Chapter 18 - Pension Funds 6th Edition

Chapter Eighteen
Pension Funds

I. Chapter Outline
1. Pension Funds Defined: Chapter Overview
2. Size, Structure and Composition of the Industry
a. Defined Benefit Versus Defined Contribution Pension Funds
b. Insured Versus Noninsured Pension Funds
c. Private Pension Funds
d. Public Pension Funds
3. Financial Asset Investments and Recent Trends
a. Private Pension Funds
b. Public Pension Funds
4. Regulation of Pension Funds
5. Global Issues
Appendix 18A: Calculation of Growth in IRA Value During an Individual’s Working
Years, available on Connect or from your McGraw-Hill representative

II. Learning Goals

1. Describe the difference between a private pension fund and a public pension fund
2. Distinguish between and calculate the benefits from a defined benefit and a defined
contribution pension fund
3. Identify the characteristics and calculate the benefits from the different types of
private pension funds
4. Identify the different types of public pension funds
5. Examine the main regulations governing pension funds
6. Review the major issues for pension funds in the global markets

III. Chapter in Perspective

Pension funds allow people to transfer wealth through time while avoiding taxation on
their investment earnings during their working years. The primary purpose of pensions is
to provide retirement income for individuals. Traditionally most pension funds have paid
set benefits to retirees based on their wage during their tenure with the company and
years of service. Today more and more individuals are covered by plans that do not pay a
set amount at retirement, rather their retirement benefits will normally be an annuitized
payment based on the terminal value of their wealth in the plan. The value of their plan
holdings depends upon the amounts paid in and the earnings on the funds invested.

IV. Key Concepts and Definitions to Communicate to Students

Private pension funds Defined benefit pension plan

Public pension funds Defined contribution plan

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Pension plan Flat benefit formula

Insured pension plan Career-average formula

Noninsured pension plan Final-pay formula

Social Security reform Fully funded

403(b) 401(k)

Roth IRA IRA

ERISA Vesting

Keogh plan PBGC

Qualified plan

V. Teaching Notes

1. Pension Funds Defined: Chapter Overview

Over 680,000 pension funds exist today. In 2013 U.S. households had about 34% of their
financial assets invested in pension funds. Private pension funds are administered by a
private corporation. Public pension funds are administered by either the federal
government or a municipality. Pension fund assets in 2013 were $18,736.60 billion, and
private pension funds comprised 56% of the total. The financial crisis reduced global
pension assets from $25 trillion to $20 trillion. U.S. retirement accounts fell by $2
trillion, causing many to postpone retirement and reduce spending to save more. At the
end of 2008 company sponsored pension plans were underfunded by $400 billion.

2. Size, Structure and Composition of the Industry

a. Defined Benefit Versus Defined Contribution Pension Funds
 Defined Benefit Plans
 Traditionally most plans have been defined benefit plans. In this type of plan the
sponsor agrees to pay employees a set (defined) benefit upon retirement according
to some formula that usually incorporates the employee’s working wages and/or
years of service. There are three types:
 Flat benefit: This type plan pays a flat amount for every year of employment.
For example, a retiree may receive $2,000 per year of service times the number of
years of service as an annual retirement benefit.

 Career-Average Formula:
 Flat percentage: Under this type plan the retiree receives a flat percentage of their
average salary over their entire work period.
 Percentage of average salary adjusted for number of years working: With this plan

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the retiree receives a given percentage of their average salary during their career
with the firm times the number of years employed. The percentage may or may
not increase with years of service.

 Final-Pay Formula: Under this formula the retiree receives a percentage of their
average salary during the last three to five years of working for the firm times the
number of years of service.

E.G.: An employee works 20 years for a firm. His average salary over his entire career
with the firm was $65,000. His average salary over the last five years was $75,000.
Annual retirement benefit for various defined benefit plans:
 Flat benefit of $2,000 per year worked: $2,000  20 years = $40,000
 Career average, flat percentage of 60% of average salary: $65,000  0.60 =
$39,000
 Career average, flat percentage amount of 4% of average salary adjusted by years of
service:
 $65,000  0.04  20 years = $52,000
 Final pay: A flat percentage amount of 4% of the last five years of salary adjusted for
years of service: $75,000  0.04  20 years = $60,000
The final pay formula usually results in the highest benefit. Some plans will take the
average of the five highest years of pay instead of the final pay. This variation generally
provides benefits similar to the final pay formula because pay rarely decreases with
seniority.

Defined benefit plans may be

 Overfunded or fully funded: The plan has assets greater than (overfunded) or equal
to (fully funded) the present value of expected future payouts.
 Underfunded: The plan has some assets held as a reserve against expected future
payouts but does not have an amount equal to the present value of expected future
liabilities. Social Security is underfunded.
 Unfunded: The plan has no assets held as a reserve against expected future
retirement benefits.
Pension plans are not required to be fully funded but there are minimum funding
requirements and penalties for excessive underfunding.

Teaching Tip: Changes in actuarial assumptions can improve the corporate plan
sponsor’s current earnings. For instance, if interest rates rise, pension fund contributions
(expenses) may be reduced because the corporate sponsor can now assume that the fund’s
assets will generate higher earnings growth. Ford Motor Co. reduced pension expenses
in 1981 and GM did the same in 1990 by assuming that the fund would earn higher
interest rates.

The plan sponsor bears the interest rate and price risk in a defined benefit plan because
the sponsor is liable for all promised pension fund payments, but the earnings rate on the
assets is not guaranteed.

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 Defined Contribution
A defined contribution plan shifts the risk of poor investment earnings onto the covered
employees. The employer does not guarantee or define the retirement benefit. If an
investor’s retirement occurs during a protracted recession, their retirement income could
be substantially reduced, particularly if their portfolio had significant equity exposure.

Teaching Tip: The SEC’s Savings and Investing Campaign (see www.sec.gov) indicates
that the majority of Americans are still not well informed about investment risk and
returns and are underinvested in stocks. A quick rule of thumb is that an individual
should invest (100 - their age) percent of their portfolio in stocks. Less well informed
individuals are usually uncomfortable with this level of risk.

In a defined contribution plan the plan sponsor (employer) typically pays a fixed amount
into an individual’s retirement plan, usually along with employee contributions. The
employee has some limited choice about where the funds are invested. The choices may
include a GIC and several mutual funds. Fixed income funds often guarantee a minimum
rate of return. Investors may seek higher returns in riskier investments, including
equities. Fundholders receive all investment profits (less management fees).

b. Insured Versus Noninsured Pension Funds

A pension plan governs the operations of the pension fund. Insured pension plans are
normally administered by life insurance firms and these plans constitute about 27% of
industry assets. Insured plans do not have segregated assets backing the plan. Pension
fund contributions are instead commingled with an insurer’s policy premiums and jointly
invested in securities. The amount owed to the pension fund is recorded as a liability
called pension fund reserves. The pension fund’s assets are thus owned by the
insurance company.

Noninsured pension plans are typically administered by a trust department of a financial

institution such as a bank or mutual fund that is appointed by the plan sponsor. The
assets of the noninsured fund are owned by the plan sponsor and are listed as separate
assets on the trustee’s balance sheet. In either case the plan sponsor sets the guidelines
for the plan such as the benefit formula or matching contributions, etc.

Noninsured pension funds tend to invest in riskier assets and earn higher rates of return
than insured pension funds. This occurs because the insurance firm is at risk of declining
values of pension fund assets, but the trustee making the investments of a noninsured
plan is not at risk from declining asset values because the assets belong to the sponsor.
Nevertheless, the prudent person rule (see below) constrains managers of both types of
funds to limit the riskiness of pension fund investments.

c. Private Pension Funds

In terms of number of plans and number of participants, defined contribution plans are
increasingly becoming the dominant form of private pension plans. Total assets in
defined contribution plans have generally exceeded total assets of defined benefit plans
since about 1996. Note that the shift from defined benefit to defined contribution plans

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shifts the risk of investment performance onto the employee. The financial crisis reduced
retirement investments in aggregate in the U.S. by $2 trillion. The losses forced many
Americans to postpone retirement and reduce current spending in order to save more. In
2013 total assets of private pension funds were $10,423.80 billion, about 27.1% of which
were administered by life insurers, 25% by mutual funds and the rest by other financial
institutions including banks.
Teaching Tip: Why one should not count on Social Security as the sole source of
retirement income:
 Social security AND a pension typically provide only a part of your pre-retirement
income.
 SS has only limited inflation protection.
 Working after retirement can reduce SS benefits.
 SS benefits can be taxed.
 Under current projections SS is underfunded and although it is unlikely, it could
conceivably go broke. (Nobody believed the S&L industry and the FSLIC would go
broke until the crisis occurred.)

Many people today will have the opportunity to invest in a 401(k) plan. These plans had
grown to $3,790 billion by 2013. There were more than 64,000 plans with over 20
million participants. 401(k) plans are employer sponsored retirement plans. 403(b) plans
are similar plans offered by tax exempt employers such as hospitals, university’s and
other educational institutions.

Teaching Tip: In a 401(k) the employee has some choices about how much to contribute
to their retirement plan and where it will be invested. Typically, the company
supplements your investment by contributing a fixed percentage of whatever the
employee pays in to the plan. The maximum employer contribution is currently 25% of
the employee’s salary or $16,500 per year, whichever is less. The maximum total
contribution is the lesser of $49,000 or 100% of compensation. The Economic Growth
and Tax Reconciliation Act of 2001 (EGTRRA) allows greater 401(k) contributions
through time. All contributions are TAX-DEDUCTIBLE, and all interest earned accrues
TAX FREE until withdrawal.1 The fixed dollar amount maximums are indexed to
inflation and increase each year. Current figures can be found at
www.retirementplanners.com. There are tax penalties for withdrawal of funds prior to
age 59 ½, although various exceptions exist. See below.

Teaching Tip: Refer to the defined benefit plan information above and find the level of
annual contribution to a 401(k) plan that would be needed to generate a retirement benefit
equal to the $60,000 per year retirement benefit of the final pay plan given the following
information:
The employer matches by paying 40% of the first 6% of the employee’s contributions.
(The employee could contribute more, but it would not be matched.)
The employee expects to earn 12% per year on all funds invested.

1
A new provision of the EGTRRA 2001 allows investors (effective 2006) to choose “Roth IRA” treatment
for their 401(k) contributions. These contributions will not be deductible, but withdrawals will not be
taxed. Certain conditions apply.

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The employee has 20 years of work remaining and will live 25 years after retirement.
Solution:
Step 1: Required PV at retirement age = = $470,588
Step 2: Required annual contribution to the plan:
; Total Contribution = $6,531
Assuming this amount is not more than 6%, the employer pays 40% of the employee’s
contribution. $6,531 = (0.40  employee contribution) + employee contribution, or the
employee’s required annual contribution is $4,665 and the employer contributes $1,866.

Note that the eroding effects of inflation on purchasing power have not been included in
this example. The $60,000 should be increased at the inflation rate over the working
period and the withdrawals should increase with inflation during the retirement period. It
is also reasonable to assume that contributions will rise over time as well.

The effect of the rate of return on employee’s required contribution:

If the plan earns only 9% the required annual employee’s contribution is $8,228. A
major equity component is often needed in retirement portfolios to get the required
contributions down to a reasonable level.

The effect of work time on employee’s required contribution:

If the plan earns 12% but the employee has only 15 years of work time remaining the
required annual employee’s contribution is $9,016. Encourage your students to begin
funding their retirement as soon as they graduate.

Individual retirement accounts (IRAs)

IRAs are investment vehicles designed to provide supplemental retirement income. The
maximum annual contribution in 2013 and 2014 to an IRA is $5,500 per year ($10,000
per household) subject to income limits in 2011.2 IRA contributions may be tax
deductible depending on the investor’s income and whether the individual has a
retirement plan at work. If the household has an adjusted gross income (AGI) of
$188,000 or less and neither spouse is covered by an employer plan then contributions
are at least partially tax deductible. As of 2013 there were over $5.7 trillion invested in
IRAs.

Teaching Tip: The following applies to IRAs, 401k and 403bs: Withdrawals before age
59½ may face a 10% tax penalty although many exceptions now exist; check current tax
law. The typical tax penalty for early withdrawal is a 10% surcharge tax plus all
withdrawals are taxed as ordinary income. Various hardship exceptions exist for medical
conditions, disability and in some cases even home purchases. To ensure taxes are paid,
in most cases 20% of the amount withdrawn must be withheld by the plan sponsor to

2
The EGTRRA 2001 allows for increases in IRA contributions through time The amount will be increased
by the cost of living increases and it will adjust in $500 increments. In addition this act allows people age
50 and over to make additional contributions up to $5,000 more in a 401(k) and $1,000 in an IRA
beginning in the year 2006. Details are available at www.retirementplanners.com or at www.irs.gov.

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ensure payment of taxes. Certain states, like Virginia, apply an additional 10%
withholding. Withdrawals must begin at or before age 70½ to avoid a tax penalty.
Withdrawals of deductible contributions and their earnings are taxable upon withdrawal.

A separate type of IRA, the Roth IRA, also exists. Contributions to the Roth IRA are not
tax deductible, but the withdrawals are generally not taxed. Investors who believe they
will be in a substantially lower tax bracket when they retire may find a Roth IRA to be
more beneficial. The $5,000 ($10,000 per household) annual contribution limit applies to
both types IRAs in total and Roth IRAs are available only to individuals with maximum
income of $129,000 or $191,000 per household. In both type IRAs excessive
contributions and their earnings face a stiff tax penalty. There are now Roth versions of
401(k) and 403(b) plans.

Teaching Tip: Why does the government decry the low savings rate in the U.S. and then
institute low maximum annual investment amounts in an IRA?

Simplified Employee Pensions (SEPs), formerly known as Keogh accounts, are for self-
employed individuals and corporations. Maximum contributions are the lesser of 25% of
your self-employment income, or $52,000, per year as of 2014. A money purchase plan
(or money sharing plan) requires fixed contributions be made by the employer each year.
A profit sharing plan allows the employer to vary the contributions year to year. Money
sharing plans allow for greater pension contributions and may be used when the employer
wants to shelter more income. Both are qualified plans.

Teaching Tip: The term qualified plan refers to whether or not the plan qualifies for full
tax benefits such as immediate employer tax deductions for plan contributions.
Unqualified plans have fewer regulations such as who must be covered and less stringent
vesting requirements, but they do not provide the same tax benefits to the employer.

d. Public Pension Funds

In 2013 public pension fund assets comprised about $8.31 trillion, about double the 2010
value.

State and local government pension funds are typically unfunded (pay as you go) where
there are no reserves held to back future liabilities. Current inflows are used to meet
current payment requirements. Many state and local plans may have a difficult time
meeting projected obligations in the years to come. In some states the plans have become
critically underfunded. Illinois and many other states have large funding deficits.
According to the Pew Trust, states were underfunded by as much as $1.38 trillion in
2010. Illinois is now facing reduced benefit increases, older retirement ages and caps on
salary in determining pension benefits. Over the 2000s the required payments needed by
states to fund their obligations more than doubled as they overpromised pension benefits
and as stock prices declined reducing the value of pension investments. In 2010 only
Wisconsin had fully funded its pension plan. Connecticut, Illinois, Kentucky and Rhode
Island had the worst levels of funding (under 55%). States had only about 5% of funds
needed to pay health care and other non-pension benefits obligations. Seventeen states

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had not set aside any money for health payments and only seven states had funded at least
25% of projected non-pension outlays. Data source, www.pewtrusts.org.

The federal government has a separate plan for federal government workers including
Congressmen and the military.3 The best known federal pension fund is the Old Age and
Survivors Insurance Fund or better known as simply “Social Security.” Social
Security (SS) was created in 1935 as a result of the Depression to provide subsistence
funds to retirees. The President at the time, Franklin Roosevelt, intended that the plan
would always be maintained on a fiscally sound basis. Social Security taxes (FICA on
your wage statement) are 7.65% of the first $115,500 earned, and employers also make
contributions to get the tax rate up to 15.30%. Self-employed individuals contribute
15.30%. In 2010 Social Security receipts were not sufficient to pay obligations for the
first time. The fund has sufficient IOUs from the Treasury to prevent bankruptcy until
the year 2033, although these projections vary with the economy.

Note: Data from the following is drawn from the sources listed at the end.
Teaching Tip: In 1960 there were 5 workers per retiree, there are currently slightly over 3
and in 2035 there are projected to be only 2 workers per retiree. In 2004 SS ran a $151
billion surplus but it is projected to begin running ever increasing deficits in 2018. The
surplus is invested in U.S. Treasury bonds which will mature when baby boomers retire
and should allow SS to pay currently promised benefits until 2033 depending on
estimates. The trust fund is currently about $1.5 trillion but is underfunded over the next
75 years by as much as $3.7 trillion. That is a large amount even to Congress. Moreover,
Medicare and Medicaid face substantially more serious funding problems. (See Article
#4)

An analysis of the numbers indicates that the longer we wait to fix the problem the
greater the burdens will be on taxpayers and/or retirees. Ignoring privatization for the
moment, the alternatives are to increase payroll taxes now, wait and increase taxes more
later, increase the amount of income on which payroll taxes are collected, raise the
retirement age, tax more SS payments, and/or cut benefits. If we raise payroll taxes now,
only a modest 15% increase from the current payroll tax level would be required. If we
wait however, payroll tax rates of 30% or more will be required.4 Other than cutting
benefits or raising taxes, several other proposals have been made to shore up the Social
Security fund, including raising the minimum age to collect full benefits, encouraging
workers to redirect some of their payroll taxes to private investments with associated
reductions in Social Security benefits, and changing how benefits are indexed to inflation.
It is likely that some combination of these changes will be implemented.

President Bush proposed partial privatization of the Social Security system. Various
ideas were considered, some would have allowed people to divert a part of their payroll
tax (usually 4%) to private accounts, other plans would require the full payroll tax be paid
into Social Security but would have allowed supplemental amounts to go to private

3
Probably a guaranteed method to ensure the continue viability of Social Security would be to include
Congressional pensions in Social Security!
4
This figure assumes that no other changes are made of course, data are drawn from Article #4)

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accounts. The President’s idea assumed benefits were likely to be cut, so the potentially
higher earnings on private accounts could be used to more than make up for losses from
the reduced SS benefits. It is important to understand however that privatization is a
separable issue from fixing the SS system. Bush argued that increasing ownership of
retirement accounts would encourage people to become more fully engaged in the
economic system. Presumably this would have provided people with incentives to work
harder and have a greater interest in how the economy performs, and of course encourage
them to manage their retirement on their own. Studies by the SEC show that too many
people do not invest enough for retirement and that people do not invest a sufficient
amount in equities although younger people now invest more in equities. From a macro
perspective, history is on Bush’s side in this argument; economies with greater levels of
ownership do tend to perform at higher levels over time. In a basic sense this is just the
old capitalism versus socialism argument in a different form.

Problems with privatization:

Privatization can be quite costly in the short run if the payroll tax were to be diverted to
private accounts. Also, given the diminishing marginal value of wealth coupled with the
fact that the poor are the least likely to take advantage of private accounts (and according
to the studies, may receive the least benefit from them) arguments can be made that
privatization adds risk to those who are least able to bear it and profit from it. In terms of
age, the figures I have seen indicate that privatization provides significant benefits for
those born in the 1990s or later. Those in this age group probably should be advised that
it is too risky for them to count on SS as their sole or main form of retirement income.

SS is currently progressive, i.e. the poorer benefit disproportionately more than the
wealthy. Moving to privatization reduces the opportunity to use SS in this way. In short,
those who believe the government should be heavily involved in income redistribution
will probably not like privatization because moving to private accounts and fostering the
idea of ownership begins to limit the flexibility of government to use SS for redistribution
purposes. Those who believe that they can do better on their own and that they should be
allowed to keep their money will tend to favor privatization (typically younger, better
educated people fit this category).

It is not clear as of this writing what form of adjustment will be made to ensure the
viability of the Social Security fund. What is clear is that the least palatable alternative is
to do nothing. Doing nothing raises the required tax levels to unacceptable amounts
and/or causes benefit cuts to be onerously large. If the government attempts to borrow
the necessary amounts to continue to fund current benefits, the pressure on the value of
the dollar will likely become enormous with debt owed to foreigners rising to
unprecedented levels. Already the U.S owes to foreigners an amount equal to about 25%
of its annual GDP. How large can this number get before painful macro adjustments
occur?

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3. Financial Asset Investments and Recent Trends

a. Private Pension Funds
Major assets include 2002 2004 2007 2010 2013
Corporate equities 45.75% 38.03% 47.27% 32.37% 30.89%
Mutual fund shares 15.88% 26.41% 27.75% 34.10% 35.98%
Treasury and agency securities 8.16% 7.49% 6.75% 11.12% 7.40%
Corporate and foreign bonds 8.05% 7.45% 5.22% 8.29% 5.97%

Over the period private pension plans have shifted assets out of direct ownership of
equities into mutual funds. Funds increased holdings of Treasuries and agencies in 2010
before reducing the percentage in 2013.

Pension funds are the largest institutional investor in the U.S. stock market. Growth in
pension fund assets has been phenomenal. The percentage invested in equities increased
during the strong bull markets of the 1990s, but had fallen from the 1999 level of 50.7%
in 2004 only to recover by 2007. The financial crisis led to a reduction in overall equity
investments that is still ongoing.

In 2013 defined benefit plans held 41.11% of their assets in equity and 15.92% in mutual
funds for a total of 57.03%. Defined contribution plans held 24.77% in equities and
47.96% in mutual funds for a total of 72.73%. Defined contribution plans directly held
less fixed income securities than defined benefit plans. The defined benefit plans appear
to be slightly more conservative than DC plans.

b. Public (State & Local) Pension Funds

Major assets include 2002 2004 2007 2010 2013
58.97 63.83
Corporate equities 55.99% 58.13% 64.03% % %
Treasury and agency 17.22 12.45
securities 17.82% 14.75% 14.45% % %
Corporate and foreign 11.40
bonds 15.72% 16.08% 7.91% % 8.55%

Investment in equities increased substantially before the financial crisis and has risen in
2013 after dipping in 2010. Note that public pension funds hold more fixed incomes than
private plans.

Social Security contributions are invested in Treasuries. The low rate of return on
Treasuries and the increasing age of the population are contributing factors to the
impending SS insolvency.

4. Regulation of Pension Funds

The Employee Retirement Income Security Act (ERISA) is a major piece of regulation
covering retirement funds. The Department of Labor enforces ERISA. The major
provisions include:
 Minimum funding requirements for private pension defined benefit plans.

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 Maximum time period (10 years) for vesting of employee benefits. Vesting refers to
the time period required until the employee ‘owns’ any employer contributions to the
employee’s pension plan.
 Establishment of the prudent man rule. This rule requires pension funds to invest the
money as if they were ‘prudent.’ Prudent was purposefully left undefined.
 Allowing employees to transfer pension benefits from one employer to another.
 Established the Pension Benefit Guarantee Corporation (PBGC or ‘Penny
Benny’) to insure benefits in defined benefit plans.

In 1994 the Retirement Protection Act increased premiums on underfunded plans. In

1999 PBGC came under fire for failing to notify beneficiaries of failed plans the full
amounts they were owed (some waited over 13 years!) and for poor internal control
procedures. PBGC charges premiums for insurance. In 2011 the rates were $35 per
participant for single employer plans and $9 per participant for multi-employer plans in a
fully funded plan. Underfunded plans pay an additional $9 per $1,000 of vested benefits.
Nevertheless PBGC has continued to generate operating losses.

The PBGC was responsible for pensions for over 1.5 million people. Workers in a failed
defined benefit plan may not receive full benefits because PBGC payouts are capped. In
2012 unfunded pension liabilities were an estimated $470 billion. Pension funds
continue to use unrealistically high expected rates of returns on investments so the actual
amount of underfunding is even greater. Nevertheless most of the companies with
pension liabilities are sound and can pay more to fund their pension liabilities if needed.
The PBGC does not have enough capital to withstand many large corporate failures with
underfunded plans. The PBGC’s loss exposure in 2012 was estimated at $295 billion.

The Pension Protection Act of 2006 increased premiums from $19 to $30 for funded
plans and instituted cost increases for underfunded plans tied to the amount the plans
were underfunded. These amounts are now higher at $49 in 2014 for single-employer
plans and $12 for multiple employer plans. Plans now have five years to reduce the
underfunding. Disclosure to employees about the extent of the deficit was also required.5

5. Global Issues
Pension plans vary across the European Union (EU). Most EU countries are working
toward establishing and improving private pension plans and reducing public pension
plans. Funding levels of plans vary from country to country, but there is general
agreement concerning the need to increase plan funding. The EU would like to
encourage standardization to encourage portability of pension benefits and free
movement of capital among member countries.

5
Britain created its own version of the PBGC called the Pension Protection Fund and it too is having
funding problems.

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In general one can classify European pension plans as to whether the link between the
amount paid in and the benefits received is weak or strong:

Link between payments & benefits

Weak Strong

UK, Sweden,
France Italy, Chile
Germany Italy
Chile
In countries with weak linkages such as France and Germany the benefits tend to be very
generous relative to amounts paid in. These plans are more costly, with average
expenditures on state pensions at over 10% and projected to rise to 14% by 2040 (U.S.
expenditure is 4.3% and Britain’s is 5.5%). Some of these plans are quite complex and
generous. Certain public workers in France can retire on full or near full benefits at age
55 for instance although in 2010 France’s parliament passed a bill to increase the
retirement age from 60 to 62. As part of the bailout plan organized by the IMF, Greece
had to agree to raise its retirement age from 65 to 67. Weeks of strikes in Greece, France
and Spain followed these and other modest reforms.

As noted before part of the pension problem in the U.S. arises from the aging of the
population. However, Europe is aging more rapidly than the U.S. Italy in particular will
have serious funding problems unless their demographics change. Japan is also aging
rapidly and will face growing funding problems in both retirement and health care.

Typical responses to the funding problems of public pensions are benefit reductions,
requirements or incentives to work longer, and privatization. Sweden, Britain,
Argentina, Australia and Chile have all added privatization elements to their public
pension plans with varied success, but generally speaking the plans have resulted in better
fiscal situations and reasonable returns to participants. There are lessons to be learned
from examining overseas pension plans (See Articles #1 and #3 for more details).
Generally speaking privatization can work but transition costs can be high, the options
should probably be kept simple, such as indexing or some limited choice of mutual funds,
and the government will have to work to keep costs down and prevent fraud.

The text refers to public pensions primarily but several European companies face large
unfunded pension liabilities as well. For instance according to Article #2 below,
Volkswagen, British Airways and Daimler-Chrysler have unfunded pension liabilities of
between 50% and 80% of market capitalization.

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Appendix 18A: Calculation of Growth in IRA Value During an Individual’s Working

Years (available in Connect or from your McGraw-Hill representative)

The appendix depicts the growth of an initial $10,000 in an IRA with an annual
contribution of $5,000 in a retirement account. The calculations show the amount of fund
contributions and earned interest.

Sources and for more information see the following:

1. “From Nations That Have Tried Similar Pensions, Some Lessons” By Bob Davis
and Matt Moffett Staff Reporters of The Wall Street Journal, February 3, 2005;
Page A.1
2. “European pension accounting: Painful,” From The Economist print edition, Nov
11th, 2004.
3. “Other countries' pension policies: Horror movies? Not really,” From The
Economist print edition, Feb 10th 2005
4. “The Basics of Social Security, Why It's at a Crossroads Now, And What It Might
Become,” By David Wessel, Staff Reporter of The Wall Street Journal,
February 1, 2005; Page B1
5. “Pension Agency's Gap Is Expected To Balloon to $71 Billion in Decade,” By
Michael Schroeder, Staff Reporter of The Wall Street Journal June 9, 2005;
Page A4

VI. Web Links

http://www.ssa.gov/ Social Security’s website

http://www.wsj.com/ Website of the Wall Street Journal Interactive edition. The

web version of the well known financial newspaper can be
personalized to meet your own needs. Instructors can also
receive via e-mail current events cases keyed to financial
market news complete with discussion questions.

http://www.economist.com The website of the Economist, one can search for

information about pension plans in different countries and
about the effects of privatization.

http://www.dol.gov/ U.S. Department of Labor website. The DOL administers

ERISA and the full text of ERISA is available here.

http://www.ici.org Investment Company Institute website. See the Mutual

Fund Factbook for industry statistics on IRAs.

http://www.pbgc.gov/ The Pension Benefit Guaranty Corporation website.

http://www.retirementplanners.com A good website with a wealth of information on

different types of retirement plans.

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Chapter 18 - Pension Funds 6th Edition

VII. Student Learning Activities

1. Go to the Social Security website http://www.ssa.gov/ and find the retirement

calculator. (This calculator may not work for Macs.) Enter your age (at least 23) and
your expected annual income using the ‘quick’ version of the calculator found under
‘benefit calculators.’ What levels of inflated Social Security earnings can you expect
at retirement? Does it matter at what age you retire? How much longer would you
have to live to make it worthwhile to retire at the minimum possible age rather than
the latest age?

2. Using the comparison calculator between a Roth IRA and a regular IRA found at
http://tcalc.timevalue.com/ decide whether an individual with the following data is
better off with a regular IRA or a Roth IRA:
Current IRA amount: $10,000
Current tax bracket: 28%
Retirement tax bracket: 15%
Projected rate of return on investments: 8%
Planned saving amount is $2,000 per year, (before taxes)
Retire in 30 years

3. Go to http://www.asec.org/int-blpk.htm and use the calculator there to ascertain how

much one needs to invest per year to generate adequate retirement income given the
following data:
Income of $60,000 per year
Age 30
Retire at age 65
Money already saved $10,000
How much more must the individual save if they were age 40 with the same data?

4. Go to the Pension Welfare Benefits Association website at

http://www.dol.gov/ebsa/. Answer the following questions:
a) What types of fees are assessed on a 401(k) plan? How do they impact an investor’s
return?
b) What is different about retirement savings requirements for new job entrants, mid-
career and near retirement individuals?

5. At the PWBA website learn about vesting requirements. What are the graded vesting
schedule and the Cliff vesting schedule?

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