Money, Banking, and International FinanceSecond type of insurance company is property and casualty insurance companies. They are
organized as either a stock company or mutual company, and they insure against theft, floods,
illness, fire, earthquakes, and car accidents. These companies tend to purchase liquid, short-term
assets because these companies cannot accurately predict the amount of future claims. Insurance
companies charge premiums that correspond to the chance of the event occurring. For example,
a homeowner in California would pay a higher premium for earthquake insurance than a
homeowner in the Midwest of the United States because California experiences more
earthquakes.
Pension funds are another contractual savings institution. Many people save money for
retirement, and pension funds become a vital form of saving. Some employers sponsor pension
funds as a job benefit, or workers can voluntarily pay into personal retirement accounts. Then
the financial companies manage the pension funds, and they invest pension funds into the
financial markets. Pension fund managers can accurately predict when people will retire and
usually invest in long-term securities, such as stocks, bonds, and mortgages. A person can only
receive benefits from the pension fund after the person becomes vested. Vested means
employees must work for their employer for a time period before they can receive the benefits
from the pension plan. Time period varies for the pension funds. For example, some city
governments require a person to be employed by the city for 10 years before this person
becomes 100% vested in the city’s pension plan.
Employers have three reasons to offer pension plans to employees. First, the pension fund
managers can more efficiently manage the fund, lowering the pension funds’ transaction costs.
Second, the pension funds may offer benefits such as life annuities. A life annuity is a worker
contributes money into the annuity until he retires. Then the worker receives regular payments
every year from the annuity until his death. Life annuities could be expensive if a worker buys
them individually. However, a large employer with many employees can request discounts from
pension plans. Finally, the government does not tax the pension fund as workers invest funds
into it, allowing the fund to grow faster. Nevertheless, government usually imposes taxes on
withdrawals from a pension fund. If the employer offered higher wages and no pension plans to
the employees, then the government taxes the greater income, reducing the amount an employee
could invest into a retirement plan.
Employers have two choices for the ownership of a pension plan. First, employees own the
value of the funds in the pension plan, called a defined contribution plan. If the pension fund is
profitable, subsequently, the retired employees will receive greater pension income. If the
pension fund is not profitable, then the retired employees will receive a low pension income.
Companies that have a defined-contribution plan are likely to invest the pension funds into the
companies’ own stock. That way, employees have an incentive to be more productive because
the value of their pension plan depends on their company’s profitability. However, this pension
fund becomes dangerous if this company bankrupts. Then the employees own worthless stock.
One infamous case was the Enron collapse in 2001. Some employees were millionaires until
their stock portfolios collapsed in value overnight. Second, the most common type of plan is the
defined-benefit plan. An employer promises a worker a specific amount of benefits that are
based on the employee’s earnings and years of service to the company. If this pension fund is