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Case 3-1 Prudent Provisions For Pensions

PFS manages a pension fund for companies and wants to make prudent investments to cover required pension payments over the next 10 years. The payments total $8 million in 2003 and increase each year to $24 million in 2012. PFS is considering investing in a money market fund and four bonds to generate interest and principal payments that match the pension obligations. PFS wants to determine the minimum investment needed on January 1, 2003 across the funds to cover all pension payments through 2012.

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183 views2 pages

Case 3-1 Prudent Provisions For Pensions

PFS manages a pension fund for companies and wants to make prudent investments to cover required pension payments over the next 10 years. The payments total $8 million in 2003 and increase each year to $24 million in 2012. PFS is considering investing in a money market fund and four bonds to generate interest and principal payments that match the pension obligations. PFS wants to determine the minimum investment needed on January 1, 2003 across the funds to cover all pension payments through 2012.

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pamela
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Case 3-1

Prudent Provisions for Pensions

Among its many financial products, the Prudent Financial Services Corporation
(normally referred to as PFS) manages a well-regarded pension fund that is used by a number of
companies to provide pensions for their employees. PFS’s management takes pride in the
rigorous professional standards used in operating the fund. Since the Enron collapse in late 2001
and the subsequent tightening of federal and state regulations for operating pension funds, PFS
has redoubled its efforts to provide prudent management of the fund.
It is now December 2002. The total pension payments that will need to be made by the
fund over the next 10 years are shown in the table below.

Year Pension Payments ($millions)


2003 8
2004 12
2005 13
2006 14
2007 16
2008 17
2009 20
2010 21
2011 22
2012 24

By using interest as well, PFS currently has enough liquid assets to meet all these pension
payments. Therefore, to safeguard the pension fund, PFS would like to make a number of
investments whose payouts would match the pension payments over the next 10 years. The only
investments that PFS trusts for the pension fund are a money market fund and bonds. The money
market fund pays an annual interest rate of 5 percent. The characteristics of each unit of the four
bonds under consideration are shown in the table below.

Current Price Coupon Rate Maturity Date Face Value


Bond 1 $980 4% Jan. 1, 2004 $1,000
Bond 2 920 2 Jan. 1, 2006 1,000
Bond 3 750 0 Jan. 1, 2008 1,000
Bond 4 800 3 Jan. 1, 2011 1,000

All of these bonds will be available for purchase on January 1, 2003, in as many units as
desired. The coupon rate is the percentage of the face value that will be paid in interest on
January 1 of each year, starting one year after purchase and continuing until (and including) the
maturity date. Thus, these interest payments on January 1 of each year are in time to be used
toward the pension payments for that year. Any excess interest payments will be deposited into
the money market fund. To be conservative in its financial planning, PFS assumes that all the
pension payments for the year occur at the beginning of the year immediately after these interest
payments (including a year’s interest from the money market fund) are received. The entire face
value of a bond also will be received on its maturity date. Since the current price of each bond is
less than its face value, the actual yield of the bond exceeds its coupon rate. Bond 3 is a zero-
coupon bond, so it pays no interest but instead pays a face value on the maturity date that greatly
exceeds the purchase price.
PFS would like to make the smallest possible investment (including any deposit into the
money market fund) on January 1, 2003, to cover all its required pension payments through
2012. Some spreadsheet modeling needs to be done to see how to do this.

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