What are Pension Plans?

Pension plans offer a guaranteed source of income for retirees. But much depends on the performance of the plan’s investments, the demographic of the firm’s workforce and the financial health of the company.

Pension Plans

When an employee agrees to pay into a pension plan, he does so in exchange for a promise that the plan sponsor will give him a pension when it comes time to retire.

The sponsor may be a company, an employer, a union or a jointly trusteed plan where both management and unions in an industry appoint trustees to a board that manages the plan. This promise is legally stated in the “pension plan document,” which lays the provisions for the plan.

Pension plans are regulated by governments. In Canada, this happens at both the federal and provincial level. The federal legislation covers federally-incorporated and regulated companies such as airlines. Each province has its own legislation and agency, such as the Ontario Pension Board.

A trustee is appointed to hold the assets in trust for the benefit of the plan members. Usually, the trustee is also the custodian who holds the plan investments. Pension plans usually hire an outside investment manager to invest the plan assets. The sponsor may also appoint an “investment consultant” to advise on investment issues and help select and assess the performance of investment managers.

Pension funds can invest in many different types of financial securities and can own assets directly. The types of investments undertaken by a pension fund depend on its “investment policy statement.” The nature of the investments allowed in the policy statement depends in large part on the financial situation of the plan. Generally speaking, the better the finances and the younger the plan participants, the riskier the investments that can be held by the plan.

Types of Pension Plans

Defined benefit pension plans promise a pension based on a defined formula. This could be a formula based on years of service, hours worked or some other predetermined calculation. A defined contribution pension plan bases the pension on the earnings of the invested contributions. Whatever these contributions earn over the life of the plan is used to buy a retirement income via a purchased annuity.

In the case of a defined benefit plan, sponsors are legally required to set aside enough money to cover the pension promise that has been made. Legislation requires that an actuary perform actuarial valuations at least every three years to establish the solvency of the plan. The valuation calculates the present value of the assets and liabilities of a plan, according to specified demographic and return assumptions.

Investment Policy Statement

Many years ago, a company might make a promise to pay pensions without setting aside any funds to support this promise. As these arrangements became more formal, government regulations were established to ensure the promised pensions were available and required that companies put aside the necessary funds to ensure that pensions were paid. Once companies were required to set aside monies to fund their pension promises, it became attractive to invest these funds to earn a higher return that would lower the cost of providing pensions.

As inflation rose in the 1960s and 1970s, companies found that rising salaries and low fixed-income returns made their pension plans very expensive. They turned increasingly to investment in equities to obtain a higher return and lower the eventual cost of their pension plans. More sophisticated plans began to place funds in direct real estate investment, venture capital, and mortgages. By the 1980s, pension plans were exploiting “non-traditional” investments in Leverage Buyout Funds (LBOs), hedge funds and even direct ownership of private companies.

The types of investments undertaken by a pension fund depend on its objectives and constraints provided for in its “investment policy statement.” Legislation demands a “prudent approach” of diversifying risk across a number of securities or asset types. Taking prudence into account, pension funds strive to achieve the highest practical return, which lowers the cost of their pension “obligation” considerably.

A Plan’s Financial Condition Matters

The major limiting factor to putting a company’s entire pension fund in very high return and “risky” assets is the financial condition of the pension fund. A pension fund that doesn’t have enough invested to cover its pension obligations is said to be “underfunded” or have a “shortfall” in invested assets, and companies are required to make this up through higher contributions. A pension fund that has more investments than necessary to cover its pension obligation is “overfunded” or said to have a pension “surplus.” Companies with a pension surplus can reduce or suspend their contributions altogether.

The financial condition of a pension plan depends on a number of factors, including:

The demographic characteristics of the plan members very much dictate the time horizon for investment. If the plan sponsor is a new company with relatively young employees, the eventual pensions are very far in the future. This means if the value of the plan investments fluctuate considerably, there will not be a need for funds to be withdrawn at a low point when the investments’ value is down considerably. A “young plan” can have a high weighting in riskier or more illiquid assets such as stocks, real estate and non-traditional investments. This is in contrast to a “mature plan” which has much older participants and actually is paying pensions to many retirees. The investments of these plans usually are much more towards fixed income securities, such as bonds and mortgages, which fluctuate much less in price and provide a stable income source to pay pensions regularly.

The financial state of the company itself is important. If a company is in a challenging financial situation, it will be more difficult to make large contributions to the pension fund to make up potential shortfalls from investment performance. This usually results in a more capital risk averse approach and higher fixed income weighting.

The historical investment performance of the fund’s investments results in the amount of assets available at any point. A plan with poor historical investment performance will have generated a much lower rate of return and therefore will have less funds on hand to provide for pension obligations. Perversely, a “conservative” investment approach with a low equity weighting will result in low returns, which might lower the future risk tolerance of a plan.

Pension Plans and Maturity

As opposed to people, patience is the characteristic of “young” and well-financed pension plans. With pension plans, “maturity” and shortfalls brings impatience and shorter time horizons as the certain pension payouts move closer with each passing year.

6 years ago