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 benefit assets?
How do fiduciaries assure prudence in the creation of an investment program?
How is risk reduced by investment diversification?
What is the investment horizon of the typical defined benefit plan?
What are derivatives?
How are derivatives used in pension funds? 

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:

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 management.

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 program? 

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 plan? 

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 years.

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Q:  What are derivatives? 

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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