THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 328

296 PA R T I I I Financial Institutions PE NSI O N F UN DS In performing the financial intermediation function of asset transformation, pension funds provide the public with another kind of protection: income payments on retirement Employers, unions, or private individuals can set up pension plans, which acquire funds through contributions paid in by the plan s participants or their employees Pension plans have grown in importance in recent years, with their share of total financial intermediary assets rising significantly 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 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 to lower risk through diversification 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 However, the strong performance of stocks in the 1950s and 1960s afforded pension plans higher returns, causing them to shift their portfolios into stocks, currently on the order of over 50% of their assets As a result, pension plans now have a much stronger presence 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 (usually based on the highest average salary and the number of years of pensionable service), 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 (at the beginning of each year) and the interest rate is 10%, after ten years the contributions and their earnings would be worth $1753.3 If the defined benefit on her pension plan pays her $1753 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 $2000, the plan is underfunded because her contributions and earnings 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, The $100 contributed in year would be worth $100 (1 0.10)10 $259.37 at the end of ten years; the $100 contributed in year would be worth $100 (1 0.10)9 $235.79; and so on until the $100 contributed in year 10 would be worth $100 (1 0.10) $110 Adding these together, we get the total value of these contributions and their earnings at the end of ten years: $259.37 $235.79 $214.36 $194.87 $177.16 $161.05 $146.41 $133.10 $121.00 $110.00 $1753.11