Pensions and Liquidity

These pages are designed for students in Introduction to Finance and other Finance courses.

TYPES OF PENSION PLANS

There are two types of Pension plans when we look at the basic attribute of who bears the risk of the size of the pension and for how long it will be paid after retirement. The defined benefit pension puts the risk on the employer and the defined contribution pension puts the risk on the employee

• Defined Benefit Plan: The employer designs a set of rules that will state who is eligible for the plan and how much they will get once they retire. These plans usually include the following.
  • Minimum number of years of service
  • Minimum age to qualify for retirement
  • Formula which calculates the annual retirement benefit as some function of salary and years of service
  • Statement about fringe benefits such as medical coverage
  • Formula for coverage of surviving spouse
  • Maximum ages to force retirement are no longer legal in the USA

• Defined Contribution Plan
  • Minimum years of service or age to begin coverage
  • Statement on vesting rights
  • Statement on employer contribution which is generally a percentage of salary
  • Statement on employee voluntary and matched contributions

DISCUSSION OF PLAN EFFECTS

SHIFTING PURCHASING POWER RISK

Defined benefit plans have some protection against inflation because the size of the retirement benefit is determined at the retirement age and is based on a salary that has probably kept up with inflation. In the best of plans the payments after retirement may also be indexed to the CPI but this is not common.

With the defined benefit plan the monies invested are under the control of the beneficiary and it is her responsibility to see that the value of the fund grows in a manner to keep up with the cost of living.

SHIFTING ACTUARIAL RISK

Under the defined benefit plan if you live longer than expected it is just tough luck for the employer. On the other hand, if you die young or before retirement the employer makes the gain. Under the defined contribution plan, if you live longer than you have planned for you will be broke, and old! If you die early you lose again, because you are dead and someone else spends your money! So the beneficiary really takes on a significant risk with the defined contribution plan. The only way to avoid this risk is to buy a retirement annuity from the insurance company that will guarantee payment until you and/or spouse dies.

SHIFTING THE INVESTMENT RISK

Under the defined benefit plan it is up to the employer to invest funds to make sure there is enough money available each year in the future to cover the expected cash obligations cause by the retirement promises. This is highly regulated, covered below and the subject of the ATLAS Pension Case. Under the defined contribution plan it is up to the beneficiary to manage his own portfolio both before and after retirement. Most people are not finance professionals and may make big mistakes here.

You should notice that the term spouse or surviving spouse is used frequently in this subject area. Such use is one of the central reasons for the controversy over legalizing gay marriages on both a federal a state basis.

Managing a Defined Benefit Pension Benefit Fund

Managing a defined benefit pension fund is both a common sense and regulated thing. In both cases the main aim is to ensure that the fund is able to meet the promised benefits for the foreseeable future. To simplify the process, we can think of setting up the plan from scratch with nobody getting any retirement payments yet. After the setup the plan must be reevaluated each year to make sure it remain adequately funded. The concept is simple. You just figure out how much the pension plan expects to pay out each year in the future and then invest the fund's money in assets that will provide a guarantee of the cash flow at the time it is needed.

Figuring out the annual outflow

• Determine the date of birth of each person covered
• Based on the date of birth and sex determine when the individual will die based on actuarial tables
• Estimate when the individual will retire, the old mandatory retirement age made this easy
• Estimate the retirement benefit and when the fund will start paying and stop paying
• If there is coverage for a surviving spouse, work out all the above for that person too

Manage the fund. This task is the combination of the beginning balance on hand, the contribution rate and the assumed reinvestment rate.

• If the fund has been around for a while there will be some balance available.
• Generally the fund is built up each year by a contribution that is some percentage of the wages paid, say 10%
• The funds assets are invested in securities like bonds and stocks. Bonds can give a steady return when held to maturity but stocks can give greater returns in the long run which is more attractive to the employer since the annual contributions can be lower.
• The balance is estimated each year to make sure that it remains positive throughout the life of the plan.

The actual administration of these funds is constrained by the rules of the I.R.S. and the Department of Labor [ERISA]

For further readingThe Pension Professor

Comments and Suggestions should may be sent togramborw@tiger.uofs.edu