Chapter 8Retirement Plans and the Fund Business

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Structure of Tax-Qualified Retirement Plans

Tax benefits of Qualified Retirement PlansThe employer’s contributions are deductible in the tax year they are made

Participants realize no taxable income

Participants do not recognize any taxable income on their own contributions

Earnings on contributions from both the employer and participants are accumulated tax free

Participants realize taxable income only when they actually receive their retirement benefits

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Basic Overview of PensionsQualified Plan:

“Qualifies” for valuable federal tax benefitsMost employees with pension are in qualified plansDesign, funding, and administration must meet very complex set of federal statutory and regulatory requirements

Non-qualified Plan – any other retirement or deferred compensation

Less regulation, but less favorable tax treatmentMainly used as a form of executive compensation

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Tax-Qualified Plans

1. Meet minimum age (>18)and service standards and minimum coverage requirements (>1 yr)

2. Contribution or benefits do not discriminate in favor of highly compensated employees

3. Contribution or benefits do not exceed certain employee contribution limits

4. Meets minimum vesting standards5. Provides for automatic survivor benefits

under certain circumstances.

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Funding

Qualified plan must be funded in advance of the employee’s retirementCan be done through:

Contributions to an irrevocable trust fundUnder an insurance contract

Funds must be under control of a fiduciary and managed solely for benefit of participants and beneficiaries

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Payout Restrictions

Tax penalty if withdrawn before early retirement, age 59½, disability or deathPayouts must begin by April 1 of the year after the participant reaches 70½

Minimum amounts specified by IRS

Restrictions on loans

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Tax Revenue Loss

In general, contributions to qualified plans are not taxed until withdrawalAccording to the OMB, the cost to federal treasury in 1999 of preferential tax treatment for pensions is about $75 billion annuallySometimes called a “tax expenditure”Congress insists on furthering social goals

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How Valuable is Tax Deferral?

Invest $1000 today and hold for 30 yearsBefore tax interest rate r = .10Tax rate t = .35 (assume same for all types of income)

1. How much is deferral worth?

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Types of Qualified Plans

Two ways to classify plans1. DB versus DC2. “Pension plans” versus “profit-

sharing plans”• Pension – provide income at retirement• Profit sharing – allow for deferral of

income, perhaps based on corporations profitability, and may allow earlier access to funds

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Defined Benefit versus Defined ContributionDefined benefit (DB) plan

Employer promises to pay specified schedule of benefits to plan participant upon retirementEmployer contributes to the plan regularly and controls investmentsEmployer is responsible for any asset shortfall due to investment performanceIf employer goes bankrupt, federal insurance covers “basic benefits”

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Overview of DB Formulas

Formula specifies benefit to be paid to the employeeInvestment risk rests with plan sponsorPayment of benefit is obligation of the employer, and thus employer is required to fund the plan in advance so that the funds will be there to payTypically insured by the PBGC (within limits)Formulas and funding can sometimes be complex

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DB Formula CharacteristicsEmployer objectives

Provide reasonable income “replacement ratio”Maximize value of tax shelter for key employees“Manage” work force (e.g., encourage retention, incentives for early retirement, etc.)

Two useful characteristics of DB formulasBenefit need not be function of total compensation

• Can design plan around desired retirement income for employee

Permitted to favor employers who enter plan at later ages

• At plan inception, often favors key employees of closely held businesses

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Allowable DB FormulasFlat-Benefit Formula

Does not take into account years of service• Flat-Amount Formula ($10,000 per year during

retirement)• Flat-Percentage Formula (50% of final salary)

Unit-Benefit FormulaBenefit is based on length of service$10 per month x (Years of Service)Annual Benefit = (2%) x (Yrs. of Service) x (Final Salary)

Role of Past service

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Defined Benefit versus Defined Contribution (cont.)Defined contribution (DC) plan

Employer’s financial contribution is limited to any annual contributionBoth employee and employer usually contribute to the planEmployee directs the investment of the plan’s assetsEmployee assumes the risk of asset shortfall due to investment performanceNo federal insurance

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Source: For 1992-1996, EBRI tabulations based on U.S. Department of Labor, Pension, and Welfare Benefits Administration, Private Pension Plan Bulletin (Winter 1999-2000); for 1997-2005, EBRI projections. Asset amounts shown exclude funds held by life insurance companies under allocated group insurance contracts for payment of retirement benefits. These excluded funds make up roughly 10 to 15 percent of total private funds assets. From EBRI, “Research Highlights: Retirement and Health Data.” January 2001. Reprinted by permission of Employee Benefit Research Institute, Research Highlights, Retirement Data, January 2001.

Growth of DB versus DC, 1992–2005

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Why Employers and Employees Prefer DC Plans

Employer benefits under DC scheme

Avoidance of long-term investment risk and future pension obligations

Avoidance of un-funded pension liabilities on balance sheets

Employee benefits under DC scheme

Control over contributions and investment choices

Ability to calibrate the amount of their contribution (and deduction)

Opportunity for higher returns (and lower returns)

DC plans tend to vest earlier than DB plans

DC plans are more portable than DB plans

In the case of employer bankruptcy, DC plan assets are not subject to creditor claims

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How 401(k) Plans Work401(k) is a section of the Internal Revenue Code governing

“cash or deferred arrangements” (CODAs) that are part of a retirement plan

Three principal types of contributions to a 401(k) plan:1. Elective: Tax deferred employee contributions made by the

plan sponsor on behalf of the employee in the form of salary reduction

2. Matching: Employer contributions that match employee contributions up to a flat dollar amount or percentage of salary contributed

3. Nonelective: Nonmatching contributions made by the plan sponsor from employer funds ( satisfy nondiscrimination tests)

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How 401(k) Plans WorkContributions are made usually as percent of employees’ salary

Employee currently has $13,000 pre-tax elective deferral limit (2004)Total limit is $40,000

Employees over age 50 may make “catch-up” contributions each year. Currently $1,000 p.y. $5,000 p.y from 2006.

Anti-discrimination tests may limit overall contributions for some. “Catch-up” contribution is not subject to anti-discrimination rules

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Anti-Discrimination Test

Design to ensure that highly compensated employees (HCE) do not contribute at a disproportionately higher rate than non-HCE.

To pass the test:

HCEs contribute at an average rate no more than 125% higher than that for nonHCEs, or

Average contribution rate for HCEs is less than 2% greater than the average rate for nonHCEs.

If the plan fails the test, a portion of HCEs contributions must be returned so that the test can be passed.

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How 401(k) Plans Work (cont.)

Participants choose investments from a retirement menu

Plan sponsor designs the investment menu

Participants may change their choices from time to time

Employee’s retirement benefits based on plan contributions and investment performance

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Why 401(k) Plans Became So Popular

Pre-tax deferrals reduce current taxes

Earnings on contributions grow tax deferred

Employer usually matches some of employee contribution

Direct payroll deduction of employee contribution

Portability in the event of job change

Participants gain control over retirement benefits

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Why Mutual FundsBecame Popular

Services800# access to account informationVoice response unitsOn-line employer access to account information

Daily valuation and daily prices in the newspaperParticipant communications

Investment educationAdvice tools

Broad investment selectionsName brand fundsSpecialized products (e.g., lifestyle funds)

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Mutual Funds and 401(k) Plans

Assets in 401(k) plans have increased, along with MF share of those assets

401(k) assets: 2000 at $1.9T; 2005 (exp) $3.2T

Growth in participants: 2000 at 41m; 2005 (exp) 55m

Growth in 401(k) plans: 2005 (exp) 435,000

Growth in MF shares in 401(k) plans1990: 9% of assets in MF

199-00 : 45% assets in MF

Prior to advent of 401(k), banks and insurance cos dominated retirement market; predominantly DB.

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Mutual Funds and 401(k) Plans

Investment options

Employers must offer at least 3 core options to qualify for safe harbor

Average number of options available is 10 (1999)

Mutual funds are usually standard options

Other options include• GICS, employer stock, brokerage window, mutual

fund window, commingled pools

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Mutual Funds and 401(k) Plans

Mutual funds in 401(k) plans are almost always no-load

Other servicesDaily processing (contribution, distribution, loans, etc.)

Participant communication (statements, plan choices, telephone, internet, etc.)

Services to plan sponsors

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SIMPLE (Small Employer) Plans

Established as of January 1, 1997Created for small businesses (100 or fewer employees)

Reduces administrative expenses to employer as compared to traditional 401(k) plansFinancial institution responsible for majority of the work

Employee Benefits from an employer-sponsored plan and automatic deductionHas $6,000 annual pre-tax deferral limit (in 2001, rising to $10,000 by 2006)

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SIMPLE (Small Employer)Plans

Employer may eitherMatch contributions dollar for dollar up to 3% of employee’s compensation

Contribute 2% of each eligible employee’s compensation

Trade-off for lowered matching/contributions is that SIMPLE plans are free from anti-discrimination tests that apply to 401(k) plans

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Mutual Fund Assets by Type of Retirement Plan

Source: Investment Company Institute, Federal Reserve Board, IRS, and Department of Labor

IRAs56%

401(k) Plans14%

403(b) Plans20%

457 & Other Plans10%

IRAs50%

401(k) Plans31%

403(b) Plans11%

457 & Other Plans8%

1991 2000

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Expansion of Traditional IRAs

Traditional IRAs provide tax deductions at the time of contribution for those that qualify (as fully phased in)

Couples with income under $80,000Individuals with income under $50,000

Spousal IRAs for non-working spouse (without W-2 income)

Eligible for own $3,000 contribution (2002 limit)Tax deduction at time of contribution if couple’s income <$150,000

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Expansion of Traditional IRAs (cont.)

Individuals over age 50 may make “catch-up” contributions

Lower-income workers able to receive a refundable tax credit of up to $1,000 per year

Taxpayers qualifying for deductions at time of contribution must pay tax on contributions and earnings at time of distribution

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Creation of Roth (back-end) IRA

No tax deduction at time of contribution

But earnings build up tax-free and are not taxed at the time of distribution if investor keeps assets in IRA

For at least 5 years and

Until age 59½

Full eligibility for Roth IRA

Individuals with income under $110,000

Couples with income under $150,000

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Growth of IRAs and Benefits to Mutual FundsExpected to grow from $2.2 trillion in 1999 to >$6 trillion in 2010

Keys to growth areAttracting new investors to contributory IRAs

Continuing to attract 401(k) and other DC participants to rollover IRAs

• Rollover IRA is one established with assets rolled over from an employer-sponsored retirement plan (usually upon leaving)

• DC distributions rolled to IRAs are projected to reach $467 billion by 2010

• Although expected to grow, rollovers can now be “rolled back” to DC plans

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Growth of IRAs and Benefits to Mutual Funds (cont.)

Reasons that mutual funds dominate the IRA marketplace

IRA holders can control their investments through mutual fund selection

There is a broad range of investments available under a mutual fund IRA

Since IRAs are retail accounts, they benefit from all the retail services available to mutual fund customers

Success of mutual funds in 401(k) marketplace has strengthened the attractiveness of mutual funds in the IRA marketplace

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Future of Retirement PlansDistribution Planning

Current accumulation phase will shift to distribution phase as population ages (as baby boomers really move into retirement)

Rollover IRA will become more important

Distribution planning for retirees will become more important

• Fund sponsors must offer tools

• Fund sponsors must focus on appropriate investment products

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Future of Retirement Plans

Social Security ReformAging population will stretch/break “pay-as-you-go” system

Possible solutions being discussed include• Reducing social security benefits for future retirees or raising

retirement age

• Increasing payroll tax for current workers

• Diverting general tax revenues from other programs to pay for social security

• Allow some form of investment—part of the trust fund or part of individuals’ accounts—in the stock market

Social Security debate raises questions about potential impact on the mutual fund industry