Retirement plans
Richard MacMinn
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Objectives
Describe pension plans and the emerging
issues
Note the common features of pension plans
Describe the methods used to finance private
pension funds
Describe the risks associated with pension
plans
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Private pension plans
Coverage
Plans
– Defined Benefit
– Defined Contribution
International comparison
Emerging issues
– Life expectancy and the
changing age
distribution
– Sources of income
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Emerging issues
Age distribution
Fertility rates
Labor force
participation
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Plan design preliminaries
The impact of legislation
– Income tax law
Tax law is favorable to qualified pension plans
– Employer contributions are tax deductible
– Investment earnings of qualified plans are exempt from income tax until benefits are paid
– Employer contributions are not taxable until received as benefit payments
Requirements of a qualified plan
– Employee retirement income security act (ERISA)
Limitations on contributions and benefits
– Letting A denote the average compensation in the last three years of employment and K be $130,000, the
benefit must not exceed min{K, A}.
– Letting k = $30,000 and S the compensation, the annual contribution to the account may not exceed
min{k, .25 S}
Prohibited transactions
– Plan assets must be legally separated from those of the employer
– Plan may be held in trust or by an insurer
Fiduciary responsibility
– Prudent person standard
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Plan design
Coverage
Coverage provisions may
Retirement age 1
vary based on length of
0.9
Benefit formulas 0.8 service, minimum age,
– Defined benefit 0.7 etc. The IRC 401(a)(26)
– Defined contribution 0.6 requires that defined defined benefit
0.5 benefit plans cover
Maximum benefits 0.4 min{50, .4 n} where n defined
contribution
0.3
Supplemental benefits denotes the number of
0.2
Employee contributions 0.1
employees.
0
Vesting 1980 1990 1998
Methods of distribution
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Plan finance
Funding procedure In this method the total benefits to be paid
– Benefit allocation an employee are estimated and the
to Two funding methods for benefits
– Cost allocation amount required to pay the benefits is
are the unit credit and the
– Funding requirements accumulated through level amounts
projected unit credit methods.
ERISA imposes funding Both of these the remaining
contributed overmethods are year of
requirements that are service. The calculation is similar to that
individual calculation methods with
generally limited to defined a level premium. If the rate
forpast service liabilities. In the of
benefit plans projected unit benefits increases
compensation orcredit method, the then
Pension Benefit Guarantee adjustment in the amount of past
ancurrent year’s service and theinsurance
Corporation (PBGC) is made and the funding of the increase in
service liability is the present value
– Bethlehem Steel of the is accomplished by a
benefits participants projected separate
– United Airlines and additional level premium payable from
retirement benefit attributable to
– IBM the date of increase and based on the
service earned prior to the
employee’s age at that time.
calculation date.
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Plan finance
Pension costs
– The following factors affect pension costs
Mortality
Interest
Expense of operations
Turnover
Disability
Age of retirement
Changes in compensation
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Plan finance
Pension finance vehicles
– Fully insured
These rely on insurance contracts to fund the plan
– Non-insured
These are self administered and require the creation of a trust
The employer is self insuring the fund
The employee faces credit risk
The PBGC insures the defined benefit plans
– Split funded
This plan relies partially on insurance
A maturity funding contract is an example
– A bank holds and invests the active life fund
– Funds are moved to insurer to provide guaranteed annuities as employees
retire
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Pension contract risks
What are the risks for the
insurer?
– More individuals may live to
retire than the mortality
tables used anticipate
– Those who retire may live
longer than the mortality
tables used anticipate
– The rate of interest earned
on investments may fall
below the anticipated level
– There may be defaults in
the investment portfolio
– Plan expenses may be
higher than anticipated
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Insured pension contracts
Single premium annuity contracts
Level premium annuity
Single premium deferred annuity
Deposit administration contracts
Immediate participation guarantee contract
(IPG)
Special investment arrangements
Guaranteed investment contract (GIC)
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Other plans
Profit sharing plan
Stock bonus plan
Employee stock ownership plan (ESOP)
Employee savings plan
Thrift plans
– Thrift plan
– 401(k)
Simplified employee pension plans (SEP)
Tax-shelter annuities (TSA)
– 403(b)
Self-employed pension plans
– Individual retirement account (IRA)
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