1. 1 INS301 Chapter 17 Retirement Plans Overview of retirement plans Defined benefit plans (DB plan) Defined contribution plans (DC plan) Cash balance plans Tax advantages of retirement plans Retirement plan provisions and regulations

2. 2 INS301 Chapter 17 Overview of Retirement Plans Methods of receiving income during retirement: Private savings Social security Savings through employment-sponsored retirement plans (focus of this chapter)

3. 3 INS301 Chapter 17 Defined Benefit (DB) Monthly benefit during retirement is defined by a formula Employer contributes to a fund so pay the benefits Employer bears the investment risk of the fund

4. 4 INS301 Chapter 17 Defined Benefit Formulas Examples of monthly benefit formulas Hourly workers monthly benefit = $50 * (years of service) Salaried employees monthly benefit = 0.02 * (years of service) * (average salary during last five years of service) Question: for an employee worked 20 years and during the last five years of employment earned $3,000 a month, what is his monthly benefit? Replacement rates: retirement benefit as a % of final salary

5. 5 INS301 Chapter 17 Defined contribution (DC) the employee makes a specific (defined) contribution to a fund and the employer usually match a contribution Typically a percent of salary Retirement benefit is based on the accumulated value of the fund Employee bears the investment risk

6. 6 INS301 Chapter 17 Types of DC Plans Money purchase plans Contributions usually = % of employees salary Profit sharing plans Contributions based on firm’s profits Explicit (5% of pretax profit) discretion of board

7. 7 INS301 Chapter 17 Types of DC Plans 401(k) Employees can elect to make tax-deferred contributions Employees have discretion over contributions allocation of assets Many plans have employer matching Employees can withdraw funds prior to retirement under certain hardship conditions.

8. 8 INS301 Chapter 17 Types of DC Plans Employee Stock Ownership Plans (ESOPs) It is required to hold at least 50 percent of its assets in the sponsoring firm’s stock. ESOP plan can borrow money to purchase stock for employees (leverage ESOP) Financing tool for corporations and a means to place stock in friendly hands to prevent takeovers.

9. 9 INS301 Chapter 17 Growth in DC Plans Primarily reflects growth in 401(k) plans Why the movement toward DC plans? Partially due to the effects of increased regulation of defined benefit plans

10. 10 INS301 Chapter 17 Individual Retirement Accounts (IRAs) Traditional IRAs tax-deductible contribution and tax-deferred earnings for people  Not in an employer-sponsored retirement plan  in employer-sponsored retirement plan if their income is less than a certain amount for other people, up to $2000 contribution that is not tax deductible, but the investment earnings are tax deferred

11. 11 INS301 Chapter 17 Individual Retirement Accounts (IRAs) Roth IRAs Difference from traditional IRAs Contributions are not tax deductible Withdraws during retirement are not taxed, which implies that investment earnings escape taxation

12. 12 INS301 Chapter 17 Cash Balance Plans (Hybrid plans) From sponsor’s perspective – like DB plan Guaranteed rate of return It is subject to the same regulation as a DB plan From employee’s perspective – like DC plan Employee can identify their account balance Prior to retirement the account balance is portable

13. 13 INS301 Chapter 17 Tax Advantages of Retirement Plans A qualified plan receives tax advantages Taxed-deferred Contributions Contributions are not taxable as personal income until the benefits are received Tax-deferred investment earnings Earnings are not taxed until they are received

14. 14 INS301 Chapter 17 Other Tax Issues Effect of lower personal tax rates during retirement Increases advantages of tax deferral

15. 15 INS301 Chapter 17 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

16. 16 INS301 Chapter 17 Funding of DB Plans Defined benefit plans have assets and liabilities Liabilities = present value of promised benefits Overfunded plans Pension Assets > Pension Liabilities Underfunded plans Pension Assets < Pension Liabilities

17. 17 INS301 Chapter 17 PBGC Insurance Pension Benefit Guaranty Corporation (PBGC) Insures DB plans PBGC pays benefits of terminated underfunded plans Insurance is compulsory Premiums now depend on funding