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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 pl

ans

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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 participatio

n

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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 Retirement age Benefit formulas

– Defined benefit– Defined contribution

Maximum benefits Supplemental benefits Employee contributions Vesting Methods of distribution

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1980 1990 1998

defined benefit

definedcontribution

Coverage provisions may vary based on length of service, minimum age, etc. The IRC 401(a)(26) requires that defined benefit plans cover min{50, .4 n} where n denotes the number of employees.

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Plan finance

Funding procedure– Benefit allocation– Cost allocation– Funding requirements

ERISA imposes funding requirements that are generally limited to defined benefit plans

Pension Benefit Guarantee Corporation (PBGC)

– Bethlehem Steel– United Airlines– IBM

Two funding methods for benefits are the unit credit and the projected unit credit methods. Both of these methods are individual calculation methods with past service liabilities. In the projected unit credit method, the current year’s service and the past service liability is the present value of the participants projected retirement benefit attributable to service earned prior to the calculation date.

In this method the total benefits to be paid to an employee are estimated and the amount required to pay the benefits is accumulated through level amounts contributed over the remaining year of service. The calculation is similar to that for a level premium. If the rate of compensation or benefits increases then an adjustment in the amount of insurance is made and the funding of the increase in benefits is accomplished by a separate and additional level premium payable from the date of increase and based on the employee’s age at that time.

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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)