THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 328

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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 do 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 1 would be worth $100 (1 0.10)10 $259.37 at the end of ten years;
the $100 contributed in year 2 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:

3

$259.37 $235.79 $214.36 $194.87 $177.16
$161.05 $146.41 $133.10 $121.00 $110.00 $1753.11