Chapter Outline

1
Chapter Outline

• 19.1 Overview of Retirement Plans
• Defined Benefit Plans
• Defined Contribution Plans
• 19.2 Tax Advantages of Retirement Plans
• Saving Outside of a Qualified Plan
• Effect of Deferral of Tax on Investment
  Earnings
• Effect of Deferring Tax on Investment Earnings
  and Contributions
• Lower Tax Rates during Retirement
• Tax Advantages of Defined Benefit Plans
• 19.3 Incentive Effects of Employer-Sponsored
  Pension Plans
• Increasing Productivity
• Participation and Vesting Requirements
• Backend Loading of Benefits
• Inducing Retirement

2
Chapter Outline

• 19.4 Types of Defined Contribution Plans
• Money Purchase and Profit Sharing Plans
• 401(k) Plans
• Employee Stock Ownership Plans (ESOPs)
• Simplified Employee Pensions (SEPs)
• Growth in Defined Contribution Plans
• 19.5 Self-Employeed (Keough) and Individual
  Retirement Accounts (IRAs)
• Keogh Plans
• Individual Retirement Plans (IRAs)
• Traditional IRAs
• Roth IRAs

3
Chapter Outline

• 19.6 Retirement Plan Provisions and Regulations
• Non-Discriminatory and Vesting Rules
• Funding Requirements
• Pension Insurance
• Excess Assets in Defined Benefit Plans
• 19.7 Summary

4
Overview of Retirement Plans

• Methods of receiving income during retirement
• Private savings
• Social security
• Savings through employment based retirement plans
  (focus of this chapter)
• Advantages
• tax
• employee incentives
• Disadvantages
• regulations
• can only be used for retirement

5
Overview of Retirement Plans

• Two basic types
• Defined Benefit (DB)
• Defined contribution (DC)
• Contribution to a fund is defined by a formula
• Retirement benefit is based on the accumulated
  value of the fund
• Most popular type of plan
• High growth in DC plans

6
Essential Characteristics of DB Plans

• Employer promises a retirement benefit defined by
  a formula
• Employer and perhaps workers contribute to a fund
  
• Contributions investment earnings are
  accumulated to pay the promised benefit
• Employer bears most of the investment risk
• A majority of US. employees are enrolled in DB
  plans

7
Defined Benefit Formulas

• Examples of monthly benefit formulas
• 1. Benefit 50 x (years of service)
• 2. Benefit 0.02 x (years of service) x (average
  salary during last five years of service)
• type 2 is more common with salary workers
• Illustration
• Average Monthly Benefit under
  Formula
• Service Monthly Salary 1 2
• 10 5,000 500 1,000
• 10 10,000 500 2,000

8
Replacement Rates

• Definition
• Retirement benefit as a of final salary
• Previous examples of defined benefit plans
• Average Replacement Rates under
  Formula
• Service Monthly Salary 1 2
• 10 5,000 10 20
• 10 10,000 5 20

9
Effect of Switching Employers on Benefits

• Example
• Benefit 0.02 x service x (final salary)
• Monthly salary after 15 years 4,000
• Monthly salary after 25 years 6,000
• Scenario 1 Service with one employer 25 years
• gt Retirement benefit 3,000
• gt Replacement rate 50
• Scenario 2 15 years of service with one employer
  and 10 years of service with another
• gt Retirement benefit 2,400
• gt Replacement rate 40

10
Essential Characteristics of DC Plans

• Employer and perhaps workers contribute to a fund
  based on a formula
• Retirement benefit accumulated value of
  contributions investment earnings
• Workers bear most of the investment risk
• Most plans in US are DC
• DC have grown in popularity

11
Tax Advantages of Retirement Plans

• A qualified plan receives tax advantages
• Main tax features
• Contributions are not taxable as personal income
  until the benefits are received
• Earnings on assets are not taxed until they are
  received
• Together gtemployee can earn the before-tax rate
  of return in a qualified plan

12
Comparing Different Methods of Saving

• Consider amount received after-tax
• from investing 1 of before-tax wages
• for T years
• in an account that earns r percent annually
• for a person with a constant tax rate t
• Outside of a qualified plan (1-t) 1 r(1-t)T
• In a tax deferred account (1-t)(1r)T - t(1r)T
  -1
• (investment earnings are not tax as earned)
• In a qualified plan (1-t)(1 r)T

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Comparing Different Methods of Saving
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Other Tax Issues

• Effect of lower personal tax rates during
  retirement
• Increases advantages of tax deferral
• Investment of retirement plan assets in tax
  advantaged securities
• Some securities are taxed at lower rates than
  others
• municipal bonds
• stocks with high expected capital gains and low
  dividends
• These securities will generally offer lower
  before-tax expected rates of return
• gt generally not good investments for qualified
  plans

15
Incentive Effects of Employer-sponsored Plans

• Plans can
• Increase productivity
• greater employee effort
• lower quit rates
• Induce retirement of older workers

16
Increasing Productivity

• Promoting effort and reducing unwanted turnover
• Make retirement benefits contingent on good
  performance and long service
• Participation requirements
• Vesting requirements
• Backend loading of benefits

17
Backend Loading of Benefits

• Typical DB formula yields additional accrued
  benefits that increase with service

18
Inducing Retirement

• Backend loading of benefits
• gt employees have less incentive to leave
• Problem employees delay retirement too long
• gt plans include provisions to induce retirement
• Benefits stop accruing after a normal retirement
  age
• Early retirement provisions

19
Types of DC Plans

• Money purchase plans
• Contributions usually of employees salary
• Profit sharing plans
• Contributions based on firms profits
• explicit
• discretion of board

20
Types of DC Plans

• 401(k)
• Similar to money purchase plan, except
• Employees can elect to make contributions
• Employees have discretion over
• contributions
• allocation of assets
• Many plans have employer matching

21
Types of DC Plans

• Employee Stock Ownership Plans (ESOPs)
• Invests primarily in employers stock
• (Other plans are limited to 10)
• Can improve incentives
• But employees hold undiversified portfolios
• Can borrow money
• (Other plans cannot)
• ESOPs can be used to raise capital
• Have special tax treatment

22
Growth in DC Plans

• Primarily reflects growth in 401(k) plans
• Why the movement toward DC plans?
• Regulatory compliance costs of DB plans
• DB plans exhibit economies of scale
• Greater number of companies with small work
  forces
• gt more DC plans
• Regulations make DB plans less effective for
  employee incentive purposes
• Less demand for stable workforces

23
Individual Retirement Accounts (IRAs)

• Two basic types
• Traditional
• Roth (introduced in 1998
• Contributions
• Limited to 2,000/year
• Withdrawals
• 10 penalty prior to age 591/2

24
Tax Effects of Traditional and Roth IRAs

• Traditional
• Contributions tax deductible
• Earnings are tax deferred
• Withdrawals tax as income
• Roth
• Contributions are not tax deductible
• Earnings are not taxed
• Withdrawals are not taxed
• Effectively increases maximum contribution s.t.
  favorable tax treatment

25
Plan Provisions and Regulations

• ERISA
• Employee Retirement Income Security Act of 1974
• Imposed numerous regulations
• Nondiscrimination rules
• Vesting requirements
• cliff vesting at 5 years
• graded vesting 20 after 3 years, 40 after 4
  years, etc.
• Funding requirements

26
Funding of DB Plans

• Defined benefit plans have assets and liabilities
• Liabilities present value of promised benefits
• Overfunded plans
• Pension Assets gt Pension Liabilities
• Underfunded plans
• Pension Assets lt Pension Liabilities

27
PBGC Insurance

• Pension Benefit Guaranty Corporation (PBGC)
• Insures defined benefit plans
• PBGC pays benefits of terminated underfunded
  plans
• Insurance is compulsory
• Premiums now depend on funding