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Chapter 9 Pension FundsChapter 9 Pension FundsChapter 9 Pension FundsChapter 9 Pension Funds
• Background
• Types
• Assets
• Regulation
• Social Security
• Background
• Types
• Assets
• Regulation
• Social Security
BackgroundBackgroundBackgroundBackground
• defined by function
-- payment of retirement benefits tax treatment
-- tax exempt earnings
& contributions or benefits
• defined by function
-- payment of retirement benefits tax treatment
-- tax exempt earnings
& contributions or benefits
Pension plan sponsorPension plan sponsorPension plan sponsorPension plan sponsor
• private or public employers
• unions
• individuals
• private or public employers
• unions
• individuals
Pension plan administratorPension plan administratorPension plan administratorPension plan administrator
• employer
• insurance company
• investment company
• commercial banks
• employer
• insurance company
• investment company
• commercial banks
Federal lawFederal lawFederal lawFederal law
• does NOT require pension plans
• but regulates existing pension plans• does NOT require pension plans
• but regulates existing pension plans
I. TypesI. TypesI. TypesI. Types
• Defined benefit plans
• Defined contribution plans
• Hybrid plans
• Defined benefit plans
• Defined contribution plans
• Hybrid plans
Defined benefit plansDefined benefit plansDefined benefit plansDefined benefit plans
• employer promised employee monthly payments during retirement
-- life contingent
-- choice of survivor benefits
• employer promised employee monthly payments during retirement
-- life contingent
-- choice of survivor benefits
How is payment determined?How is payment determined?How is payment determined?How is payment determined?
• formula salary
-- average last several years
-- average of best years years of service with sponsor
• formula salary
-- average last several years
-- average of best years years of service with sponsor
VestingVestingVestingVesting
• minimum years of service necessary to receive benefits complex federal rules about
vesting 5-7 years max for full vesting
• minimum years of service necessary to receive benefits complex federal rules about
vesting 5-7 years max for full vesting
Advantages Advantages Advantages Advantages
• (for employee)
• limited investment risk payments promised reguardless of
portfolio return but sponsor bankruptcy could
affect payment size
• (for employee)
• limited investment risk payments promised reguardless of
portfolio return but sponsor bankruptcy could
affect payment size
• no risk of outliving assets payments life contingent,
NOT lump sum
• no risk of outliving assets payments life contingent,
NOT lump sum
DisadvantagesDisadvantagesDisadvantagesDisadvantages
• lack of portability from job to job largest benefits accrue after 20
years DB plans encourage loyalty
• lack of portability from job to job largest benefits accrue after 20
years DB plans encourage loyalty
• lack of control how pension funds are invested is sponsor investing enough?
-- is pension fully funded?
• lack of control how pension funds are invested is sponsor investing enough?
-- is pension fully funded?
example:example:example:example:
• salary base average of best 5 years
• pay % of salary, based on years of service 5 years, 25% 20 years, 60% 30 years, 85%
• salary base average of best 5 years
• pay % of salary, based on years of service 5 years, 25% 20 years, 60% 30 years, 85%
Defined Contribution PlansDefined Contribution PlansDefined Contribution PlansDefined Contribution Plans
• employee/individual contributes funds employer may match contributions
• employee chooses among investment options range of choice varies among
sponsors
• employee/individual contributes funds employer may match contributions
• employee chooses among investment options range of choice varies among
sponsors
• amount accumulated at retirement depends on investment performance
• lump sum at retirement decision about spending possible purchase an annuity
• amount accumulated at retirement depends on investment performance
• lump sum at retirement decision about spending possible purchase an annuity
types of DC planstypes of DC planstypes of DC planstypes of DC plans
• employer sponsored 401(k), 403(b), 414(h), 457 $12,000 contribution limit 2003
• individual IRA, Roth IRA $3000 contribution limit 2003
• employer sponsored 401(k), 403(b), 414(h), 457 $12,000 contribution limit 2003
• individual IRA, Roth IRA $3000 contribution limit 2003
Advantages (employee)Advantages (employee)Advantages (employee)Advantages (employee)
• portability value accumulates steadily balance rolled over to new plans
• cash value build up cash out (tax penalty) borrow against survivor benefits
• portability value accumulates steadily balance rolled over to new plans
• cash value build up cash out (tax penalty) borrow against survivor benefits
DisadvantagesDisadvantagesDisadvantagesDisadvantages
• employee bears investment risk
• retiree risks outliving assets• employee bears investment risk
• retiree risks outliving assets
exampleexampleexampleexample
• I contribute 3% of gross salary (pretax) SUNY matches 9%
• I choose investments through TIAA-CREF growth, index, international, bonds,
etc.
• quarterly statements
• I contribute 3% of gross salary (pretax) SUNY matches 9%
• I choose investments through TIAA-CREF growth, index, international, bonds,
etc.
• quarterly statements
Cash balance planCash balance planCash balance planCash balance plan
• hybrid plan features of both DB, DC plans
• fixed employer contribution % of salary (5%)
• guaranteed annual return on balance Treasury rate
• hybrid plan features of both DB, DC plans
• fixed employer contribution % of salary (5%)
• guaranteed annual return on balance Treasury rate
DB featuresDB featuresDB featuresDB features
• employer bears investment risk must make up difference if actual
return lower than promised return but keeps potential surplus
• employer bears investment risk must make up difference if actual
return lower than promised return but keeps potential surplus
DC featuresDC featuresDC featuresDC features
• each employee monitors own account
• vested benefits portable
• each employee monitors own account
• vested benefits portable
controversycontroversycontroversycontroversy
• conversion from DB to CB younger employees better off older employees often worse off
-- DB plans get most of value in last 5-10 years of service
• conversion from DB to CB younger employees better off older employees often worse off
-- DB plans get most of value in last 5-10 years of service
exampleexampleexampleexample
• IBM 1999 announced conversion to CB older employees stood to lose
over 50% of expected benefits
• after EEOC inquiry, lawsuits, IBM allowed older workers to choose their plan
• IBM 1999 announced conversion to CB older employees stood to lose
over 50% of expected benefits
• after EEOC inquiry, lawsuits, IBM allowed older workers to choose their plan
II. AssetsII. AssetsII. AssetsII. Assets
• Defined benefit plans 75% U.S. stocks, bonds unions less likely to hold
international assets
• Defined benefit plans 75% U.S. stocks, bonds unions less likely to hold
international assets
• corporate defined contribution plans hold over 25% of assets as own
company stock
-- Enron 60%
-- Anheuser Bush, Coca Cola,
McDonald’s over 74% big lack of diversification
-- but easier to match 401(k) contributions w/ stock than w/cash
• corporate defined contribution plans hold over 25% of assets as own
company stock
-- Enron 60%
-- Anheuser Bush, Coca Cola,
McDonald’s over 74% big lack of diversification
-- but easier to match 401(k) contributions w/ stock than w/cash
• 401ks invested heavily in company stock have led to huge losses Enron, Lucent, Xerox
• 401ks invested heavily in company stock have led to huge losses Enron, Lucent, Xerox
III. RegulationIII. RegulationIII. RegulationIII. Regulation
• tax treatment tax exempt contributions
-- DB, 401k, IRA, CB tax deferred earnings
-- all tax exempt withdrawals
-- Roth IRA
• tax treatment tax exempt contributions
-- DB, 401k, IRA, CB tax deferred earnings
-- all tax exempt withdrawals
-- Roth IRA
• early withdrawal of funds (DC, CB) before age 59.5 taxable AND extra 10% penalty
-- exceptions for
-- medical bills
-- education
-- disability
-- home buyers
• early withdrawal of funds (DC, CB) before age 59.5 taxable AND extra 10% penalty
-- exceptions for
-- medical bills
-- education
-- disability
-- home buyers
ERISA (1974)ERISA (1974)ERISA (1974)ERISA (1974)
• set funding standards DB plans must be fully funded not
“pay-as-you-go” sponsors must set aside funds for
employees, not pay obligations out of current income
• set funding standards DB plans must be fully funded not
“pay-as-you-go” sponsors must set aside funds for
employees, not pay obligations out of current income
• set vesting standards 5-7 years max for full vesting
• federal insurance for DB pensions PBGC vested benefits up to a limit no COLA trustee to over 2500 plans
• set vesting standards 5-7 years max for full vesting
• federal insurance for DB pensions PBGC vested benefits up to a limit no COLA trustee to over 2500 plans
• guidelines for pension fund mgmt. both DB, DC plans plan must provide prudent,
investing options Enron lawsuit
-- must show stock was not a prudent option
• guidelines for pension fund mgmt. both DB, DC plans plan must provide prudent,
investing options Enron lawsuit
-- must show stock was not a prudent option
• How long can employer keep 401k contributions before investing? old rule: 90 days since 1997: 15 days after end of
month of payday
• How long can employer keep 401k contributions before investing? old rule: 90 days since 1997: 15 days after end of
month of payday
IV. Social SecurityIV. Social SecurityIV. Social SecurityIV. Social Security
• established 1935
• DB plan supported by payroll tax 6.2% employee & employer tax wages up to $87,000
• established 1935
• DB plan supported by payroll tax 6.2% employee & employer tax wages up to $87,000
• benefits based on age of retirement # years worked income annual COLAs based on CPI
• benefits based on age of retirement # years worked income annual COLAs based on CPI
• SS is pay-as-you-go retirees today paid with current
payroll taxes right now
payroll tax revenue
> benefits
this surplus is “invested” in Treasury IOUs
• SS is pay-as-you-go retirees today paid with current
payroll taxes right now
payroll tax revenue
> benefits
this surplus is “invested” in Treasury IOUs
Problems w/ SSProblems w/ SSProblems w/ SSProblems w/ SS
• U.S. population is aging too many collecting benefits
relative to how many paying taxes 3.4 payer-to-receiver today 2 payer-to-receiver in 2030
• U.S. population is aging too many collecting benefits
relative to how many paying taxes 3.4 payer-to-receiver today 2 payer-to-receiver in 2030
• today revenue > benefits
• by 2015 benefits > revenues draw on Treasury IOUs
• by 2040 assets exhausted must supplement with other tax
revenue
• today revenue > benefits
• by 2015 benefits > revenues draw on Treasury IOUs
• by 2040 assets exhausted must supplement with other tax
revenue
Solutions?Solutions?Solutions?Solutions?
• increase retirement age already increased from 65 to 67 for
those born after 1960
• increase payroll tax regressive tax already risen from 2% to 12.4%
• increase retirement age already increased from 65 to 67 for
those born after 1960
• increase payroll tax regressive tax already risen from 2% to 12.4%
• investing surplus in assets other than Treasury IOUs higher return BUT higher risk government stock ownership is
problematic
-- corporate control
-- price volatility
• investing surplus in assets other than Treasury IOUs higher return BUT higher risk government stock ownership is
problematic
-- corporate control
-- price volatility
• Private retirement accounts allow % of payroll tax for workers
to invest in choice of investments how to deal with risk? do workers have investment
savvy? disability/survivor benefits? how to transition?
• Private retirement accounts allow % of payroll tax for workers
to invest in choice of investments how to deal with risk? do workers have investment
savvy? disability/survivor benefits? how to transition?
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