Archive for the ‘CFA Level III’ Category

Defined Benefit Plans & Defined Contribution Plans (CFA III) – 2

Wednesday, November 2nd, 2011

In our previous blog on pensions, we discussed defined benefit plans, defined contribution plans, cash balance plans, and profit sharing plans. We discussed funded status, ABO, PBO, future liability, retired lives, and active lives.

It is vital for the CFA III curriculum to understand the difference between defined contribution plans and defined benefit plans in more detail:

In a defined benefit plan:

  • The employee receives periodic payments beginning at retirement based on an eligibility date formula
  • Does not bear the risk of portfolio performance or market movements
  • Receives stable retirement income
  • Usually faces a vesting period and faces a restricted withdrawal of funds
  • There is an adverse effect on diversification because both job and pension are linked to employer health
  • Employee is subject to early termination risk if employee is terminated prior to retirement
  • The employer is responsible for managing the plan assets to meet pension liabilities
  • The employer thus takes investment risk
  • Benefits are determined by stated criteria usually associated with years of service and salary at retirement
  • Pension benefits are a liability
  • Regulated by ERISA and state governments

In a defined contribution plan:

  • The employee bears all the investment risk
  • Legally owns all personal contributions, and owns all sponsor contributions once vested
  • DC plan lowers taxable income
  • Employee must make all investment decisions for his/her retirement
  • Employee must decide on asset allocation and risk tolerance
  • There is restricted withdrawal of funds
  • Employee owns plans assets and can move assets to other plans
  • The employer must offer employees a sufficient variety of investment vehicles
  • The only financial liability is making contributions to the employee account
  • Has lower liquidity requirements
  • Has fewer regulations to deal with, but is usually required to have an IPS that addresses how plan will help employees meet objectives and constraints
  • Defined contribution plans also come in 2 forms, participant-directed and sponsor-directed (profit sharing)
  • In a profit sharing plan, the employer decides the investments

A plan is considered qualified in the U.S. if it meets federal and state tax laws for retirement funds.

Defined benefit plan objectives include:

  • Returns: To have pension assets generate returns sufficient to cover liabilities
  • Return requirement depends on funded status and contributions based on accrued benefits
  • Also determined by future pension contributions: return levels can be calculated to eliminate the need for contributions to plan assets, contribution minimization goal more realistic
  • Pension income should be recognized in the income statement
  • Plan Surplus: Indicates cushion provided by plan assets to meet liabilities
  • Greater the surplus, greater ability to take risk
  • Underfunded means decreased ability to take risk
  • Risk: Common risk exposure measured by correlation between firm’s operating characteristics and pension asset returns
  • Lower the correlation, higher the risk tolerance
  • Higher the correlation, lower the risk tolerance
  • Financial Condition: Can be measured by debt-to-asset or other leverage ratios (debt-to-cap, debt-to-EBITDA), using sponsor’s balance sheet
  • Lower debt ratios imply better ability to tolerate risk
  • Higher debt ratios imply lower ability to tolerate risk
  • Profitability: Can be represented by current or pro former financials
  • Workforce: Age of the workforce and ratio of active to retired lives is a strong indicator of performance
  • Usually the younger the workforce, the greater the ratio of active to retired, increased ability to tolerate risk
  • When older, lower rate of active to retired and higher risk
  • Plan Features: Some offer option of either retiring early or receiving lump-sum payments instead of a retirement annuity

Defined benefit plan constraints include:

  • Liquidity: Pension plans receives contributions and payments to beneficiaries…any outflow represents liquidity constraint.
  • Liquidity is affected by the number of retired lives; greater the #, the more liquidity is needed
  • The amount of sponsor contributions; smaller the contributions, the greater the liquidity need
  • Plan features; early retirement features would increase liquidity need
  • Time horizon: mainly determined by whether the plan is a going concern and workforce age and ratio of active to retired lives
  • Legal & regulatory: ERISA, the Employee Retirement Income Security Act regulates defined benefit plans, above state and local pension law
  • Pension fund assets should be invested for the sole benefit of the participant, not the sponsor
  • Pension funds have to exercise diligence before alternative asset classes can be added to asset base
  • Pension plans may prohibit investment in traditional asset choices like investments in defense industry, firms that produce alcoholic beverages, or firms that have a reputation for being destructive to environment

Understanding Pension Plans (CFA III) – 1

Tuesday, September 27th, 2011

One of the largest investors in hedge funds, mutual funds, and alternative asset classes, including private equity, timber, and commodities is the pension fund.  As an analyst or a portfolio manager, it is essential to understand the purpose of pension plans, how they are structured, and how they allocate risk.

A pension plan is a portfolio of assets (securities, hard assets) that can support future retirement benefits.  The promise to pay these benefits in the future is a key responsibility of the plan sponsor.

The plan sponsor is the company, non-profit, or government agency that funds the pension plan through periodic payments.

The plan participants are the individuals who receive the pension benefits as they are paid out from the pension plan.

There are also four main types of pension plans, the defined contribution plan, the profit-sharing plan, the defined benefit plan, and the cash balance plan:

1) Defined Contribution Plan: is a pension plan whose retirement payout expectations are framed by contributions to the plan by the plan sponsor.  The liability to the sponsor is only the plan contribution, not the benefit received by the plan participants.

2) Profit Sharing Plan: is a defined contribution plan, where the contributions to the plan are determined by the plan sponsor’s profitability.

3) Defined Benefit Plan: is a pension plan that is framed by the benefits paid to plan participants instead of by the contributions.  Benefits are calculated by taking to account years of service, expected return, expected salary, and other factors that will be explained later.

4) Cash Balance Plan: is a defined pension plan that maintains individual account records for plan participants.  This plan shows each member’s accrued benefits and manages accounts instead of an actual fund.


Funded Status: relationship between PV (present value) of the pension plan assets and the pension plan liabilities.

Underfunded: PV (present value) of pension plan assets here is less than the PV of the pension plan liabilities.  When plans are underfunded, the may require the sponsors to make special contributions to the plan in addition to regular contributions.

Fully Funded: PV (present value) of pension plan assets here is greater than or equal to the PV of the pension liabilities.  Sponsors can temporarily stop making contributions to the plan’s asset base when the PV of assets > PV of liabilities.

Surplus: difference between the PV of pension plan assets and the PV of pension plan liabilities.


Active lives: the number of plan participants who are not currently receiving pension payments and are still working to save for retirement.

Retired lives: the number of plan participants currently receiving benefits (retirees).

Accumulated Benefit Obligation (ABO): is the total PV of pension liabilities to date, assuming no further accumulation of benefits.

Projected Benefit Obligation (PBO): (PBO) is the ABO  plus projections of future employee compensation increases.  The PBO is the pension liability for a going concern and is the liability figure used in calculating funding status.

Total Future Liability: is the measure of pension liability that is the most comprehensive, because it takes into account not only changes in workforce and inflation in benefits, but salary increases as well.  Total future liabilty is used when setting long term objectives and goals for the plan within the IPS (Investment Policy Statement).

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