Transcript Document

Chapter 8
Retirement
Plans and the
Fund Business
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Structure of Tax-Qualified
Retirement Plans
Tax benefits of Qualified Retirement Plans
The 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 Pensions
Qualified Plan:
“Qualifies” for valuable federal tax benefits
Most employees with pension are in qualified
plans
Design, 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 treatment
Mainly 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 standards
5. Provides for automatic survivor benefits
under certain circumstances.
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Funding
Qualified plan must be funded in
advance of the employee’s retirement
Can be done through:
Contributions to an irrevocable trust fund
Under 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Tax penalty if withdrawn before early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 death
Payouts 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 withdrawal
According to the OMB, the cost to federal
treasury in 1999 of preferential tax treatment
for pensions is about $75 billion annually
Sometimes 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
years
Before tax interest rate r = .10
Tax 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 plans
1.
2.
DB versus DC
“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
Contribution
Defined benefit (DB) plan
Employer promises to pay specified schedule of
benefits to plan participant upon retirement
Employer contributes to the plan regularly and
controls investments
Employer is responsible for any asset shortfall due
to investment performance
If employer goes bankrupt, federal insurance
covers “basic benefits”
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Overview of DB Formulas
Formula specifies benefit to be paid to the
employee
Investment risk rests with plan sponsor
Payment 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 pay
Typically insured by the PBGC (within limits)
Formulas and funding can sometimes be
complex
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DB Formula Characteristics
Employer 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 formulas
Benefit 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 Formulas
Flat-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 Formula
Benefit 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 contribution
Both employee and employer usually contribute to
the plan
Employee directs the investment of the plan’s
assets
Employee assumes the risk of asset shortfall due
to investment performance
No federal insurance
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Growth of DB versus DC, 1992–
2005
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.
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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 Work
401(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 Work
Contributions 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 Funds
Became Popular
Services
800# access to account information
Voice response units
On-line employer access to account information
Daily valuation and daily prices in the newspaper
Participant communications
Investment education
Advice tools
Broad investment selections
Name brand funds
Specialized 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) plans
1990: 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 services
Daily 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, 1997
Created for small businesses (100 or fewer
employees)
Reduces administrative expenses to employer as compared
to traditional 401(k) plans
Financial institution responsible for majority of the work
Employee
Benefits from an employer-sponsored plan and automatic
deduction
Has $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 either
Match 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
1991
2000
457 &
Other
Plans
10%
403(b)
Plans
11%
457 &
Other
Plans
8%
403(b)
Plans
20%
IRAs
50%
IRAs
56%
401(k)
Plans
14%
401(k)
Plans
31%
Source: Investment Company Institute, Federal Reserve Board, IRS, and Department of Labor
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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 $80,000
Individuals 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 Funds
Expected to grow from $2.2 trillion in 1999 to
>$6 trillion in 2010
Keys to growth are
Attracting 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 Plans
Distribution 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 Reform
Aging 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
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