Chapter: 03

Bank Vs Non-Bank Financial Institutions

i. Cheques can be issued against bank deposits whereas

no such facility is available in case of non-banking
financial institution.
ii. Bank may be defined as an institution which is
governed by the Banking Regulation Act but NBFIs
do not fall under the category of Banking regulation
Act and, thereby, they are more or less completely
free from Central Banking Control.
iii. Generally, the commercial banks offer lesser rate of
interest on deposits and also charge lesser rate of
interest on lending than that of the NBFIs.
Bank Vs Non-Banking Financial Institution
iv. Commercial banks are able to enjoy certain facilities
like rediscounting facilities, deposit insurance
coverage facilities etc. These facilities are not
extended to NBFIs.
v. A variety of assets in the form of loans of various
types, cash credits, overdrafts, bill discounting etc are
held by commercial banks whereas the assets of
NBFIs are more or less specialized in nature. For
insurance, hire-purchase companies specialize in
consumer loans and housing finance companies
specialize in housing finance alone, investment
companies invest on principal securities and pass on
the benefits to small investors.
 Non-depository Financial Intermediaries

Non-depository Financial Intermediaries include:

(1) Insurance companies
(2) Investment companies
(3)Pension fund.
 Insurance Companies: An Overview
Insurance companies provide (sell and service)
insurance policies, which are legally binding
contracts for which the policy holder (or owner)
pays insurance premiums. According to
insurance contract, insurance companies promise
to pay specified sums contingent on the
occurrence of future events, such as death or an
automobile accident. Thus insurance companies
are risk bearers. They accept or underwrite the
risk in return for an insurance premium.
 Insurance Companies: An Overview
(Cont..)
The major part of the insurance company underwriting
process is deciding which application for insurance they
should accept and which ones they reject, and if they
accept, determining how much they should charge for the
insurance. This is called underwriting process. For
example, an insurance company may not provide life
insurance to some one with terminal cancer or
automobile insurance with numerous traffic violations.
And in some cases, they may provide different classes of
insurance with different premiums. The underwriting
process is critical to an insurance company.
 Insurance Companies: An Overview
(Cont..)
Because insurance companies collect insurance
premiums initially and make payment later when
(e.g., the insured person’s death) or if (e.g., an
automobile accident) an insured event occurs,
insurance company maintain the initial premiums
collected in an investment portfolio, which
generates a return. Thus insurance companies have
two sources of income: the initial underwriting
income (the insurance premium) and investment
income which occurs over time.
 Insurance Companies: An Overview
(Cont..)
The payments on the insurance policies are one major
expense of the insurance company. These payments vary
among the different types of insurance policies and
companies. The payments may be very unstable,
depending on the type of insurance. The other major type
of expense is the operating expense of the insurance
company. This expense tends to be quite stable.
Insurance company’s profits result from the difference
between their insurance premiums and investment returns
on the one hand, and their operating expense and
insurance payments or benefits on the other.
 Types of insurance
1. Life insurance • Other
• Term insurance
• Whole life 4. Other insurance
• Universal life • Disability
• Second to die (Survivorship) • Long-term care

2. Health insurance 5. Structured Settlements

• Medical
• dental 6. Investment Oriented Products
• Other • Guaranteed Investment Contract
• Annuities
3. Property and Casualty
• Property
• Liability
 Life insurance
For life insurance, the risk insured against is death. The life
insurance company pays the beneficiary of the insurance
policy in the event of the death of the insured.
Term insurance: is pure life insurance. If the insured dies while
the policy is intact, the beneficiaries of the policy receives the
death benefits. If the insured does not die within the period,
the policy is invalid and has no value. There is no cash value
or investment value for a term insurance policy. In addition,
the policy holder cannot borrow against the policy.
With respect to the premium paid, there are two different types
of term policy. The first is level term. For this type, the
premium is constant over the life of the policy. The second
type is annual renewable term, whereby the policy provides
guaranteed protection over the term of the policy (e.g., 10
years), but at an increasing premium. However, a maximum
premium schedule is provided.
 Life insurance (Cont..)
Whole life or Cash value or Permanent life insurance:
In addition to providing pure life insurance (as does term
insurance), whole life insurance build up a cash value or
investment value inside the policy. This cash value can be
withdrawn and can also be borrowed against by the owner
of the policy. Or, if the owner wishes to let the policy
lapse, he or she can withdraw the cash value. This cash
value develops because of the level premium approach to
paying for this type of insurance. The actuarial cost of
pure insurance increases with age, but the premium
charged on this type of insurance is level. The
policyholder is therefore overpaying for insurance early in
the life of the policy and underpaying thereafter.
 Life insurance (Cont..)
Flexible premium policies - Universal life:
The key element of universal life is the flexibility of
the premium for the policy owner. This flexible
premium concept separates pure insurance
protection (term insurance) from the investment
(cash value) element of the policy. The policy cash
value is set up as the cash value fund (or
accumulation fund) to which the investment income
credited and from which cost of term insurance for
the insured (the mortality charge) is debited. The
expenses are also debited.
 Life insurance (Cont..)
Survivorship (second to die) insurance:
Most whole life insurance policies are designed to pay death
benefits when one specified insured dies. An added dimension
of the whole life policies is that two people (usually a married
couple) are jointly insured and the policy pays the death
benefit not when the first person dies, but when the second
person (the “surviving spouse”) dies. This survivorship feature
can be added to standard cash value whole life, universal life
policies.
In general, the annual premium for a survivorship insurance
policy is lower than for a policy on a single person because, by
construction, the second person of two people to die has a
longer life span than the first.
 Health insurance
In the case of health insurance, the risk insured is medical treatment of
the insured. The health insurance company pays the insured (or the
provider of the medical service) all or a portion of the cost of medical
treatment by doctors, hospitals or others.
The major type of health insurance available was indemnity insurance.
According to indemnity insurance, the insurance company agrees to
indemnify (reimburse) the insured for covered medical or hospital
expenses. That is, the insurance company pays the medical provider
(doctors, hospital, etc.) for the medical services provided to insured.
The provider is selected by the insured and can provide whatever
service the provider deems appropriate.
Very often there is an annual minimum amount below which the issuer
does not pay for the service, the insured pays (a deductible). Typically,
there is also a copayment (a “Co-pay”) required by the insured. For
example, the insured pays 20% of the charge for the service and insurer
pays the other 80%.
 Property and Casualty insurance
The risk insured by property and casualty (P&C) insurance
company is damage to various types of property. Specifically,
it is insurance against financial loss caused by damage,
destruction or loss to property as the result of an identifiable
event that is sudden, unexpected or unusual. The types of such
insurance are:
✓ A house or its contents against risk such as fire, flood and
theft; and
✓ Vehicles against collision, theft and other damage.
Liability Insurance:
With liability insurance, the risk insured against is litigation or
the risk of lawsuits against the insured due to actions by the
insured or others.
 Disability insurance
Disability insurance insures against the inability of employed persons
to earn an income in either their own occupation (“own occ” disability
insurance) or any occupation (“any occ”). Typically, “own occ”
disability insurance is written for professionals in white-collar
occupations and “any occ” for blue-collar workers. Another distinction
in disability insurance is the sustainability of the policy. Regarding to
sustainability, there are two types of policies. The first is guaranteed
renewable (or guaranteed continuable) whereby the issuer has to sustain
the policy for the specified period of time and the issuer cannot make
any changes in the policy except that it can change the premium rates
for the entire class of policy (but not an individual policy holder). The
other type is non-cancellable and guaranteed renewable (or simply non-
cancellable) whereby the issuer has no right to make any change in any
policy during the specified period. Disability insurance is also divided
between short term disability and long term disability, with six months
being the typical dividing time.
 Long-term care insurance
As individuals have been living longer, they
have been concerned about outliving their assets
and being unable to care for themselves as they
age. In addition, custodial care for the aged has
been very expensive. Thus there has been an
increased demand for insurance to provide
custodial care for the aged who are no longer
able to care for themselves. This care may be
provided in either the insured’s own residence or
a separate custodial facility.
 Structured settlements
Structured settlements are fixed, guaranteed periodic
payments over a long period of time, typically resulting
from a settlement on a disability policy or other type of
policy. For example, suppose an individual is hit by an
automobile and as a result, is unable to work for the rest
of his or her life. The individual may sue the P&C
company for future lost earnings and medical care. To
settle the suit, the P&C companies may agreed to make
specified payments over time to the individual. The P&C
company may then purchase a policy from the life
insurance company to make the agreed upon payments.
 Investment-Oriented Products
Guaranteed Investment Contract (GIC):
Insurance companies have increasingly sold products that
have a significant investment component in addition to
their insurance component. The major investment oriented
products developed by life insurance company was the
Guaranteed Investment Contract (GIC). According to a
GIC, a life insurance company agrees, in return for single
premium, to pay the principal amount and a
predetermined annual crediting rate over the life of the
investment, all of which are paid at the maturity date of
the GIC.
 Investment-Oriented Products (Cont..)
Annuity:
Another insurance company investment product is an annuity. An
annuity is often described as “a mutual fund in an insurance wrapper”.
What does this mean? To answer this question, assume that an
insurance company investment manager has two identical common
stock portfolios, one a mutual fund and the other is an annuity. On the
mutual fund, all income (i.e., dividend) is taxable and the capital gains
(or losses) realized by the fund are also taxable, although at potentially
different tax rates. The income and realized gains are taxable whether
they are withdrawn by the mutual fund holder or not.
Because of the insurance wrapper, the annuity is treated as an insurance
product and as a result receives a preferential tax treatment.
Specifically, the income and realized gains are not taxable if not
withdrawn from the annuity product. Thus, the “inside buildup” of
returns is not taxable on an annuity, as it is not an other insurance
products.
 Determinants of Insurance Premiums
The premium charged by an insurance company for each
insurance policy is based on the probability of the condition under
which the company will have to provide a payment to the insured
(or the insured’s beneficiary) and the potential size of the
payment. The premium may also influenced by the degree of
competition within the industry for the specific type of insurance
offered. Insurance companies can estimate the present value of a
payment that they will have to make for a specified insurance
policy. The premium charged for that insurance is influenced by
the present value of the expected payment. The premium will also
contain a markup to cover overhead expenses and to provide a
profit beyond expenses.
The insurance premium is higher when there is more uncertainty
about the size of the payment that may ultimately have to made.
Insurance companies tend to charge lower premiums when they
provide services to all employees of a corporation through plans.
Life insurance company: Sources of funds
The sources of funds of life insurance company
are as follows:
1. Life insurance premiums
2. Health insurance premiums
3. Annuity plans (offer a predetermined amount
of retirement income to individuals)
4. Investment income
5. Other income
 Life insurance company: Uses of funds
The uses of funds by life insurance companies strongly influence their performance.
Life insurance companies are major institutional investors. The following are the
assets of life insurance companies, indicates how funds have been used.
1. Government securities (such as treasury securities, local government bonds
and foreign government bonds. These securities provide safety and liquidity.)
2. Corporate securities (corporate bonds and stocks)
3. Mortgages: Life insurance companies hold all type of mortgages. These
mortgages are typically originated by another financial institutions and then
sold to insurance companies in the secondary market. Most of the mortgages
are the commercial mortgages and they help to finance shopping centers and
office buildings.
4. Real estate: Although life insurance companies finance real estate by
purchasing mortgage, their return is limited to the mortgage payments. In
attempt to achieve higher returns, they sometimes purchase real estate and lease
it for commercial purposes.
5. Policy loans: Life insurance companies lend a small portion of their funds to
whole life policy holders.
6. Cash and other assets
 Structure of insurance companies
Insurance companies are a composite of three companies. First, there
is the “home office” or actual insurance company. This company
design the insurance contract (“manufacturer” of contract) and
provides the backing for the financial guarantees on the contract, that
is, assures the policyholder that the contract will pay off under the
conditions of the contract. This company is called the manufacturer
and guarantor of the insurance policy.
Second, there is the insurance component that invests the premiums
collected in the investment portfolio. This is the investment company.
The third element of an insurance company is the distribution
component or the sales force. There are different types of
distribution forces. They are agents (associated with the company and
sell only or mainly the company’s own manufactured products),
brokers (who are not associated with any company but the insurance
products of many companies), producer groups (brokers operating in
groups but not individually), bankassurance (commercial bank
distribution of insurance company products ) and even through
internet.
 Structure of insurance companies (Cont..)
These three components of insurance companies traditionally
have been combined in one overall company , but they are
increasingly being separated and the three functions are being
provided by different companies. First, many insurance
companies use independent brokers or producer groups to
distribute their products rather than their own agents. Many
companies no longer have their own agents and sell all their
products exclusively through brokers, producer groups or on
the internet. Second, insurance companies are increasingly
outsourcing parts of their investment portfolio or even the
entire portfolio to external independent investment managers.
Third, while the home office component of an insurance
company seems to be the core of the insurance company,
some home offices use external actuarial firms to design their
contracts. And more importantly, they may reinsure some or
all of the liabilities they incur in providing insurance.
 Forms of insurance companies
Two major forms of insurance companies: stock and mutual.
A stock insurance company is similar in structure to any
corporation or public company. Shares (of ownership) are
owned by independent shareholders and are traded publicly.
The shareholders care only about the performance of their
shares, that is the stock appreciation and dividends. Their
holding period and thus their view may be short term. The
insurance policies are the products or business of the
company.
Mutual insurance companies have no stocks and no external
owners. Their policyholders are also their owners. The
owners, that is, the policy holders, care primarily or even
solely about the performance on their insurance policies,
notably the company’s ability to pay on the policy. Since
these payments may occur into the future, the policyholder’s
view may be long term.
Individual Versus Group Insurance
All insurance products are sold to individuals.
Some insurance products are also sold groups,
typically to the employees of specific company
through their employers, or educational, medical
or other professional associations. Among the
major types of products distributed to groups are
term life insurance, whole life insurance, medical
insurance, disability insurance and investment
products such as mutual funds, annuities.
 Development of Insurance in
Bangladesh
❑During the British rule in India, some insurance
companies started transacting insurance business
particularly life, in this part of the world and gained
momentum.
❑There were about 49 companies transacting both life
and general insurance business during pre-liberation
period.
❑In 1972 insurance industry become nationalized in
Bangladesh by Presidential Order No.95, more
specifically known as the Bangladesh Insurance
(Nationalization) order 1972.
 Development of Insurance in
Bangladesh (Cont..)
❑ Five insurance corporatiion were initially established –Jatiya
Bima Corporation, Teesta Bima Corporation, Karnafuli Bima
Corporation, Rupsa Bima Corporation and Surma Bima
corporation.
❑ As per the order, Teesta and Karnafuli were made responsible
for general insurance business, and Rupsa and Surma were
made responsible for life insurance business. The Jatiya Bima
Corporation was a central corporation to supervise and control
the activities of these four corporations.
❑ Because of unnecessary administrative expenses for
maintaining these four corporations on 14th May
1973,structural arrangement under nationalization was
changed by [Link],[Link] five corporations were abolished
and, instead, two corporations were established-1) Sadharan
Bima Corporation and 2) Jiban Bima Corporation.
Sadharan Bima Corporation (SBC)
❑This corporation deals with general insurance
business only.
❑In a contract of general insurance, the insurer, in
consideration of Premium paid by the insured,
undertakes to indemnify the assured against loss or
losses which may arise in certain circumstances
subject to fulfillment of the conditions laid shown
therein.
❑If the assured does not suffer a loss, the question of
payment of compensation by the insurer to the
insured does not arise.
 Sadharan Bima Corporation (Cont..)
Some types of General Insurance:
i. Fire Insurance
ii. Marine
iii. Motor
iv. Engineering
v. Aviation
vi. Miscellaneous Accident: Burglary and house
breaking policy, Employer's liability,
personal Accident, crops insurance etc.
 Jiban Bima Corporation (JBC)
This corporation deals with life insurance business only.
Policies under JBC: Various types of policies or schemes
are available under the heading of life assurance,
Basically ,there are three types, rest of the schemes are
primarily the mixture or modification of these three.
i. Term or Temporary Assurance: The policy is issued
for a certain term or period. The contract provides that
the sum assured under the policy shall be paid only if
the life assured dies within the period mentioned in
the policy, nothing is payable if the assured survives
this period, and the contract comes to an end.
 Jiban Bima Corporation (Cont..)
ii. Whole-life Assurance: Under this type of policies,
sum assured is payable only after death of the life
assured, whenever such death might take place,
premium is usually payable throughout the life
span of the life assured. However, arrangements
may be made for payment of premium up to a
certain selected age, hereafter the premium
payment ceases.
iii. Pure Endowment Assurance: Under this type of
policy the sum assured is payable only if the life
assured survives the stipulated period mentioned in
the policy, otherwise nothing will be paid.
 Jiban Bima Corporation (Cont..)
Other types of coverage:
❑ Endowment Assurance: It is virtually a combination or
mixture of term assurance and pure endowment. Under the
policy sum assured is payable either at the death of the life
assured or maturity of the policy on varying term from 15, 20,
25, 30 years to be decided by the insured.
❑ Group Life Assurance: This type of assurance is commonly
used by a group of employees of an organization. All the
employees working in an organization get themselves insured
under one policy and get insurance protection at a very low
rate of premium.
❑ Group Pension Scheme: This scheme also applicable to
groups of employees working in various organizations. It
secures pensions for the individual employee from the time of
retirement.
 What is an investment company?
Investment companies are financial
intermediaries that sell shares to the public and
invest the proceeds in a diversified portfolio of
securities. Each share sold represents a
proportional interest in the portfolio of securities
managed by the investment company on behalf
of its shareholders. The types of securities
purchased depends on the company’s investment
objective.
 Types of investment companies
There are three types of investment companies:
1. Open-end funds
2. Closed-end funds and
3. Unit trusts.
The first two investment companies are managed
companies, offering professional management of
the portfolio. The third investment company (i.e.,
unit trust) is unmanaged.
 Open-end funds (Mutual Funds)
Most familiar type of managed company, are popularly
referred to as mutual funds and continue to sell shares to
investors after the initial sale of shares that start the fund. The
capitalization of the open-end fund is continually changing –
that is, it is open-ended – as new investors buy additional
shares and some existing shares back to the company.
There are several important aspects of mutual funds.
First, investors of mutual funds own a pro rata share of the
overall portfolio.
Second, the investment manager of the mutual fund actively
manage the portfolio, that is, buys some securities and sells
others.
 Open-end funds (Mutual Funds)
Third, the value or price of each share of the portfolio,
called the net asset value (NAV), equals the market value
of the portfolio minus the liabilities of the mutual fund
divided by the number of shares owned by the mutual
fund investors. That is
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜−𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
NAV=
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑢𝑛𝑔
For example, suppose that a mutual fund with 10 million
shares outstanding has a portfolio with a market value of
$215 million and liabilities of $15 million. The NAV is
$215,000,000−15,000,000
NAV=
10,000,000
= $20
 Open-end funds (Mutual Funds)
Fourth, the NAV or price of the mutual fund is
determined only one each day, at the close of the
day. For example, the NAV of a stock mutual
fund is determined from the closing prices for
the day.
Fifth, all new investments into the fund or
withdrawals of the fund during a day are priced
at the closing NAV.
 Open-end funds (Mutual Funds)
The total number of shares in the fund increases if there are more investments
than withdrawal during the day and vice versa. For example, assume that at
the beginning of a day a mutual fund portfolio has a value of $1 million, there
are no liabilities, and there are 10,000 shares outstanding. Thus NAV of the
fund is $100. assume that during the day $5,000 into the fund, $1,000
withdrawn, and the prices of all securities in the portfolio remain constant.
This mean that 50 shares were issued for the $5,000 deposited (since each
share is $100) and 10 shares redeemed for $1,000. the net number of new
shares issued is then 40. therefore, at the end of the day there will be 10,040
shares and the total value of the fund will be $1,004,000. the NAV will
remain at $100.
If instead, the prices of securities in the portfolio change, both the total size of
the portfolio and therefore, the NAV will change. In the previous example,
assume that during the day the value of the portfolio doubles to $2 million.
Since the deposits and withdrawals are priced at the end of the day, which is
now $200 after the doubling of the portfolio’s value, the $5000 deposit will
be credited with 25 shares ($5000/200) and the $1000 withdrawn will reduce
the number of shares by 5 shares ($1000/200). Thus at the end of the day
there will 10,020 shares in the funds with a NAV of $200, and the value of the
fund will be $2,004,000 (i.e., 10,020X$200).
 Closed-end funds
Closed-end fund usually sells no additional shares of its
own stock after the initial public offering. Therefore, their
capitalizations are fixed unless a new offering is made.
The shares of a closed end-fund are very similar to the
shares of common stock of a corporation. The new shares
of a closed-end fund are initially issued by an underwriter
for the fund. And after the new issue, the number of
shares remains constant. After the initial issue, there are
no sales or purchases of fund shares by the fund company
as there are for open-end funds. The shares are traded on a
secondary market, either on an exchange or in the over-
the-counter market.
 Closed-end funds
Investors can buy shares either at the time of initial issue or in
the secondary market. The price of the shares of a closed-end
fund are determined by the supply and demand in the market in
which these fund are traded. Thus, investors who transact
closed-end fund shares must pay a brokerage commission at
the time of purchase and at the time of sales.
The NAV of closed-end funds is calculated in the same way as
for open-end funds. However, the price of a share in a closed-
end fund is determined by the supply and demand, so the price
can fall below or rise above the NAV per share. Shares selling
below NAV are said to be “trading at discount,” while shares
trading above NAV are “trading at a premium.”
 Closed-end funds
There are two important differences between open-
end funds and closed-end funds. First, the number
of shares of an open-end fund varies because the
fund sponsor will sell new shares to investors and
buying existing shares from shareholders. Second,
by doing so, the share price is always the NAV of
the fund. In contrast, closed end funds have a
constant number of shares outstanding because the
fund sponsor does not redeem shares and sales new
shares to the investors. Thus the price of the fund
shares will be determined by the supply and demand
in the market and may be above or below the NAV.
 Unit Trusts
An unmanaged form of investment company, typically holding
fixed income securities, offering investors diversification and
minimum operating cost.
A unit trust is similar to a closed-end fund in that the number of
unit certificates is fixed. Unit trusts typically invest in bonds. They
differ in several ways from both mutual funds and closed-end funds
that specialize in bonds. First, there is active trading of the bonds in
the portfolio of the unit trust. Once the unit trust is assembled by
the sponsor (usually a brokerage firm or bond underwriter) and
turned over to a trustee, the trustee holds all the bonds until they are
redeemed by the issuer. The only time the trustee can sell an issue
in the portfolio is if there is a dramatic decline in the issuer’s credit
quality. Second, unit trusts have a fixed termination date, while
mutual funds and closed-end funds do not. Third, unlike the mutual
fund and closed-end fund investor, unit trust investor knows that
the portfolio consists of a specific portfolio of bonds and has no
concern that the trustee will alter the portfolio.
 Types of Mutual funds
There are two major types of mutual funds:
❖Money market mutual funds (short term
fund) concentrate on short-term investing by
holding of money market assets
❖Stock funds and bond and income funds
(long term funds) concentrate on longer-term
investing by holding mostly capital market
assets.
 Expenses of mutual funds
Mutual funds pass on their expenses to their shareholders.
The expenses include compensation to the portfolio
managers and other employees, research support and
investment advice, record-keeping and clerical fees, and
marketing fees.
Expenses can be compared among mutual funds by
measuring the expense ratio, which is equal to the annual
expenses per share divided by the fund’s NAV. An
expense ratio of 2% in a given year means that
shareholders incur annual expenses reflecting 2% of the
value of the fund. Many mutual funds have an expense
ratio between 1% and 2%.
 Sales load
Mutual funds can also be classified as either load,
meaning that there is a sales charge, or no-load,
meaning that the funds are promoted strictly by the
mutual fund of concern (i.e., those that do not
charge a sales fee). Load funds are promoted by
registered representatives of brokerage firms, who
earn a sales charge typically ranging between 3%
and 8.5%. Investors of a load fund pay this charge
through the difference between the bid and ask
prices of the load funds. Loads, commissions, and
bid-ask spread are not included in the expense ratio
of a mutual fund.
 Types of loads
Mutual funds charge different types of loads: front-end loads and
back-end load.
A front-end load is paid only once, at the time you invest money
in the mutual fund. Mutual funds with a front-end load often offer
discount like breakpoints, right of accumulation, letter of intent or
free transfer. Breakpoints are basically volume discount, which
means that the percentage load becomes smaller as you invest
more ($25,000 & more). A right of accumulation is a discount
based on the total amount of money you invest in the fund family
(as opposed to just the individual fund). Letters of intent are often
used for investors who invest only a small amount today but
commit themselves to additional purchase over the next years.
Free transfer allow investors to move money between funds with
no additional loads, provided the money stays in the same family.
A back-end load (also known as a rare load or reverse load) is a
withdrawal fee assessed when you withdraw money from the
mutual fund.
 Background of Pension Funds
Pension funds protect individual and families against loss of income
in their retirement years by allowing workers to set aside and invest
a portion of their current income. A pension plan places current
savings in a portfolio of stocks, bonds and other assets in the
expectation of building an even large pool of funds in the future. In
this way, the pension plan member can balance planned consumption
after retirement with the amount of savings set aside today.
Pension funds are major institutional investors and participate in the
financial markets. Pension fund have become important for several
reasons. First, income and wealth have grown steadily over the post
World War II period, leaving households more money for long-term
savings. Second, people are living longer and can expect more
financial needs for longer retirement periods. Third, pensions
represent compensation to employees that is free of tax liability to
the employee until after the worker retire and their income from
employment ceases, and employer contributions are tax deductible
to their employer.
 Introduction to pension plans
A pension plan is a fund that is established for the eventual payment
of retirement benefits. The entities that establish pension plans,
called plan sponsors, may be private business entities for their
employees (called corporate or private plans); federal, state or local
entities on behalf of their employees (called public plans); union on
behalf of their members (called Taft Hartley plans); and individual
for themselves (called individual sponsored plans).
Pension plans are financed by contributions by the employer. In
some plans, employer contributions are matched to some degree by
employees. The great success of private pension plans is somewhat
surprising because the system involves investing in an asset– the
pension contract– that for the most part is very illiquid. It can not be
used, not even collateral, until retirement. A pension is a form of
employee remuneration for which the employee is not taxed until
fund are withdrawn. Pension funds have also traditionally served to
discourage employees from quitting, since the employee, until
vested, could lose at least the accumulation resulting from the
employer contribution.
 Types of pension plans
There are two basic and widely used types of
pension plans: defined benefit plans and defined
contribution plans. In addition, a recently
developed hybrid type of plan called a cash
balance plan, combines features of both these
types.
 Defined Benefit Plan
In a defined benefit plan, the plan sponsor agrees to make
specified amount of payments annually to qualifying
employees beginning at retirement (and some payments to
beneficiaries in case of death before retirement). These
payments typically occur monthly. The retirement payments
are determined by a formula that usually takes into account the
length of service of the employee and the employee’s earnings.
The pension obligations are effectively a debt obligation of the
plan sponsor. The plan sponsor, thereby, assumes the risk of
having insufficient funds in the plan to satisfy the regular
contractual payments that must be made to retired employees.
Benefits become vested when employees reach a certain age
and complete enough years of service so that they meet the
minimum requirements for receiving benefits upon retirement.
 Defined Contribution Plan
In defined contribution plan, the plan sponsor is
responsible only for making specified contribution into
the plan on behalf of qualifying participants, not specified
payments to the employee after retirement. The amount
contributed is typically either a percentage of employee’s
salary and/or a percentage of employer’s profits. The plan
sponsor does not guarantee any specific amount at
retirement. The payments that will be made to qualifying
participants upon retirement depend on the growth of the
plan assets. That is, retirement benefit payments are
determined by the investment performance of the funds in
which the assets are invested and are not guaranteed by
the plan sponsor.
 Defined Contribution Plan
There are several fundamental differences between
defined benefit plans and defined contribution plans. In
defined benefit plan, the plan sponsor (1) guarantees the
retirement benefits; (2) makes the investment choices; and
(3) bear the investment risk if the investments do not earn
enough to fund the guaranteed retirement benefits. In
contrast, in a defined contribution plan, the employer does
not guarantee any retirement benefits. However, the
employer does not agree to make specified contributions
to the employee’s account. The employee selects the
investment options, and the employee has for retirement
only the return on the investment portfolio (plus, of
course, the employee and employer contributions).
 Hybrid pension plans: Cash Balance Pension Plan
A cash balance plan is basically a defined benefit that some of the
features of a defined contribution plan. A cash balance plan is a
defined benefit plan in that it defines future pension benefits, not
employer contribution. Retirement benefits are based on a fixed
amount annual employer contribution and a guaranteed minimum
annual investment return. Each participant in a cash balance plan has
an account that is credited to with a dollar amount that resembles an
employer contribution and is generally determined as a percentage
of pay. Each participant’s account is also credited with interest
linked to some fixed or variable index such as consumer price
index(CPI). The plan usually provides benefits in the form of lump-
sum distribution in an annuity. Interest is credited to the employee’s
account at a rate specified in the plan and is unrelated to the
investment earnings of the employer’s pension trust. The employee’s
benefit does not vary based on the interest credit. The promised
benefits are fixed and the investment gains or losses are borne by the
employer. However, as in a defined contribution plan, an individual
employee can monitor his or her cash balance plan “account” in a
regular statement.
 Hybrid pension plans: Cash Balance
Pension Plan
Also like a defined contribution plan and important
to today’s job-changing workforce, many cash
balance plans allow the employee to take a lump
sum payment of vested benefits when terminating,
which can be rolled over into an individual
Retirement Account (IRA) or to the new
employer’s plan. That is cash balance plan is
portable from one job to another. In the next slide,
we summarize the features of cash balance plan
that are similar to defined benefit and defined
contribution plans.
 Hybrid Pension Plan: Cash Balance
Pension Plan
Defined Benefit Like Features Defined Contributions Like
Features
Plan benefits are fixed based on a Assets accumulated in an
formula “account” for each employee
Investment responsibility is borne Vested assets may be taken as a
by the employer lump sum and rolled into an
Individual Retirement Account
(IRA) or another qualified plan
when the employee terminates
employment
Employees are automatically
included in the plan
 Managers of pension funds
A plan sponsor chooses one of the following to manage the
defined benefit pension assets under its control: (1) use in-
house staff to manage all the pension assets itself; (2)
distribute the pension assets to one or more money
management firms to manage; or (3) combine alternatives (1)
and (2). In case of a defined contribution pension plan, the
plan sponsor typically allows participants to select how to
allocate their contributions among funds managed by one or
more fund groups.
Insurance companies also have subsidiaries that manage
pension funds. The trust departments of commercial banks,
affiliates of investment banks and broker/dealers, and
independent money management firms also manage pension
funds.