History of Pension Funds

Information about IBM

IBM’s main function is to provide customer solutions with the help of advanced information technology. IBM operates in more than 150 countries worldwide. They strive to leas in the invention, development and manufacture of the industry’s most advanced information technologies.

Pension funds acting as Financial Intermediaries.

In order to see how Pension funds, and in particular how IBM works as a financial intermediary, we need to know what a financial intermediaries are. Fabozzi et al  defines it as “playing the basic role of transforming financial assets that are less desirable for a large part of the public into other financial assets – their liabilities- which are more widely preferred.” Below are the main functions of a financial intermediary:

Function 1: Diversification to reduce risk.

Diversification is defined as “transforming more risky assets into less risky ones” which is used by financial intermediaries to reduce risk which is in effect one of the fundamental characteristics of pension funds. Pension funds offer much lower costs of diversification because they are economies of scale in large transactions, related partly to the fixed costs involved . Pooling  is also a risk reducing technique where it provides a better trade-off of risk for small investors than for direct holdings. The manager of pension funds can “collect the income from a large number of small savers and then distribute it among a much wider variety of securities than an individual saver could possibly do.”  

Function 2: Maturity Transformation

Maturity transformation is defined as “the conversion of funds lent for a short period into loans of longer duration.” Pension fund creates more attractive assets and liabilities, by mostly maturity transformation. They deal with maturity transformation by investing the long term funds into the stock market because of the large pool of funds, when employees retire; liquidity would be available to them. All this can be done, is due to the fact of economies of scale.

Function 3: Transaction Costs

Pension funds do not function in exchanging goods, services, assets directly and it also does not offer liquid liabilities. However, it still has an indirect role in boosting the efficiency of the financial systems, by influencing the structure of securities markets. Pension Funds help to generate liquidity by their own activity on arbitrage, trading and diversification and from the fact that liquidity is a form of increasing return to scale, as larger markets in which pension funds are active attractive more trading, reducing costs and improving liquidity further. 

 also mentions other functions in which pension funds act as financial intermediaries. For example providing ways to manage uncertainty and to control risk via retirement income insurance and providing price information.

Pension Funds in shortfall

IBM is listed on the NYSE (New York Stock Exchange) which is the oldest and largest auction market for stocks in the US.

In appendix 1 it can be seen that the stock prices has fallen steadily since the middle of 2001, but it was in the beginning of 2002 when the stock prices has dramatically fallen. Which has been reported as “one of the worst years for corporate profitability in a decade.” In the chart it shows that over the past two years there is a decline in the equity markets which has caused many problems for many companies including IBM which has affect their price performance. It has resulted on IBM cutting its actuarial rate of return from10% to 9.5%. This “is expected to reduce the income the company’s pension fund contributes to its total earnings.” This had made a huge impact on IBM’s US pension fund because it has reached its lowest point as “IBM’s pension income is destined to decline this year for the first tome since pensions became an income item instead of a cost item for the company in 1996.” It can be seen from appendix 2 during the five year period from beginning of 1999 to 2003 the highest peak was in mid 1999 with its stocks priced at approximately 140 dollars. It’s lowest point as mentioned earlier was Oct-Nov 2002, reaching to below 60 dollars which is a far cry from the years before results (2001) which IBM had recently disclosed in its annual report which stated that “the company has reported a “pension income amounting to $1.45 billion, an amount accounting for 13% of its $10.95 billion pre-tax profit.” 

        This downfall has resulted in IBM and many other company’s pension fund to be underfunded. IBM’s US pension plan had been underfunded in total by approximately $4.5 billion. IBM, however, “has stepped up as the first major bellwether to address the simmering issue of its multi-billion dollar pension shortfall.” Because of such event IBM reacted to this problem by contributing 41.5billion to its US plan each year until 2005. Yet, making this move would result in the firm losing about 5 cents per share during it’s earnings next year due to issuing and selling stocks to raise cash, as mentioned by Merill Lynch

        However, due to improvements in the equity markets making a recovery, the status of IBM’s pension fund has seem to be recovered. Due to the stock markets recovery. It has decreased the $4.5 billion down to $3 billion which is more manageable to handle. Therefore, IBM reacted to this news by announcing that “it plans to fund the company’s US pension plan fully through a contribution of cash and/or stock this year.” 

        From an interview made with John Joyce, IBM’s senior vice president and chief financial officer, he stated that IBM has chosen to put the largest part of this ‘gap [i.e. the underfunded pension fund] behind them which most companies could not do so because it does not have the strength of IBM’s cash flow and balance sheet.” Therefore, IBM is in a position to deal with this deficit now. Mr. Joyce has also pointed out advantages due to this strategy taken place, which is “not only is this the best interests of our retirees and employees, but shareholders also benefit because by stepping up to funding gap now, we decrease uncertainty about the future. Another advantage of this move made by the IBM is that not only will it solve the problem of the IBM’s pension fund deficit, but also “it would not affect operating budgets or strategic initiatives.” Mr. Joyce went on to mention that they have other plans to invest in such as “5 billion in research and planning, $5 billion in capital expenditures and so on.” Things would seem to look up as their expectations for earnings per share in 2003 would not change unlike their previous plan.

        Finally, in December 2002 IBM had “restored the company’s US pension plan to fully funded status”showing the company has not only be one of the first to announce a strategy to deal with the problem but also to be successful in their solution within the time they planned (by year end). They succeed in fully funding the pension fund by contributing “totals approximately $3.95 billion, $2.09 billion or 52.9% in cash with remaining $1.86 billion or 47.1% pension fund with 24,037,354 shares of IBM stock. Its success also relies on the “performance of capital markets, which decreased the value of the pension plan’s assets in the intervening weeks.”

        By looking back at the both of the charts, it shows that the price performance had increased during the year 2003.

Bibliographical references

Printed Publications

• Meir Kohn (1994), Financial Institutions and Markets. McGraw-Hall Inc.
• Peter Howells and Keith Bain (2000), Financial Markets and Institutions,  3rd Edition, FT Prentice Halls.
• Frank Fabozzi, Franco Modigliani, Frank Jones, Michael Ferri (2002),  Foundations of Financial Markets and Institutuions, 3rd Editon. Prentice Halls.
• Charles R Geisst (1993) A guide to Financial Institutions. 2nd Edition. The  Macmillan Press Ltd.

Electronic Sources

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