Financial Markets and Institutions (2-downloads)

Private pension plans, sponsored by employers, groups, and individuals, have grown

rapidly as people have become more concerned about the viability of Social Security

and more sophisticated about preparing for retirement. In the past, private pension

plans invested mostly in government securities and corporate bonds. Although these

instruments are still important pension plan assets, corporate stocks, mortgages, open

market paper, and time deposits now play a significant role. Figure 21.5 shows the dis-

tribution of private pension plan assets. They are now the largest institutional investor

Corporate &

Foreign Bonds

7.77%

Government

Securities

9.33%

Stock

65.32%

Miscellaneous

13.69%

Open Market Paper

0.49%

Time Deposits

1.33%

Cash

2.07%

F I G U R E   2 1 . 5

Distribution of Private Pension Plan Assets (end of 2009)

Source:

http://www.federalreserve.gov/releases/z1/current/z1.pdf

, Table L118.

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Part 6 The Financial Institutions Industry

in the stock market. This makes pension plan managers a potentially powerful force

if they choose to exercise control over firm management (see the Mini-Case box).

An alternative to privately sponsored pension plans are the public plans, though

in many cases there is very little difference between the two. A public pension plan

is one that is sponsored by a governmental body.

The largest of the public plans is the Federal Old Age and Disability Insurance

Program (often called simply Social Security). This pension plan was established in

1935 to provide a safety net for aging Americans and is a “pay-as-you-go” system—

money that workers contribute today pays benefits to current recipients. Future gen-

erations will be called on to pay benefits to the individuals who are currently

contributing. Many people fear that the fund will be unable to meet its obligations

by the time they retire. This fear is based on problems that the fund encountered

in the 1970s and on the realization that a large number of people from the baby boom

generation (born between 1946 and 1964) will swell the ranks of retirees in the

rapidly approaching future.

The amount of the Social Security benefits a retiree receives is based on the per-

son’s earnings history. Workers contribute 6.2% of wages up to a current maximum

wage of $106,800 (as of 2010). Employers contribute the same amount. There is a

certain amount of redistribution in the benefits, with low-income workers receiving

a relatively larger return on their investment than high-income workers. One way

to evaluate the amount of the benefits of a pension plan is to determine how the

monthly benefits compare to preretirement income. This replacement ratio ranged

from 49% for someone earning $15,000 a year to 24% for someone earning $53,400.

Figure 21.6 shows that the total assets in the Social Security fund decreased in

the late 1970s and early 1980s at the same time that the number of insured people

was increasing. This situation led to a restructuring that included raising the pro-

gram’s contributions and reducing the program’s benefits. To build public confidence,

the Social Security system has started accumulating reserves to be used as the baby

boom generation begins retiring.

The problem is that the 77 million baby boomers born between 1946 and 1964

will begin reaching their normal retirement ages in 2011. Meanwhile, the number

M I N I - C A S E