Can someone give me a quick breakdown on pensions?

CFA Level III
#1

Alright, so as many of you know, lots of AM questions deal with pension IPS scenarios. Caluclating liquidity needs, return requirements, etc. I always get caught up in questions asking me tio calculate liquidity needs- I think it’s because of my lack of solid understanding of pension operations.

I just took a mock that stated liquidity needs as outflows minus inflows- outflows are payments to beneficiaries, whilst inflows are contributions. I always thought that contributions were outflows for a pension. Isn’t their objective usually to minimize or reduce contributions (outflows)? This question relates to Mark Meldrum’s fourth mock by the way (so Magician, if you’re reading this- can you help?? hahah)

Thanks

#2

Outflows: Pension payments to retired employees

Inflows: Contributions (i.e. employer contributions into the fund)

You’re right about wanting to minimize contributions… if the pension fund can achieve a rate of return that keeps PVA > PVL, high contributions won’t be necessary. But once PVL > PVA, it is normally smarter to increase contributions rather than to seek higher return (when PVL > PVA, risk tolerance is low, so seeking high returns can become dangerous)

#3

so the company is paying the contributions, and not the pension fund? but their goal is to minimize this burden on the company?

#4

Some pension plans require the employees to contribute along with the employer. Contributions + investment earnings accumulate to pay the future pension benefits.

#5

Pensions are dieing off in the world. A lot of state government agencies, cities, and even some private/public companies offer pensions. But overall they are going away for your traditional “defined contirbution plan” 401K that transfers the risk over to the participant in choosing there investments that guide there retirement portfolio.

Now a pension or defined benefit planned is what you are having trouble understanding.

It is a commitment from the organization whoever it be: gov agency, public/private company, whoever employs and commits to offering its employees a pension.

A pension is usually based on some formula that is known to the employee Salary*(years of service)*0.025

Here 0.025 is percent of salary earned per year. So if you work lets say 30 years at the company you get 75% of your salary for the rest of your life.

Now some pensions or most have all these rules or options where you can cash out early. Imagine you are 22 years old when you start at the company. And you work 30 years that puts you are 52. You could retire right and get your 75% of salary forever. Well not so fast most policies say if you retire early age of below 60 years there is some discount factor to disencentivize you to start getting distributions. Some pensions want to cut there losses and switch people off there plan giving them cash out options so they arent liable for some unknown future stream of liabilities

Working age of people putting into the pension matter as more younger people putting in vs retirees means more is going into the pension then going out which is why this affects risk tolerance

But back to kind of what you are asking. Is Pension Asset value vs Pension Liabilities What is it ? What does it mean?

Well think of your pension assets as everything you own from all the active employees contributing into the program. This is what you actually own it can be stocks, bonds whatever.

Then think of your pension liabilities. This is some calculated estimated amount based on your average age of participant how many people will begin taking distributions looking at all that in a spreadsheet discounting it back to a present value. But in the CFA we just see one line item PENSION LIABILITES makes it so easy but SO MUCH GOES INTO THAT DAMN NUMBER it is just given to us. Very nice.

But how do interest rates affect your Pension assets and how they affect your liabilities? Well liabilities are discounted right? Because you have this 55 year dude that is going to get 75% of his salary when he can begin pulling from the pension at 65. So you know 10 years out he is going to start getting payments him and all his other people you have all this estimated and you discount this stream of liabilties back. AND YOU DO IT AT A LOWER RATE. Well crap that means its a higher LIABILITY VALUE. That is why in these answers you are seeing that lower rates increase the pension liabiltty and decrease the surplus. I have seend this referenced already a couple times.

Then theres pension assets what happens when rates go down? How does it impact your asset values?

IDK that is how i am currently thinking about it and working through it.

#6

Hence the need to immunize pension liabilities by making sure the 1) Macaulay durations are matched, 2) dispersion is low (in the context of choosing from a basket of bond portfolios), 3) making sure convexity of the chosen bond portfolio is higher than the liabilities you are immunizing.

matched durations with low dispersion reduce cash flow mismatch risk (risk of not meeting cash flow needs when due), higher convexity mitigates against yield curve changes i.e. rates go up, asset values drop lesser than liabilities ; rates go down, asset values increase higher than liabilities

#7

You have to understand the basics here. The question is asking you about the liquidity requirement of the pension assets - not the company itself.

Understand that the company (plan sponsor) deposits money to a pension fund. This money is no longer theirs and now belongs to the pensioners. They then hire a third party to manage the money for them. The money manager will manage the money in accordance with the plan sponsor’s goals (i.e. achieve a rate of return high enough that limits their need for further contributions).

From a liquidity standpoint (from the perspective of the pension assets), contributions from the sponsor are a cash inflow and payments to pensioners are a cash outflow. So, if the pension plan is mostly made up on young people (high active lives vs. retired) the company will be making more contributions to the plan (inflow) and the plan will be paying out less to pensioners (outflow) because the majority of the pension participants are still working. This results in a low liquidity requirement and generally above average ability to take risk - assuming the plan is fully funded.

#8

i get all that. I’m talking specifically when they ask to state the liquidity requirement. If contributions are 1000, and payments to beneficiaries are 800, that would be a net inflow and there would be no liquidity requirement, right?

So their goal is typically to minimize the need for these contributions by earning a higher return. But they don’t pay the contributions, they would just like to minimize them- but contributions HELP the pension fund

do i have this right?

#9

You got it

#10

appreciate the help my good sir

#11

if the plan is properly funded that could mean the pension has an abillity to take on risk

If the plan has a high percentage of its participants in retirement and low active employees that means there is a liquidity constraint or concern.

The plan cannot be in surplus but if the duration is very high becaues a lot of young active people are participating and not withdrawling then the liquidity constraint would not be a conern the funded status would be a concern on the ability to take risk

#12

Almost. Like any investor, the plan (or those managing it) will have objectives - BOTH risk and return, not just return. For many plan sponsors, minimizing contributions (maximizing returns) at an acceptable level of risk is indeed the goal. Others focus more on risk and then use that to determine expected (or a range) of returns and manage the resulting contribution requirements. Same idea really, but some make one more primary than the other.