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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. Overview of Retirement Plans. Methods of receiving income during retirement:

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retirement plans
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

overview of retirement plans
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

defined benefit db
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

defined benefit formulas
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

defined contribution dc
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

types of dc plans
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

types of dc plans1
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

types of dc plans2
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

growth in dc plans
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

individual retirement accounts iras
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

individual retirement accounts iras1
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

cash balance plans hybrid plans
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

tax advantages of retirement plans
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

other tax issues
Other Tax Issues
  • Effect of lower personal tax rates during retirement
    • Increases advantages of tax deferral

INS301 Chapter 17

plan provisions and regulations
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

funding of db plans
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

pbgc insurance
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