Pension Funds

Pension funds are plans designed to save and invest in order to provide income for plan beneficiaries upon retirement. The entity that sets up the plan is referred to as the plan sponsor and is usually an employer.

There are two major types of pension plans: (1) defined benefit (DB), in which a plan sponsor defines the benefit that will be paid to beneficiaries upon retirement in the future and (2) defined contribution (DC), in which contributions to plan assets today are defined, but there is no guarantee of ultimate benefits paid to beneficiaries.

Characteristics/FeaturesDefined Benefit Pension PlanDefined Contribution Pension Plan
Benefit paymentsBenefit payouts are defined by a contract between the employee and the pension plan (payouts are often calculated as a percentage of salary).Benefit payouts are determined by the performance of investments selected by the participant.
ContributionsThe employer is the primary contributor, though the employee may contribute as well. The size of contributions is driven by several key factors, including performance of investments selected by the pension fund.The employee is typically the primary contributor—although the employer may contribute as well or may have a legal obligation to contribute a percentage of the employee’s salary.
Investment decision makingThe pension fund determines how much to save and what to invest in to meet the plan objectives.The employee determines how much to save and what to invest in to meet his/her objectives (from the available menu of investment vehicles selected by the plan sponsor).
Investment riskThe employer bears the risk that the liabilities are not met and may be required to make additional contributions to meet any shortfall.The employee bears the risk of not meeting his/her objectives for this account in terms of funding retirement.
Mortality/Longevity riskMortality risk is pooled. If a beneficiary passes away early, he/she typically leaves a portion of unpaid benefits in the pool offsetting additional benefit payments required by beneficiaries that live longer than expected. As a result, the individual does not bear any of the risk of outliving his/her retirement benefits.The employee bears the risk of not meeting his/her objectives for this account in terms of funding retirement. The employee bears longevity risk.
Comparison of Defined Benefit and Defined Contribution Pension Plan Features

DB Pension Plan

The following are stakeholders in a DB pension scheme:

  • Plan sponsors (employers) must make contributions to plan assets. Poor investment performance will result in sponsors having to make extra contributions to an underfunded plan (i.e., when assets are lower than liabilities).
  • Plan beneficiaries (employees and retirees) face the ultimate risk that an employer defaults on contributions to plan assets.
  • The investment staff, the investment committee, and/or the board are directly impacted by the success or failure of the plan.
  • Governments are stakeholders in that they provide tax incentives for employees to save for retirement, and taxpayers will ultimately face the costs of providing welfare for those that have failed to adequately save for retirement.
  • Shareholders in the corporate employer are stakeholders since an underfunded plan will cause a balance sheet liability and lower income for the company. It will also lead to higher financial risk, which will likely increase share price volatility.

The liabilities of a DB pension plan are the present value of the future benefits promised to plan participants. Employees usually only qualify to receive these benefits after meeting certain requirements called vesting conditions—typically a required minimum number of years of service.

The main objective of a DB plan is to have sufficient assets to cover future benefit payments. The funded status of the plan can be measured using the funded ratio, or vested benefit index:

funded ratio = fair value of plan assets / PV of DB obligations

The major factors affecting the size of the liability are summarized in  DB Pension Plan Liability Factors.

FactorImpact on Liabilities
Service/tenureDepending on plan design, often the longer the period of service or tenure, the larger the benefit payments.
Salary/earningsThe faster salaries or earnings grow, the larger the benefit payments.
Additional or matching contributionsAdditional or matching contributions are often rewarded by a step change increase in benefit payments.
Mortality/Longevity assumptionsIf life expectancy increases, the obligations or liabilities will increase.
Expected VestingIf employee turnover decreases, expected vesting will increase.
Expected Investment ReturnsIn some cases, increases in expected returns will result in a higher discount rate being used—hence, lower obligations or liabilities.
Discount RateA higher (lower) discount rate results in lower (higher) liabilities.
Factors Affecting Calculation of Defined Benefit Liabilities

Additional considerations in DB pension design are:

  1. the size of the pension plan relative to the size of the sponsor’s balance sheet; and
  2. the cyclicality of the plan sponsor’s core business.

If plan assets and liabilities are small relative to the sponsor’s balance sheet, then there may be more flexibility in taking investment risk and more tolerance for volatility in employer contributions.

Another important factor is the core business of the plan sponsor. If the plan sponsor’s revenues are highly cyclical, it will not want plan funded status to deteriorate when the core business suffers from a cyclical downturn.

The plans sponsor’s ability to tolerate volatility of contribution rates may impact the investment horizon, and hence the pension plan’s appetite for such illiquid investments as private equity and venture capital.

Another important factor determining the investment horizon is the mix of active plan participants versus retirees. The higher the proportion of retirees relative to the proportion of active participants, the more mature the plan—hence, the lower its risk tolerance. Generally, the more mature a pension fund, the shorter its investment horizon, which directly affects risk tolerance and the allocation between fixed-income assets and riskier assets.

Although pension plans typically have long investment time horizons, they still must maintain sufficient liquidity relative to their projected liabilities. Liquidity needs are driven by:

  • Proportion of active employees relative to retirees—The former contribute to the plan, while the latter receive benefit payments. More mature pension funds have higher liquidity needs.
  • Age of workforce—Liquidity needs rise as the age of the workforce increases, since the closer participants are, on average, to retirement, the sooner they will switch from the contribution phase to benefit payment stage. This is true for both DB and DC plans.
  • DB plan funded status—If the plan is well funded, the plan sponsor may reduce contributions, generating a need to hold higher balances of liquid assets to pay benefits.
  • Ability of participants to switch/withdraw from plan—If pension plan participants can switch to another plan or withdraw on short notice, then higher balances of liquid assets must be held to facilitate these actions. This applies to DB and some DC plans.

A pension plan with lower liquidity needs can hold larger balances in private investments—such as real estate, infrastructure, private equity, and hedge funds —and can invest a higher proportion in equities and credit.

A pension plan with higher liquidity needs, however, must invest a higher proportion of its assets in cash, government bonds, and highly liquid, investment-grade corporate bonds.

It is important for pension plans to regularly perform liquidity stress tests, which may include stressing the value of their assets and modelling reduced liquidity of certain asset classes in a market downturn.

Plan statusPlan funded status (surplus or deficit)Higher pension surplus or higher funded status implies potentially greater risk tolerance.
Sponsor financial status and profitabilityDebt to total assets
Current and expected profitability
Size of plan compared to market capitalization of sponsor company
Lower debt ratios and higher current and expected profitability imply greater risk tolerance.
Large sponsor company size relative to pension plan size implies greater risk tolerance.
Sponsor and pension fund common risk exposuresCorrelation of sponsor operating results with pension asset returnsThe lower the correlation, the greater the risk tolerance, all else equal.
Plan featuresProvision for early retirement
Provision for lump-sum distributions
Such options tend to reduce the duration of plan liabilities, implying lower risk tolerance, all else equal.
Workforce characteristicsAge of workforce
Active lives relative to retired lives
The younger the workforce and the greater the proportion of active lives, the greater the duration of plan liabilities and the greater the risk tolerance.
Factors Affecting Risk Tolerance and Risk Objectives of Defined Benefit Plans

Regulations vary by country. Many regulators now require extensive reporting on fees and costs incurred by plans both internally and externally. Personal liability for pension trustees has been increased to ensure they act in the best interests of plan beneficiaries. While this has led to lower liabilities, it may also lead to higher risk taking in order to generate the higher returns needed to maintain funded status, since the value of liabilities will grow at this higher discount rate over time.

From a tax perspective, pension funds are often treated favorably by governments in order to encourage individuals to save for retirement. Funds that are subject to taxation should consider the tax implications of their investment decisions.

Accounting rules, again, differ by country. In the United States, corporate DB pension plans must follow GAAP, particularly Accounting Standards Codification (ASC) 715, Compensation—Retirement Benefits, which requires that funded status be shown as an asset or liability on the balance sheet. Public pension plans must follow Governmental Accounting Standards Board (GASB) rules, which require assets to be reported at market values and liabilities to be reported using a blended approach. The blended approach for liabilities uses the expected return on plan assets as the discount rate for the funded portion of the liability, and a lower discount rate—the yield on tax-exempt municipal bonds—for the unfunded portion. Using a higher discount rate for the funded liabilities could incentivize plans to take more risk in order to maintain the funded status of the plan over time.

For DB pension plans, the primary objective is to achieve a target return over a specified long-term horizon, while assuming a level of risk that is consistent with meeting its contractual liabilities. A secondary objective could be to minimize the cash contributions the sponsor will be required to provide.

The target return of the plan should reflect the fact that plan assets need to grow through contributions and investment returns in line with the growth in liabilities of the plan. If a plan is in deficit, then plan assets need to grow faster than the liabilities.

DC Pension Plan

The stakeholders in a DC pension scheme include the following:

  • Plan sponsors (employers), while not facing the investment risk or longevity risk of the assets, retain important fiduciary responsibilities.
  • Plan beneficiaries (employees and retirees) face the investment risk of contributions and investment returns not meeting retirement needs.
  • The board must communicate with participants to keep them well informed, and these communications must consider the participants’ level of sophistication.
  • Governments are stakeholders in that they provide tax incentives for employees to save for retirement, and taxpayers will ultimately face the costs of providing welfare for those that have failed to adequately save for retirement.

The liabilities of a DC plan sponsor are the required contributions to plan assets, there is no liability associated with future benefits. Through pooling and increased scale, the DC plan may invest in alternative investments not usually available directly to retail investors. The DC plan sponsor bears the liquidity risk of any event that causes participants to exit the plan.

Individuals in a DC plan have an investment horizon linked to their age—older participants will have a shorter investment horizon because they will be retiring and drawing benefits sooner.

Many DC plans offer a default life-cycle option (target date option) where asset mix is managed according to a desired retirement date. These life-cycle options can be either participant-switching options, which automatically switch members to a more conservative asset allocation as they age, or a participant/cohort option, which involves pooling the participant with other investors with a similar retirement date and the fund being managed more conservatively as the retirement date is approached.

The primary drivers of liquidity needs are the age of the workforce and ability of participants to switch or withdraw from the plan.

Regulations vary by country. Regulators typically recognize that many DC plan participants have low levels of understanding about investments; therefore, there is a requirement that plan sponsors educate participants on saving for retirement, particularly with regard to default options for disengaged participants.

From a tax perspective, DC plans in the United States (referred to as 401(k) plans) are tax deferred. Withdrawals before age 59½ are penalized with an additional 10% tax. A similar tax-deferral system operates in the U.K., with the first 25% of benefits being tax-free.

The main objective of DC plans is to prudently grow assets to meet spending needs in retirement. If the plan offers funds with active management, a secondary objective may be to outperform the passive asset class returns of the default option’s strategic asset allocation. In environments where participants can voluntarily switch between competing DC plan providers, outperforming other DC plans may be an investment objective.

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