The Basics of
Pension Plans Regulated by ERISA
Investment of Defined Benefit Plan AssetsHow well funded are
private defined benefit pension plans?
What broad rules govern the investment of employee
How do fiduciaries assure prudence in the
creation of an investment program?
How is risk reduced by investment
What is the investment horizon of the typical
defined benefit plan?
What are derivatives?
How are derivatives used in pension
Q: How well funded are
private defined benefit pension plans?
A: Based on Form 5500s filed with the
Internal Revenue Service as of the end of 1997, the percent of
projected benefit liabilities funded for single employer and
multiemployer pension plans was as follows:
% of Liabilities
Less than 100%
100% to 129%
130% and 0ver
A plan's funded status depends on factors affecting both assets
and liabilities. On the asset side, cash contributions made
by the employer and good investment results increase available
funds. The growth of liabilities is affected by actuarial
assumptions, particularly the discount rate used to determine the
present value of future benefit payments. The lower the
interest rate used, the higher the present value of those future
liabilities will be. In an environment of steady interest
rates and strong financial markets, such as the decade of the 90's,
plans are able to achieve higher levels of funding than in an
environment where interest rates are dropping and financial markets
are not performing well. Under these circumstances, the
funded status of a plan is negatively impacted on both the asset
and liability sides.
Besides establishing standards for investment practices, ERISA
had the foresight to give employers the flexibility to adopt
investment policies that can evolve with the markets, subject to
prudent-expert tests. As a result, plan sponsors have been
able to improve diversification by investing in a broad range of
financial instruments and investment opportunities.
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Q: What broad rules
govern the investment of employee benefit assets?
A: As discussed above, the cornerstone of
ERISA's fiduciary standards is found in Section 404, which
explicitly sets forth ERISA's requirements for prudence in asset
Given these requirements, plan fiduciaries must make investment
decisions to provide the best possible assurance that the pension
promise will be honored; the overall return on the fund should be
maximized without exposing investment principal to the risk of
large losses. What these requirements do not set forth is any
specific permission to use, or prohibition on the use of, any type
of securities. Rather, fiduciaries are required to make
decisions that are prudent in light of the requirements of the
statute and of their circumstances.
Q: How do fiduciaries
assure prudence in the creation of an investment
A: Typically plan fiduciaries begin by
comparing the level and expected growth in plan liabilities,
benefit payments, and other factors to the current level of plan
assets and the results that can be expected from investing in
various diversified portfolios of public and private market
securities. The fiduciaries also evaluate the risks entailed
in these portfolios by examining what impact negative investment
results would have on the financial health of the plan and the
level of required cash contributions. Taking both expected
risk and return into account, the fiduciaries select an investment
program (asset allocation) that should enable the plan sponsor to
meet its pension obligations.
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Q: How is risk
reduced by investment diversification?
A: Asset allocation is the first and most
fundamental decision made in the investment process. The
allocation dictates what proportion of the fund should be invested
in various classes of assets such as stocks, bonds, real estate and
private market investments. In making the asset allocation
decision plan fiduciaries compare the risk/return characteristics
of a range of asset classes. Some of the investments included
in a well-diversified portfolio can, in and of themselves, have a
relatively high amount of risk. These investments may
prudently be included if the analysis indicates that they
complement the rest of the portfolio. Combining asset classes
with distinctly different return patterns over time (low
correlations) can increase the expected return of the total
portfolio without a proportional increase in risk. Judicious
diversification sets the underperformance of one segment off
against the outperformance of another, thereby smoothing results
over time. Generally, prudent diversification will
reduce total portfolio risk.
After the asset allocation decision is made, independent
investment advisers or the plan sponsor's in-house personnel invest
the assets belonging to the plan. These portfolios are also
generally diversified and structured in accordance with guidelines
agreed upon between the sponsor and the adviser.
Q: What is the
investment horizon of the typical defined benefit
A: Employers, governed by the long term
nature of pension payout obligations, generally invest for the long
term. Although liability profiles differ between plans,
employers are less concerned with short term movements in
valuations of asset classes than with long term returns of the
entire diversified portfolio. As a rule, fiduciaries make
material changes in the broad asset allocation only once every few
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Q: What are
A: The term "derivatives" refers to a
broad array of financial contracts. Each contract "derives"
its value from specific asset(s), interest or other reference
rate(s) to which it is linked. These instruments do not as a
group constitute a separate asset class. "Derivatives" are
thus as varied as the full range of investable assets, with a wide
variety of contract characteristics as well, and do not lend
themselves easily to generalization.
Q: How are derivatives
used in pension funds?
A: The most frequent applications of
derivatives in pension fund include asset allocation, currency
hedging, cost reduction, risk reduction and liquidity
enhancement. Since derivatives are tools which support
prudent investment choices but which can be misused, CIEBA
encourages its members to maintain strong control and monitoring
procedures specifically designed for the use of derivatives.
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