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Retirement Plans

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  1. 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 INS301 Chapter 17

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

  3. 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 INS301 Chapter 17

  4. 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 INS301 Chapter 17

  5. 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 INS301 Chapter 17

  6. 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 INS301 Chapter 17

  7. 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. INS301 Chapter 17

  8. 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. INS301 Chapter 17

  9. 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 INS301 Chapter 17

  10. 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 INS301 Chapter 17

  11. 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 INS301 Chapter 17

  12. 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 INS301 Chapter 17

  13. 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 INS301 Chapter 17

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

  15. 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 INS301 Chapter 17

  16. 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 INS301 Chapter 17

  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 INS301 Chapter 17