Table Of ContentManaging Pension and
Retirement Plans:
A Guide for Employers,
Administrators, and
Other Fiduciaries
August J. Baker
Dennis E. Logue
Jack S. Rader
OXFORD UNIVERSITY PRESS
Managing Pension and Retirement Plans
This page intentionally left blank
MANAGING PENSION AND
RETIREMENT PLANS
A Guide for Employers, Administrators,
and Other Fiduciaries
August J. Baker
Dennis E. Logue
Jack S. Rader
1
2005
1
Oxford NewYork
Auckland Bangkok BuenosAires CapeTown Chennai
DaresSalaam Delhi HongKong Istanbul Karachi Kolkata
KualaLumpur Madrid Melbourne MexicoCity Mumbai Nairobi
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Copyright (cid:1) 2005 by Oxford UniversityPress, Inc.
PublishedbyOxfordUniversityPress,Inc.
198MadisonAvenue,NewYork,NewYork10016
www.oup.com
OxfordisaregisteredtrademarkofOxfordUniversityPress
Allrightsreserved.Nopartofthispublicationmaybereproduced,
storedinaretrievalsystem,ortransmitted,inanyformorbyanymeans,
electronic,mechanical,photocopying,recording,orotherwise,
withoutthepriorpermissionofOxfordUniversityPress.
LibraryofCongressCataloging-in-PublicationData
Baker,AugustJ.
Managingpensionandretirementplans:aguideforemployers,administrators,
andotherfiduciaries/AugustBaker,DennisLogue,andJackRader.
p. cm.
Includesbibliographicalreferencesandindex.
ISBN0-19-516590-X
1. Pensiontrusts—Managment. 2. Pensiontrusts—Investments. I. Logue,
DennisE. II. Rader,JackS.,1949– III. title.
HD7105.4.B35 2005
658.3'253—dc22 2004009737
9 8 7 6 5 4 3 2 1
PrintedintheUnitedStatesofAmerica
onacid-freepaper
Preface
THE SHIFTING LANDSCAPE
This book evolved from an earlier work on pension plans that waspublishedin
1998.1 At that time, we were nearing all-time highs in the U.S. equity markets.
Employers in Defined Benefit (DB) pension plans had seen the asset pools that
they managed growmuchmorerapidlythantheliabilitiestheywereestablished
to fund—so much so that many plan sponsors made little or no contributions
forthebetterpartofthe1990s—anextendedvacationfromwhathadhistorically
beenasignificantexpenditure.Furthermore,earningsonpensionassetsofpublic
corporations added substantially to company earnings for many firms. This, in
turn, had a positive effect on executive compensation schemes and may have
made the stocks of these companies more attractive to investors.
Employees who worked for sponsors offering Defined Contribution (DC)
plans were in love with their pension schemes. Many employees had small
fortunes in the DC asset pools they owned—they were wealthy!Plannedretire-
ment ages were being moved forward; people were thinking seriously about
retiring at 55 instead of 65.Visions of luxurious retirement lifestylesdancedin
people’s heads. And the common wisdom—everywhere, it seemed—was that
Defined Contribution pension plans were the only pension plans that made any
sense whatsoever.
Then came March 2000. The equity markets turned down. Way down. By
theendofAugust2002,theWilshire5000indexhadfallenbynearly38%from
its previous high, and the NASDAQ index had fallen by 74%.
Many employees saw their DC asset pools shrink by huge amounts. Some
unfortunate people who had virtually all of their pensions in their employer’s
stock watched in horror as their employer’s stock became worthless. They
losteverything—100%oftheirsavingsvanished.Amongotherthings,theseun-
expected results led people to reassess the value of Defined Contributionstruc-
tures as the advantages (to employees) of defined benefit plans became more
apparent.
vi Preface
Defined Benefit plans also suffered. Employers with overfunded plans sud-
denly had plans that were underfunded. Contributions were needed to correct
thisunderfunding.Makingthingsworse,theeconomyweakenedand,alongwith
the weak economy, corporate profits and cash flow took a nosedive, making
unanticipatedpensioncontributionsahardshipformanycorporations.Thespon-
sors of public pension plans experienced a similar funding challenge as tax
receipts fell and government budgets came under significant financial pressure.
As a final blow, interest rates fell, thus raising the economic value of pension
plan liabilities.
With all this, it became clear, once again, that pension fund decisions and
management matter—a lot. These are complex issues that deserve a lot of at-
tention and a lot of effort. Pension fund management is not the “no-brainer”
that some had come to think. Further, the fraud and misstatement of earnings
that subsequently came to light lend urgency to pension fund decision making
and management.We need informed fiduciaries in fact as well as in name.
Partiallyinresponsetothistumultuousenvironment,andpartiallyinresponse
to some significant advances in financial and pension decision making, we de-
cided that a new book is required. In this volume, we present an economicand
financial view on how pension plans can create value for their sponsors. We
hopethatitwillbeusefulforthosewhoareinvolvedindecisionmaking,policy,
management, and advising pension funds and the sponsors of pension funds.
This is not a book of sound bites, nor is it intended to be a book that over-
simplifies some very challenging and complex issues. To the contrary, it is in-
tended to pull together what the reader needs to know to make informed judg-
ments abouteverything thatmattersintheworldofpensions.Wethinkwehave
succeeded; we hope you agree.
THE CONTEXT OF PENSION PLAN MANAGEMENT
The U.S. population is getting older. At present, for every person of retirement
age, there are fiveworking-agepeople. Overthenextthirtyyears,thisratiowill
decrease to three workers per retiree.2 Most retirees will be eligible for Social
Security income, but many Americans areskepticalaboutSocialSecurity.Only
about 13% of Americans expect Social Security to be their largest source of
income during retirement.3 As a supplement to Social Security income, many
people participate in employment-based retirement plans, collectivelyknownas
“pension plans.”4 There are many different varieties of pension plans that are
currently being offered. At one extreme arethetraditionalDBplans,whichpay
retirees a fixed income as long as they live. At the other extreme are the more
“modern” DC plans, such as 401(k) plans, which provide retirees with assets
built up over time in investment accounts.
We will discuss both of these plan types—and several others—in thisbook.
What the plans all have in common is that they are based in the employment
relationship. A person becomes eligible for them through working, and their
ultimate value depends on the terms of the person’s employment. For example,
Preface vii
thevalueoftheplanmaydependonhowmanyyearsthepersonworksfortheir
employer, or what their salary was during their employment.
It is usually the employer who establishes and sponsors a pension plan.Vir-
tuallyanyemployercansponsorapensionplanofsomekindoranother.Private
for-profitcompaniescananddosponsorplans.Stateandlocalgovernmentsalso
sponsor significant plans, as do public school systems and nonprofit organiza-
tions. Labor unions can and do sponsor pension plans as well.
In the aggregate, these pension plans have built up significant assets and are
continually growing. At the end of 2003, pension plans held about $7.4 trillion
inassets.State,local,andfederalgovernmentplansheldabout45%ofthistotal.
The remainder was distributed across the various nongovernmental “private”
plans.5
Plan participants are, of course, keenly interested in these plans: the success
oftheirplancandeterminetheirstandardoflivingduringretirement.Itcanalso
determine whether they can retire as early as they would like. Investors in gen-
eral are interested in these plans because of the plans’ significant clout in the
financial markets and because private pension obligations and funding come
from firms that have publicly traded bonds and stock. In addition, employers
arekeenlyinterestedintheseplans.Apensionplancanhelpanemployerattract,
retain, and motivate a competent workforce. Moreover, theemployer’sfinancial
health can depend significantly on the financial health of its pension plan.
The list of interested parties does not end there. Many government agencies
take an interest in pensions. On the federal level, the Treasury Departmentand
the Department of Labor are two prominent examples, andonthestatelevel,as
well as on the federal level, there is substantial regulation and governmental
oversight of pension plans. For a pension plan, complying with all the relevant
laws, regulations, and fiduciary obligations can be a significant undertaking.
Finally, the news media and the general public are also interested parties.
When a sizable pension plan fails, for example, there will be a lot of public
discussion about it. Pension plans are important to the financial well-being of
our older citizens and are key determinants of their standard of living in retire-
ment. This subject matter can elicit strong reactions.
THE PURPOSE OF THIS BOOK
In the middle of all the interested parties are the people who establish and
manage pension plans, the people who make sometimes difficult and always
complexdecisionsregardingpensionplans.Ourprimarypurposeinwritingthis
book is to provide a text that can be helpful to these decision makers.Wehope
to provide some clarity on the underlying economics and finance of pension
plans. We also hope to provide some practical advice; for example, on pension
plan investment strategies. In general, pension plan managers make many de-
cisions that have high stakes, and we hope this book will help themmakegood
choices.
This book will also be of interest to all who come in close contact with
viii Preface
public and private pension plans. Chief financial officers, ofcourse,shouldfind
itofinterest.Pensionplanadministrators,investmentmanagers,consultants,and
members of corporate boards of directors and public pension trustees will also
find much of value here, as will pension actuaries, accountants, and eventhose
who comment on the pension scene for one reason or another. Some of the
materialmay seem abitchallengingforthosewhoarenottrainedineconomics
or finance. Although pension fund management is challenging, we hope the
analysis is not excessively daunting. Where we have had to assume a level of
technical expertise that some readers may not have (e.g., in discussing risk
management and the proper use of derivatives), we do so knowing that there
areotherresourcesavailabletotheinterestedreader.Weaskyourunderstanding:
pension management is not easy, so the topics do not always lend themselves
to simple assertions or rules of thumb.
ADVISORY SERVICES
To adviseand assisttheplansponsorinstructuringplanswiththerightfeatures
and in making other pension decisions, there exist a plethora of consultants.
Benefits consultants help sponsors determine the proper replacement rate and
the appropriate plan design for particular employers. They advise with respect
to compliance with pension law, and they also help set up various plans for
different sectors of the sponsor’s business.
Tax lawyers advise regarding the plan’s compliance with IRS rules and reg-
ulations. Similarly, actuaries tell the defined benefit sponsor how much itneeds
to set aside each period to comply with the law and to have enough money to
pay retirees.
There are consultants who help plan sponsors find and monitor the perfor-
manceofexternalmoneymanagersandthedealer/brokerswhoprovideresearch
and execute investment trades. These consultants further assist in developing
investment strategies for both internally and externally managed funds.
Thus,thepensionplansupportsandhasaccesstoadvice,counsel,andservice
frommanyserviceindustries.Pensionplansare“bigbusiness,”andtheyinteract
with other big businesses that work on their behalf. The risk, of course, is that
a wonderful pension plan design developed in isolation of the employer’sother
interestscanprovetobeamistakewithinthelargerorganizationalcontext.Thus,
sponsors have to focus on the long-term goals of the organization and make
sure consultants are aware of these goals.
ORGANIZATION OF THE BOOK
The book is divided into five parts. Part I, Fundamentals, covers what pension
plansdo and how they do it. Itstartswithanintroductiontothetwomajorplan
types: Defined Benefit plansand DefinedContributionplans.Italsoincludesan
overview of fiduciary principles and regulatory compliance. Part II focuses on
Defined Benefit plans. Part III focuses on Defined Contribution plans and “hy-
brid” plans. Part IV goes beyond the fundamentals to discuss measuring, eval-
