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Chapter 8

Chapter 8. Retirement Plans and the Fund Business. Viewing recommendations for Windows: Use the Arial TrueType font and set your screen area to at least 800 by 600 pixels with Colors set to Hi Color (16 bit).

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Chapter 8

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  1. Chapter 8 Retirement Plans and the Fund Business Viewing recommendations for Windows: Use the Arial TrueType font and set your screen area to at least 800 by 600 pixels with Colors set to Hi Color (16 bit). Viewing recommendations for Macintosh: Use the Arial TrueType font and set your monitor resolution to at least 800 by 600 pixels with Color Depth set to thousands of colors

  2. Structure of Tax-Qualified Retirement Plans Tax benefits of Qualified Retirement Plans • The employer’s contributions are deductible in the tax year they are made • Participants realize no taxable income • Participants do not recognize any taxable income on their own contributions • Earnings on contributions from both the employer and participants are accumulated tax free • Participants realize taxable income only when they actually receive their retirement benefits

  3. Basic Overview of Pensions • Qualified Plan: • “Qualifies” for valuable federal tax benefits • Most employees with pension are in qualified plans • Design, funding, and administration must meet very complex set of federal statutory and regulatory requirements • Non-qualified Plan – any other retirement or deferred compensation • Less regulation, but less favorable tax treatment • Mainly used as a form of executive compensation

  4. Tax-Qualified Plans • Meet minimum age (>18)and service standards and minimum coverage requirements (>1 yr) • Contribution or benefits do not discriminate in favor of highly compensated employees • Contribution or benefits do not exceed certain employee contribution limits • Meets minimum vesting standards • Provides for automatic survivor benefits under certain circumstances.

  5. Funding • Qualified plan must be funded in advance of the employee’s retirement • Can be done through: • Contributions to an irrevocable trust fund • Under an insurance contract • Funds must be under control of a fiduciary and managed solely for benefit of participants and beneficiaries

  6. Payout Restrictions • Tax penalty if withdrawn before early retirement, age 59½, disability or death • Payouts must begin by April 1 of the year after the participant reaches 70½ • Minimum amounts specified by IRS • Restrictions on loans

  7. Tax Revenue Loss • In general, contributions to qualified plans are not taxed until withdrawal • According to the OMB, the cost to federal treasury in 1999 of preferential tax treatment for pensions is about $75 billion annually • Sometimes called a “tax expenditure” • Congress insists on furthering social goals

  8. How Valuable is Tax Deferral? • Invest $1000 today and hold for 30 years • Before tax interest rate r = .10 • Tax rate t = .35 (assume same for all types of income) • How much is deferral worth?

  9. Types of Qualified Plans • Two ways to classify plans • DB versus DC • “Pension plans” versus “profit-sharing plans” • Pension – provide income at retirement • Profit sharing – allow for deferral of income, perhaps based on corporations profitability, and may allow earlier access to funds

  10. Defined Benefit versus Defined Contribution • Defined benefit (DB) plan • Employer promises to pay specified schedule of benefits to plan participant upon retirement • Employer contributes to the plan regularly and controls investments • Employer is responsible for any asset shortfall due to investment performance • If employer goes bankrupt, federal insurance covers “basic benefits”

  11. Overview of DB Formulas • Formula specifies benefit to be paid to the employee • Investment risk rests with plan sponsor • Payment of benefit is obligation of the employer, and thus employer is required to fund the plan in advance so that the funds will be there to pay • Typically insured by the PBGC (within limits) • Formulas and funding can sometimes be complex

  12. DB Formula Characteristics • Employer objectives • Provide reasonable income “replacement ratio” • Maximize value of tax shelter for key employees • “Manage” work force (e.g., encourage retention, incentives for early retirement, etc.) • Two useful characteristics of DB formulas • Benefit need not be function of total compensation • Can design plan around desired retirement income for employee • Permitted to favor employers who enter plan at later ages • At plan inception, often favors key employees of closely held businesses

  13. Allowable DB Formulas • Flat-Benefit Formula • Does not take into account years of service • Flat-Amount Formula ($10,000 per year during retirement) • Flat-Percentage Formula (50% of final salary) • Unit-Benefit Formula • Benefit is based on length of service • $10 per month x (Years of Service) • Annual Benefit = (2%) x (Yrs. of Service) x (Final Salary) • Role of Past service

  14. Defined Benefit versus Defined Contribution (cont.) • Defined contribution (DC) plan • Employer’s financial contribution is limited to any annual contribution • Both employee and employer usually contribute to the plan • Employee directs the investment of the plan’s assets • Employee assumes the risk of asset shortfall due to investment performance • No federal insurance

  15. Growth of DB versus DC, 1992–2005 Source: For 1992-1996, EBRI tabulations based on U.S. Department of Labor, Pension, and Welfare Benefits Administration, Private Pension Plan Bulletin (Winter 1999-2000); for 1997-2005, EBRI projections. Asset amounts shown exclude funds held by life insurance companies under allocated group insurance contracts for payment of retirement benefits. These excluded funds make up roughly 10 to 15 percent of total private funds assets. From EBRI, “Research Highlights: Retirement and Health Data.” January 2001. Reprinted by permission of Employee Benefit Research Institute, Research Highlights, Retirement Data, January 2001.

  16. Why Employers and Employees Prefer DC Plans • Employer benefits under DC scheme • Avoidance of long-term investment risk and future pension obligations • Avoidance of un-funded pension liabilities on balance sheets • Employee benefits under DC scheme • Control over contributions and investment choices • Ability to calibrate the amount of their contribution (and deduction) • Opportunity for higher returns (and lower returns) • DC plans tend to vest earlier than DB plans • DC plans are more portable than DB plans • In the case of employer bankruptcy, DC plan assets are not subject to creditor claims

  17. How 401(k) Plans Work 401(k) is a section of the Internal Revenue Code governing “cash or deferred arrangements” (CODAs) that are part of a retirement plan Three principal types of contributions to a 401(k) plan: • Elective: Tax deferred employee contributions made by the plan sponsor on behalf of the employee in the form of salary reduction • Matching: Employer contributions that match employee contributions up to a flat dollar amount or percentage of salary contributed • Nonelective: Nonmatching contributions made by the plan sponsor from employer funds ( satisfy nondiscrimination tests)

  18. How 401(k) Plans Work • Contributions are made usually as percent of employees’ salary • Employee currently has $13,000 pre-tax elective deferral limit (2004) • Total limit is $40,000 • Employees over age 50 may make “catch-up” contributions each year. Currently $1,000 p.y. $5,000 p.y from 2006. • Anti-discrimination tests may limit overall contributions for some. “Catch-up” contribution is not subject to anti-discrimination rules

  19. Anti-Discrimination Test • Design to ensure that highly compensated employees (HCE) do not contribute at a disproportionately higher rate than non-HCE. • To pass the test: • HCEs contribute at an average rate no more than 125% higher than that for nonHCEs, or • Average contribution rate for HCEs is less than 2% greater than the average rate for nonHCEs. • If the plan fails the test, a portion of HCEs contributions must be returned so that the test can be passed.

  20. How 401(k) Plans Work (cont.) • Participants choose investments from a retirement menu • Plan sponsor designs the investment menu • Participants may change their choices from time to time • Employee’s retirement benefits based on plan contributions and investment performance

  21. Why 401(k) Plans Became So Popular • Pre-tax deferrals reduce current taxes • Earnings on contributions grow tax deferred • Employer usually matches some of employee contribution • Direct payroll deduction of employee contribution • Portability in the event of job change • Participants gain control over retirement benefits

  22. Why Mutual FundsBecame Popular • Services • 800# access to account information • Voice response units • On-line employer access to account information • Daily valuation and daily prices in the newspaper • Participant communications • Investment education • Advice tools • Broad investment selections • Name brand funds • Specialized products (e.g., lifestyle funds)

  23. Mutual Fundsand 401(k) Plans • Assets in 401(k) plans have increased, along with MF share of those assets • 401(k) assets: 2000 at $1.9T; 2005 (exp) $3.2T • Growth in participants: 2000 at 41m; 2005 (exp) 55m • Growth in 401(k) plans: 2005 (exp) 435,000 • Growth in MF shares in 401(k) plans • 1990: 9% of assets in MF • 199-00 : 45% assets in MF • Prior to advent of 401(k), banks and insurance cos dominated retirement market; predominantly DB.

  24. Mutual Fundsand 401(k) Plans • Investment options • Employers must offer at least 3 core options to qualify for safe harbor • Average number of options available is 10 (1999) • Mutual funds are usually standard options • Other options include • GICS, employer stock, brokerage window, mutual fund window, commingled pools

  25. Mutual Fundsand 401(k) Plans (cont.) • Mutual funds in 401(k) plans are almost always no-load • Other services • Daily processing (contribution, distribution, loans, etc.) • Participant communication (statements, plan choices, telephone, internet, etc.) • Services to plan sponsors

  26. SIMPLE (Small Employer) Plans • Established as of January 1, 1997 • Created for small businesses (100 or fewer employees) • Reduces administrative expenses to employer as compared to traditional 401(k) plans • Financial institution responsible for majority of the work • Employee • Benefits from an employer-sponsored plan and automatic deduction • Has $6,000 annual pre-tax deferral limit (in 2001, rising to $10,000 by 2006)

  27. SIMPLE (Small Employer)Plans (cont.) • Employer may either • Match contributions dollar for dollar up to 3% of employee’s compensation • Contribute 2% of each eligible employee’s compensation • Trade-off for lowered matching/contributions is that SIMPLE plans are free from anti-discrimination tests that apply to 401(k) plans

  28. Legal/Regulatory Issues • 404(c) Regulation • Scope • Applies to virtually all participant-directed retirement plans • Optional safe harbor for employers/sponsors • Fiduciaries of plans that do comply will be relieved of liability for the results of their participants’ investment decision • Conditions • Offer at least three options with different risk/return characteristics • Changes in investments permitted at least quarterly • Participants must be given adequate information to make informed investment decisions

  29. Legal/Regulatory Issues (cont.) • DOL interpretative bulletin • Limits the circumstances in which participant education programs would constitute “investment advice” by an ERISA fiduciary • Examples of “safe harbor” information include • Plan information • General financial and investment information • Asset allocation models • Interactive investment materials

  30. Mutual Fund Assets by Type of Retirement Plan 1991 2000 Source: Investment Company Institute, Federal Reserve Board, IRS, and Department of Labor

  31. Expansion of Traditional IRAs • Traditional IRAs provide tax deductions at the time of contribution for those that qualify (as fully phased in) • Couples with income under $80,000 • Individuals with income under $50,000 • Spousal IRAs for non-working spouse (without W-2 income) • Eligible for own $3,000 contribution (2002 limit) • Tax deduction at time of contribution if couple’s income <$150,000

  32. Expansion of Traditional IRAs (cont.) • Individuals over age 50 may make “catch-up” contributions • Lower-income workers able to receive a refundable tax credit of up to $1,000 per year • Taxpayers qualifying for deductions at time of contribution must pay tax on contributions and earnings at time of distribution

  33. Creation of Roth(back-end) IRA • No tax deduction at time of contribution • But earnings build up tax-free and are not taxed at the time of distribution if investor keeps assets in IRA • For at least 5 years and • Until age 59½ • Full eligibility for Roth IRA • Individuals with income under $110,000 • Couples with income under $150,000

  34. Growth of IRAs and Benefits to Mutual Funds • Expected to grow from $2.2 trillion in 1999 to >$6 trillion in 2010 • Keys to growth are • Attracting new investors to contributory IRAs • Continuing to attract 401(k) and other DC participants to rollover IRAs • Rollover IRA is one established with assets rolled over from an employer-sponsored retirement plan (usually upon leaving) • DC distributions rolled to IRAs are projected to reach $467 billion by 2010 • Although expected to grow, rollovers can now be “rolled back” to DC plans

  35. Growth of IRAs and Benefits to Mutual Funds (cont.) • Reasons that mutual funds dominate the IRA marketplace • IRA holders can control their investments through mutual fund selection • There is a broad range of investments available under a mutual fund IRA • Since IRAs are retail accounts, they benefit from all the retail services available to mutual fund customers • Success of mutual funds in 401(k) marketplace has strengthened the attractiveness of mutual funds in the IRA marketplace

  36. Future ofRetirement Plans • Distribution Planning • Current accumulation phase will shift to distribution phase as population ages (as baby boomers really move into retirement) • Rollover IRA will become more important • Distribution planning for retirees will become more important • Fund sponsors must offer tools • Fund sponsors must focus on appropriate investment products

  37. Future ofRetirement Plans (cont.) • Social Security Reform • Aging population will stretch/break “pay-as-you-go” system • Possible solutions being discussed include • Reducing social security benefits for future retirees or raising retirement age • Increasing payroll tax for current workers • Diverting general tax revenues from other programs to pay for social security • Allow some form of investment—part of the trust fund or part of individuals’ accounts—in the stock market • Social Security debate raises questions about potential impact on the mutual fund industry

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