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4. Some individuals transfer the retirement risk to their children or to society by not preparing for retirement. 18-4. An Overview of Retirement Planning Process ...

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Reasons for the Retirement Risk

  • 1. Retirement risk arises from uncertainty concerning the time of death

  • 2. It is influenced by physiological and cultural hazards

    • people tend to live longer today

    • people are retiring earlier


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Risks Associated with Superannuation

  • Two parts to the retirement risk

    • individual will not have accumulated sufficient assets by the time retirement arrives

    • assets that have been accumulated will not last for the remainder of his or her lifetime


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Retirement Risk Alternatives

  • 1. Some people attempt to avoid the retirement risk by not retiring.

  • 2. Continuing employment does not totally avoid the risk, since the probability of disability increases with age.

  • 3. The risk of outliving an accumulation can be transferred to an insurer.

  • 4. Some individuals transfer the retirement risk to their children or to society by not preparing for retirement.


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An Overview of Retirement Planning Process

  • 1. Estimate future income need

  • 2. Determine how the funds required to meet the need will be accumulated

  • 3. Plan the manner in which the accumulation will be consumed


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Sources of Retirement Funding

  • 1. The first leg: Social Security

  • 2. The second leg: Qualified pensions and profit sharing plans

  • 3. The third leg: Personal savings


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Annuities

  • 1. Reverse application of the law of large numbers as it is used in life insurance.

  • 2. Law of averages permits a lifetime guaranteed income to each annuitant.

  • 3. Persons who live longer than average offset those who live a shorter-than-average period.

  • 4. Every payment to annuitant is part interest, part principal, and part survivorship benefit.


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Annuities

  • Classification of annuities

  • 1. Individual versus Group

  • 2. Fixed versus Variable

  • 3. Immediate versus Deferred

  • 4. Single Premium versus Installment

  • 5. Single Life versus Two or More Lives

  • 6. Pure Life Annuity versus Annuity Certain


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Tax Treatment of Annuities

  • Investment Nontaxable Payment X in Contract = Return of Expected Return Capital

  • $6,000 = $60,000 = $60,000 ($500 X 12) X 15 $90,000

  • $6,000 X $60,000 = $4,000 $90,000


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Specialized Annuities

  • Single-Premium Deferred Annuity

  • 1. Increased popularity since TRA-86 eliminated many tax shelters.

  • 2. Currently taxed same as other annuities:earnings accumulate on tax-deferred basis.

  • 3. Some insurers sell SPDAs with deposit premium as low as $2,500, but more common minimum is $10,000.


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Variable Annuity

  • 1. Designed as means of coping with inflation.

  • 2. Premiums invested in common stocks or similar investments.

  • 3. Based on assumption that the value of a diversified portfolio of common stocks will change in the same direction as price level.

  • 4. Variable annuity may be variable during accumulation period and fixed during payout period or variable during both accumulation and payout period.


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Annuities as Investments for Retirement

  • 1. Return earned over life of an annuity depends on several features.

  • 2. Most important determinants of the rate of return are:

    • interest rate

    • surrender charge

    • administrative expenses


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Qualified Retirement Plans

  • Qualified plans are those that conform to the requirements of federal tax laws and for which the law provides favorable tax treatment.

    • 1. Employee contributions are tax deductible when they are made.

    • 2. Employee is not taxed on employer’s contribution or investment earnings until benefits are distributed.


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ERISA

  • Employee Retirement Income Security Act of 1974 (ERISA) establishes federal standards for qualified retirement plans:

    • 1. Prescribes which employees must be included.

    • 2. Establishes minimum vesting standards.

    • 3. Sets minimum funding standards.

    • 4. Requires extensive reporting and disclosure information about pensions and other employee welfare programs.


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Qualification Requirements

  • 1. Designed for exclusive benefit of employees.

  • 2. In writing and communicated to employees.

  • 3. Must meet one of several vesting schedules.

  • 4. Cannot discriminate in favor of officers, stock-holders or highly compensated employees.

  • 5. Must provide for definite contributions by employer or definite benefits at retirement.

  • 6. Life insurance included only on an incidental basis.

  • 7. Top-heavy plans are subject to special vesting and contribution requirements.


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Vesting Requirements (specified in plan documents)

  • 1. No vesting for 5 years, 100% vested after 5 years.

  • 2. 20% vested after 3 years with 20% per year thereafter so employee is 100% vested at the end of 7 years.

  • 3. For top-heavy plans:

    • 100% in three years, or

    • 20% per year after first year


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Types of Qualified Plans (corporations)

  • 1. Defined Benefit Pension Plans

  • 2. Defined Contribution Pension Plans

  • 3. Qualified Profit-sharing Plans

  • 4. Employee Stock Ownership Plans

  • 5. Section 401(k) Plans


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Factors Influencing Benefit Levels

  • Benefit received by employees at retirement is based on a formula applicable to all employees.

    • 1. All plans fall into one of two benefit formula categories

      • defined contribution

      • defined benefit.

    • 2. Plans may be contributory (with employee contributions) or noncontributory (where employer bears the entire cost).


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Amount of Benefits or Contributions

  • Defined Contribution Plans

  • 1. Work exactly as the name implies: employer’s contribution is set by the employment agreement

  • 2. Contribution is usually a percentage of compensation, such as 5% or 10% of employee wages


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Amount of Benefits or Contribution

  • Defined Benefit Plans

  • 1. In defined benefit plan, amount of benefits employee will receive is specified in the benefit formula

  • 2. In most benefit formulas, retirement benefit is a function of employee’s salary, the benefit accrual rate, and employee’s years of service

  • 3. Most plans are final average salary plans but some are career average salary plans.


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Amount of Benefits or Contributions

  • FINAL AVERAGE SALARY PLAN

  • Benefit depends on salary earned in final years of employment and number of years worked

    • example: 1% of average monthly salary during final three years of employment for each year employed

    • an employee with 35 years employment would receive 35% of average monthly employment in the final three years


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Amount of Benefits or Contributions

  • CAREER AVERAGE SALARY PLAN

  • Benefit depends on salary earned in all years of employment and number of years worked

    • example: 1% of average monthly salary during all years of employment for each year employed,

    • an employee with 35 years employment would receive 35% of average monthly employment over employment career.


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Amount of Benefits and Contributions

  • Defined Contribution Plans

  • 1. Maximum allowable contribution to a defined contribution plan varies with the type of plan

  • 2. For a defined contribution pension plan, the limit is 25% of year’s earnings, subject to a dollar maximum that is adjusted for inflation

  • 3. Dollar maximum was set at $30,000 in 1986 and will be adjusted for inflation when dollar maximum for defined benefit plans reaches $120,000


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Amount of Benefits or Contributions

  • Defined Benefit Plans

  • 1. Maximum benefit in a defined benefit plan is 100% of employee’s earnings in three consecutive years of highest earnings.

  • 2. Dollar maximum for defined benefit was set at $90,000 in 1988 and is adjusted for inflation since that time.


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Contribution for Keogh Plans

  • 1. Keogh plans are subject to essentially the same limitations, deductions and benefits as applicable to corporate pension and profit-sharing plans.

  • 2. A special definition of earned income is used to make contributions by self-employed persons correspond to those for a common-law employee.

  • 3. Percentage limitations apply after the contribution to the plan is deducted from income.


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Keogh Plan Contribution Illustrated

  • Partnership establishes a defined contribution plan with 25% of employee compensation.

  • Partner earns $100,000.

  • Partner’s contribution is limited to 25% of income after the contribution:

  • Taxable NontaxableIncome Contribution Total

  • Employee $40,000 $10,000 $50,000

  • Owner 80,000 20,000 100,000


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Maximum Contribution 401(k) Plans

  • 1. Permit pretax contributions (called “elective deferrals”) by employees.

  • 2. Employees elect to contribute to a profit-sharing plan and instruct employer to make contributions on their behalf.

  • 3. I.R.C. treats contributions as if they were made by employer rather than by employee.

  • 4. Limit on employee deferrals to 401(k) plan or SEP is the lesser of 25% of compensation or a dollar maximum (set at $7,000 in 1988 and indexed for inflation since that time).


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Nature of the Employer’s Promise

  • INVESTMENT RISK

  • Under defined contribution plan, employer promises to make contributions to an account that earns investment income.

    • Since benefits depend on contributions and investment income, the employee bears the investment risk in defined contribution plans.

    • Because the employee bears the investment risk, he or she is likely to have some say in how funds are invested.


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Nature of the Employer’s Promise

  • INVESTMENT RISK

  • In a defined benefit plan, the employer promises to provide a certain level of retirement benefits to the employee.

    • Employer therefore bears the investment risk in a defined benefit plan.


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Advantages to Younger and Older Employees

  • 1. A higher proportion of ultimate retirement benefits are earned in early years of participation in a defined contribution plan.

  • 2. Present value of benefits promised to younger workers under a defined benefit plan tends to be small compared with present value of benefits promised when the worker is closer to retirement.


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Distribution Requirements

  • 1. Commencement of benefits: April 1 after year in which individual reaches age 70 1/2 or the date of retirement, if later.

  • 2. Distribution must be made over

    • the life of the participant or joint lives of participant and spouse (i.e., an annuity).

    • the life expectancy of the participant and his or her beneficiary.


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Premature Distributions

  • 10% penalty prior to age 59 1/2 except for

    • deductible medical expenses

    • in form of lifetime annuity

    • at age 55 by worker who meets plan requirements for retirement


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Taxation of Distributions

  • 1. Retirement benefits traditionally paid to participants in form of a lifetime annuity.

  • 2. Installment distributions taxable only to the extent they exceed employee’s investment in the contract.

  • 3. Lump-sum distributions may be rolled-over into an annuity and taxed under installment rules.

  • 4. Lump-sum distributions that are not rolled-over may be subject to five-year averaging.


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Individual Retirement Accounts (traditional IRA)

  • 1. A person who is not covered by an employer-sponsored plan can make tax-deductible contribution to an IRA of $2,000 annually.

  • 2. Persons covered by an employer plan may be entitled to same deduction, a partial deduction, or no deduction, depending on income.

  • 3. Persons not eligible for deduction may make a nondeductible contribution.

  • 4. New rules under TRA-97 allow a full $2,000 deductible contribution by a spouse who is not employed outside the home.


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Individual Retirement Accounts (traditional)

  • Adjusted Gross Income Phase Out Levels

  • $25,000 to $35,000 for single taxpayers

  • $40,000 to $50,000 for married filing jointly

  • 0 to $10,000 for married filing jointly

  • TRA-97 gradually increases AGI phase-out levels to double the present level by 2007.


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IRA Taxation Formula

  • Total Nondeductible Tax-Free Amount Contributions All _ Withdrawals Distributed X Years to IRAs in Prior Years From IRA Fair Market Value Amount DistributedDuring Year of all IRAs at + From IRA During End of Year the Year


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The New Roth IRA

  • Beginning in January of 1998, contributions permitted to Roth IRA

    • contributions only on a non-deductible basis.

    • earnings tax-free when the funds are withdrawn for retirement (i.e., after age 59½).

    • annual contributions of $2,000 (100% of compensation) per individual.

    • AGI phase-out $95,000 single $150,000 joint.

    • no requirement for withdrawals at 70½ and contributions may continue after age 70½.

    • $2,000 limit for Traditional IRA and a Roth IRA.


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Education IRA

  • Introduced by TRA-97 - despite its designation, has nothing to do with retirement.

    • designed for saving for higher education.

    • up to $500 annually per student (to age 18).

    • phased out for joint filers - $150,000 to $160,000,$95,000 and $110,000 for single taxpayers.

    • nondeductible, but earnings tax-free.

    • distributions under age 30 not taxable if used for qualified higher education expenses.

    • distributions in excess of qualified education expenses taxable with a 10% penalty.

    • Education IRA contributions are in addition to Roth IRA Plus and traditional IRAs.


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