PowerPoint Presentation

Pension funds

A pension plan is a fund that is established forthe eventual payment of retirement benefits.

The entities that establish pension plans, iscalled plan sponsors, may be private businessentities acting for their employees ( calledcorporate or private plans); federal state andlocal entities on behalf of their employees (called public plans), unions on behalf of theirmembers ( called Taft Hartley plans), andindividuals for themselves (Called individuallysponsored plans)

Types of pension plans

Defined benefit plans

Defined contribution plans

Defined benefit plans

The plan sponsor agrees to make specified dollarpayments annually to qualifying employeesbeginning at retirement (or in case of deathbefore retirement).

These payments occur monthly.

The retirement payments are determined by aformula that usually takes into account thelength of service of the employees and theemployee’s earnings.

Defined benefit plans that are insured by the lifeinsurance products are called insured benefitplans.

Defined contribution plan

The plan sponsor is responsible only formaking specified contributions into theplan on behalf of qualifying participants,not specified payments to the employeesafter retirement.

Differences between Defined benefit plans &Defined contribution plans

In Defined benefit plan –

The Plan Sponsor, 1. Guarantees the

retirement benefit, 2. Makes the investment

choices, 3. Bears the investment risk, if the

investment doesn’t earn enough.

In a Defined contribution plan, the

employer doesn’t guarantee any retirement

benefit.

Hybrid Pension plans

Hybrid pension plans are combinations ofdefined benefit plans and definedcontribution plans.

The most common hybrid pension plan iscash balance plan.

Cash balance plan

A cash balance plan is a defined benefit plan inthat, the plan benefits are fixed based on aformula.

Investment responsibility is borne by theemployer.

A cash balance plan is a defined contributionplan in that, each participant has an account,which is credited with the individualscontribution and the account is credited withinterest linked to some fixed or variable index,such as consumer price index.

Properties and pricing of financial assets

Properties of financial assets are –

1.Money ness

2.Divisibility and denomination

3.Reversibility

4.Cash flow

5.Term to maturity

6.Convertibility

7.Currency

8.Liquidity

9.Return predictability

10.Complexity

11.Tax status.

Duration

The approximate percentage change inprice for a 100 basis point change ininterest rates around the prevailing yield.Even for very low yield, the measure ofprice sensitivity is nicely estimated withduration.

Properties of duration:

1.Bonds with same coupon rate and sameyield, the longer the maturity the greaterthe duration

2.Bonds with same coupon rate and sameyield, the lower the coupon rate thegreater the duration

3.Lower the initial yield the greater theduration for a given bond.

Please read –

Macaulay duration ( page 187)

Effect of coupon rate ( page 181-182)