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Pension Plans and Finance Companies. Chapter 19. © 2003 South-Western/Thomson Learning. Learning Objectives. Various kinds of pension plans and finance companies Benefits provided by pension plans and finance companies

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Pension Plans and Finance Companies

Chapter 19

© 2003 South-Western/Thomson Learning

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Learning Objectives

  • Various kinds of pension plans and finance companies

  • Benefits provided by pension plans and finance companies

  • Principal sources and uses fo funds for both of these financial intermediaries

  • Primary regulations and regulatory agencies with which both of these FIs must comply

  • Recent changes in way these FIs do business

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Pension Plans

  • First in U.S. were created to provide income for disabled American veterans of Revolutionary War

  • In early 1800s, benefits were extended to retired veterans

  • First private pension plan in U.S. was offered in 1875 by American Express company

  • Railroads followed by adding pensions in 1880s

  • Labor unions added them in early 1900s

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Types of Pension Plans

  • Contributory Plans

    • Both employee and employer contribute

  • Noncontributory Plans

    • Only the employer contributes

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Types of Pension Plans

  • Public Pension Plans

    • Can be sponsored publicly (governmental units)

    • U.S. retirement plan assets

    • One-third assets managed by public pension plans sponsored by:

      • State and local government employees

      • Federal civilian employees

      • Railroad retirement

      • Social Security’s Old-Age, Survivor and Disability Insurance program

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Types of Pension Plans

  • Private Pension Plans

    • Sponsored by single corporation, union, small business or individual

    • Two-thirds of all pension assets sponsored and managed by:

      • Private pension funds

      • Mutual funds

      • Banks

      • Brokerage firms

      • Life insurers

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Types of Pension Plans

  • SIMPLE Plans (Savings Incentive Match Plan for Employees of Small Employers)

    • Simplified defined-contribution plans created by Congress in 1996

    • Assist small businesses in offering salary deductions and matching contributions to fund retirement savings for their workers

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Types of Pension Plans

  • Individually Sponsored and Self-Employed Private Pension Plans

    • Individual Retirement Accounts (IRAs)

      • Tax advantaged saving accounts

      • Administered by insurance companies, pension funds, and other intermediaries

      • Purpose to accumulate wealth for retirement

      • Roth IRA

        • Contributions are taxed

        • Earnings accumulated within account are tax-exempt

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Types of Pension Plans

  • Individually Sponsored and Self-Employed Private Pension Plans

    • Keogh Plans

      • Tax advantaged saving accounts

      • Administered by banks and other financial intermediaries

      • For retirement needs of self-employed people

    • Simplified Employee Pensions (SEPs)

      • Small-business pension plans

      • Fewer reporting requirements

      • Less administrative complexity and costs than traditional pension plans

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Types of Pension Plans

  • Defined-Benefit Plans

    • Contract promising specific level of income upon retirement based on worker’s years of service and level of earnings

    • Benefit calculations can be specified in variety of ways for eligible employees

    • Plan may state benefit as a percentage of salary and years of service

      • 2% of final pay, times years of service,

        for example, 2% x $40,000 x 30 = $24,000 annually

    • In some cases, specific percentage of employee’s highest 5-year average earnings

      Ex., 68% x $40,000 = $27,200 annually

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Types of Pension Plans

  • Defined-Benefit Plans

    • The calculation may be based on specific dollar amount and years of service

      • For example, $70 per month at retirement times the number of years worked

        $70 x 12 x 30 = $25,200

    • Some firms offer retiree the option to take lump-sum payment at retirement based on similar sorts of calculations

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Types of Pension Plans

  • Defined-Contribution Plan

    • Contract specifying that a particular and periodic share of employee’s wages will be contributed by employers, employees, or both

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Recent Trends in Private Pensions

This trend away from defined-benefit plans is explained by three main factors:

  • Decrease in share of employment at large, unionized manufacturing companies, traditionally the largest users of defined-benefit plans

  • Legislation passed in the 1980s to ensure adequate reserves were set aside in defined-benefit plans

  • 401(k) Plans introduced in 1981

    • Special type of defined-contribution plan

    • Allows for greater flexibility in employer and employee contributions

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Pension Plan Regulation and Insurance

  • Employee Retirement Income Security Act (EIRSA) -

  • Established first federal standards for financing and operation of private, defined-benefit plans

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Pension Plan Regulation and Insurance

  • Plan’s sponsor must make minimum contributions such that projected benefit payments are actuarially sound

  • All contributions must be invested in prudent manner

  • Plans must have minimum vesting requirements

  • Plans must increase disclosure of information to employees regarding the contents and financial health of their plans

  • Department of Labor named as primary regulator to enforce EIRSA’s provisions

  • Act created Pension Benefit Guarantee Corporation (PBGC)

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Social Security

Federal government program that provides retirement and survivors pensions, and disability and health insurance benefits to qualifying individuals.

  • Old Age Survivors and Disability Insurance (OASDI)

    • Core program of social security

    • Funded by payroll taxes to pay retirement and disability payments to eligible individuals and their dependents

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Social Security: Plans for Reform

To ensure that Social Security meets 100% of its future payment commitments:

  • Increase revenues coming into the system

    • Raising tax rate

    • Increasing tax base on which it is applied

  • Reduce benefits

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    Social Security: Plans for Reform

    • Turn system into true pension system

      • Partial or total “privatization”

      • Using system’s funds to purchase corporate securities

      • Three main approaches:

        • Allow portion of workers’ payroll taxes to be invested in IRAs

        • Have federal government use current S surplus to purchase stocks and bonds

        • Encourage workers to contribute to personal accounts in addition to their FICA contributions

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    Finance Companies

    • Second type of specialized, nondepository financial intermediary that lend funds to:

      • Households to finance consumer purchases

      • Businesses to finance inventories and accounts receivable and purchase of machinery/equipment

      • Both consumers and businesses for real estate loans

    • Three main types:

      • Consumer finance companies

      • Business finance companies

      • Real estate loan companies

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    Consumer Finance Companies

    • Offer personal loans to consumers to purchase (or lease) motor vehicles, mobile homes, furniture and appliances

    • Provide credit card services

    • Assist in refinancing of debts

    • Consumers can apply for “in-store credit”

      • Once loan approved, store originates loan

      • Immediately sells the paper or loan at a discount to finance company

      • Benefits store (generates sales, eliminates store’s exposure to default risk, keeps store out of bill processing and collections

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    Consumer Finance Companies

    • In case of default, finance company retains right to repossess property (repossession)

      • Lender takes back assets used to secure loan

      • Two types:

        • Ordinary finance companies

          • Make secured loans for variety of different products or firms

        • Sales finance companies

          • Make loans to consumers so they can purchase product from particular manufacturer or retailer

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    Business Finance Companies

    • Equipment leasing and loans

    • Loans for retail and wholesale motor vehicle loans and leases

    • Loans on accounts receivables or factored commercial accounts

    • Floor-Plan Loans

      • Dealers of automobiles, boats and construction equipment use inventory as collateral for loans repaid when vehicles are sold

    • Factoring Companies

      • Specialized finance companies purchase accounts receivables of other firms at discount

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    Real Estate Loan Companies

    • Specialize in second mortgages

      • Homeowner takes out additional mortgage loan against the accrued equity in property

    • Make home purchase and commercial real estate loans

    • Home Equity Loans

      • Mortgage loans of specific amount

      • Private residence serves as collateral

    • Home Equity Lines of Credit

      • Credit cards secured by second mortgage on one’s home

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    Finance Companies: Trends

    • Industry grew steadily

    • Real estate receivables grew

    • Securitization of automobile loans and leases for consumers and businesses steadily increased

    • Composition of finance company sources and uses of funds continue to evolve

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    Finance Companies: Trends

    • Subprime Lending

      • High-fee, high-interest-rate loans

      • Made to borrower with blemished or nonexistent credit records

    • Manufactured Housing Lending

      • High-fee, high-interest-rate loans

      • Made to homebuyers whose homes were built in factories instead of on site

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    Finance Companies Regulation

    • Finance companies face credit, interest rate, and liquidity risk

    • Face less regulation

    • Do not accept deposits

    • Federal regulators have less reason to restrict their activities