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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

Pension Plans and Finance Companies

Chapter 19

© 2003 South-Western/Thomson Learning

learning objectives
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
pension plans
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
types of pension plans
Types of Pension Plans
  • Contributory Plans
    • Both employee and employer contribute
  • Noncontributory Plans
    • Only the employer contributes
types of pension plans5
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
types of pension plans6
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
types of pension plans7
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
types of pension plans8
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
types of pension plans9
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
types of pension plans10
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

types of pension plans11
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
types of pension plans12
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
recent trends in private pensions
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
pension plan regulation and insurance
Pension Plan Regulation and Insurance
  • Employee Retirement Income Security Act (EIRSA) -
  • Established first federal standards for financing and operation of private, defined-benefit plans
pension plan regulation and insurance15
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)
social security
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
social security plans for reform
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
social security plans for reform18
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
finance companies
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
consumer finance companies
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
consumer finance companies21
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
business finance companies
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
real estate loan companies
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
finance companies trends
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
finance companies trends25
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
finance companies regulation
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