, the plan is underfunded, because her contributions and earnings do not cover this amount.

A second characteristic of pension plans is their vesting, the length of time that a person must be enrolled in the pension plan (by being a member of a union or an employee of a company) before being entitled to receive benefits. Typically, firms require that an employee work five years for the company before being vested and qualifying to receive pension benefits; if the employee leaves the firm before the five years are up, either by quitting or being fired, all rights to benefits are lost.

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