Transcript Section II - Bryant University

Reasons for the Retirement Risk
1. Retirement risk arises from uncertainty
concerning the time of death
2. It is influenced by physiological and
cultural hazards
• people tend to live longer today
• people are retiring earlier
18-1
Risks Associated with Superannuation
Two parts to the retirement risk
• individual will not have accumulated
sufficient assets by the time retirement
arrives
• assets that have been accumulated will not
last for the remainder of his or her lifetime
18-2
Retirement Risk Alternatives
1. Some people attempt to avoid the
retirement risk by not retiring.
2. Continuing employment does not totally
avoid the risk, since the probability of
disability increases with age.
3. The risk of outliving an accumulation can
be transferred to an insurer.
4. Some individuals transfer the retirement
risk to their children or to society by not
preparing for retirement.
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An Overview of Retirement Planning Process
1. Estimate future income need
2. Determine how the funds required to meet
the need will be accumulated
3. Plan the manner in which the accumulation
will be consumed
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Sources of Retirement Funding
1.
The first leg:
Social Security
2.
The second leg:
Qualified pensions and
profit sharing plans
3.
The third leg:
Personal savings
18-5
Annuities
1.
Reverse application of the law of large
numbers as it is used in life insurance.
2.
Law of averages permits a lifetime
guaranteed income to each annuitant.
3.
Persons who live longer than average offset
those who live a shorter-than-average
period.
4.
Every payment to annuitant is part interest,
part principal, and part survivorship benefit.
18-6
Annuities
Classification of annuities
1.
Individual versus Group
2.
Fixed versus Variable
3.
Immediate versus Deferred
4.
Single Premium versus Installment
5.
Single Life versus Two or More Lives
6.
Pure Life Annuity versus Annuity Certain
18-7
Tax Treatment of Annuities
Investment
Nontaxable
Payment X
in Contract = Return of
Expected Return
Capital
$6,000
=
$6,000
X
$60,000
=
($500 X 12) X 15
$60,000
$90,000
$60,000
$90,000
$4,000
=
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Specialized Annuities
Single-Premium Deferred Annuity
1. Increased popularity since TRA-86
eliminated many tax shelters.
2. Currently taxed same as other annuities:
earnings accumulate on tax-deferred basis.
3. Some insurers sell SPDAs with deposit
premium as low as $2,500, but more
common minimum is $10,000.
18-9
Variable Annuity
1. Designed as means of coping with inflation.
2. Premiums invested in common stocks or
similar investments.
3. Based on assumption that the value of a
diversified portfolio of common stocks will
change in the same direction as price level.
4. Variable annuity may be variable during
accumulation period and fixed during
payout period or variable during both
accumulation and payout period.
18-10
Annuities as Investments for Retirement
1.
Return earned over life of an annuity
depends on several features.
2.
Most important determinants of the rate of
return are:
• interest rate
• surrender charge
• administrative expenses
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Qualified Retirement Plans
Qualified plans are those that conform to the
requirements of federal tax laws and for which
the law provides favorable tax treatment.
1. Employee contributions are tax
deductible when they are made.
2. Employee is not taxed on employer’s
contribution or investment earnings until
benefits are distributed.
18-12
ERISA
Employee Retirement Income Security Act of
1974 (ERISA) establishes federal standards for
qualified retirement plans:
1. Prescribes which employees must be
included.
2. Establishes minimum vesting standards.
3. Sets minimum funding standards.
4. Requires extensive reporting and
disclosure information about pensions
and other employee welfare programs.
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Qualification Requirements
1.
2.
3.
4.
Designed for exclusive benefit of employees.
In writing and communicated to employees.
Must meet one of several vesting schedules.
Cannot discriminate in favor of officers,
stock-holders or highly compensated
employees.
5. Must provide for definite contributions by
employer or definite benefits at retirement.
6. Life insurance included only on an incidental
basis.
7. Top-heavy plans are subject to special
vesting and contribution requirements. 18-14
Vesting Requirements (specified in plan
documents)
1.
No vesting for 5 years, 100% vested after 5
years.
2.
20% vested after 3 years with 20% per year
thereafter so employee is 100% vested at
the end of 7 years.
3.
For top-heavy plans:
•
100% in three years, or
•
20% per year after first year
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Types of Qualified Plans (corporations)
1.
2.
3.
4.
5.
Defined Benefit Pension Plans
Defined Contribution Pension Plans
Qualified Profit-sharing Plans
Employee Stock Ownership Plans
Section 401(k) Plans
18-16
Factors Influencing Benefit Levels
Benefit received by employees at retirement is
based on a formula applicable to all
employees.
1. All plans fall into one of two benefit
formula categories
• defined contribution
• defined benefit.
2. Plans may be contributory (with employee
contributions) or noncontributory (where
employer bears the entire cost).
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Amount of Benefits or Contributions
Defined Contribution Plans
1.
Work exactly as the name implies:
employer’s contribution is set by the
employment agreement
2.
Contribution is usually a percentage of
compensation, such as 5% or 10% of
employee wages
18-18
Amount of Benefits or Contribution
Defined Benefit Plans
1. In defined benefit plan, amount of benefits
employee will receive is specified in the
benefit formula
2. In most benefit formulas, retirement benefit
is a function of employee’s salary, the
benefit accrual rate, and employee’s years
of service
3. Most plans are final average salary plans
but some are career average salary plans.
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Amount of Benefits or Contributions
FINAL AVERAGE SALARY PLAN
Benefit depends on salary earned in final years
of employment and number of years worked
• example: 1% of average monthly salary
during final three years of employment for
each year employed
• an employee with 35 years employment
would receive 35% of average monthly
employment in the final three years
18-20
Amount of Benefits or Contributions
CAREER AVERAGE SALARY PLAN
Benefit depends on salary earned in all years
of employment and number of years worked
•
example: 1% of average monthly salary
during all years of employment for each
year employed,
•
an employee with 35 years employment
would receive 35% of average monthly
employment over employment career.
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Amount of Benefits and Contributions
Defined Contribution Plans
1. Maximum allowable contribution to a
defined contribution plan varies with the
type of plan
2. For a defined contribution pension plan, the
limit is 25% of year’s earnings, subject to a
dollar maximum that is adjusted for
inflation
3. Dollar maximum was set at $30,000 in 1986
and will be adjusted for inflation when
dollar maximum for defined benefit plans 18-22
reaches $120,000
Amount of Benefits or Contributions
Defined Benefit Plans
1. Maximum benefit in a defined benefit plan
is 100% of employee’s earnings in three
consecutive years of highest earnings.
2. Dollar maximum for defined benefit was set
at $90,000 in 1988 and is adjusted for
inflation since that time.
18-23
Contribution for Keogh Plans
1. Keogh plans are subject to essentially the
same limitations, deductions and benefits
as applicable to corporate pension and
profit-sharing plans.
2. A special definition of earned income is
used to make contributions by selfemployed persons correspond to those for
a common-law employee.
3. Percentage limitations apply after the
contribution to the plan is deducted from
income.
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Keogh Plan Contribution Illustrated
Partnership establishes a defined contribution
plan with 25% of employee compensation.
Partner earns $100,000.
Partner’s contribution is limited to 25% of
income after the contribution:
Taxable
Income
Employee
Owner
$40,000
80,000
Nontaxable
Contribution
$10,000
20,000
Total
$50,000
100,000
18-25
Maximum Contribution 401(k) Plans
1. Permit pretax contributions (called
“elective deferrals”) by employees.
2. Employees elect to contribute to a profitsharing plan and instruct employer to make
contributions on their behalf.
3. I.R.C. treats contributions as if they were
made by employer rather than by employee.
4. Limit on employee deferrals to 401(k) plan
or SEP is the lesser of 25% of
compensation or a dollar maximum (set at
$7,000 in 1988 and indexed for inflation
since that time).
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Nature of the Employer’s Promise
INVESTMENT RISK
Under defined contribution plan, employer
promises to make contributions to an account
that earns investment income.
• Since benefits depend on contributions and
investment income, the employee bears the
investment risk in defined contribution
plans.
• Because the employee bears the investment
risk, he or she is likely to have some say in
how funds are invested.
18-27
Nature of the Employer’s Promise
INVESTMENT RISK
In a defined benefit plan, the employer
promises to provide a certain level of
retirement benefits to the employee.
• Employer therefore bears the investment
risk in a defined benefit plan.
18-28
Advantages to Younger and Older Employees
1. A higher proportion of ultimate retirement
benefits are earned in early years of
participation in a defined contribution plan.
2. Present value of benefits promised to
younger workers under a defined benefit
plan tends to be small compared with
present value of benefits promised when
the worker is closer to retirement.
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Distribution Requirements
1. Commencement of benefits: April 1 after
year in which individual reaches age 70 1/2
or the date of retirement, if later.
2. Distribution must be made over
• the life of the participant or joint lives of
participant and spouse (i.e., an annuity).
• the life expectancy of the participant and
his or her beneficiary.
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Premature Distributions
10% penalty prior to age 59 1/2 except for
• deductible medical expenses
• in form of lifetime annuity
• at age 55 by worker who meets plan
requirements for retirement
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Taxation of Distributions
1. Retirement benefits traditionally paid to
participants in form of a lifetime annuity.
2. Installment distributions taxable only to the
extent they exceed employee’s investment
in the contract.
3. Lump-sum distributions may be rolled-over
into an annuity and taxed under installment
rules.
4. Lump-sum distributions that are not rolledover may be subject to five-year averaging.
18-32
Individual Retirement Accounts (traditional IRA)
1. A person who is not covered by an
employer-sponsored plan can make taxdeductible contribution to an IRA of $2,000
annually.
2. Persons covered by an employer plan may
be entitled to same deduction, a partial
deduction, or no deduction, depending on
income.
3. Persons not eligible for deduction may
make a nondeductible contribution.
4. New rules under TRA-97 allow a full $2,000
deductible contribution by a spouse who is
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not employed outside the home.
Individual Retirement Accounts (traditional)
Adjusted Gross Income Phase Out Levels
$25,000 to $35,000 for single taxpayers
$40,000 to $50,000 for married filing jointly
0 to $10,000 for married filing jointly
TRA-97 gradually increases AGI phase-out
levels to double the present level by 2007.
18-34
IRA Taxation Formula
Amount
Distributed
X
From IRA
During Year
Total
Nondeductible
Contributions All
Years to IRAs
Fair Market Value
of all IRAs at
End of Year
_
+
Tax-Free
Withdrawals
in Prior Years
Amount Distributed
From IRA During
the Year
18-35
The New Roth IRA
Beginning in January of 1998, contributions
permitted to Roth IRA
 contributions only on a non-deductible basis.
 earnings tax-free when the funds are
withdrawn for retirement (i.e., after age 59½).
 annual contributions of $2,000 (100% of
compensation) per individual.
 AGI phase-out $95,000 single $150,000 joint.
 no requirement for withdrawals at 70½ and
contributions may continue after age 70½.
 $2,000 limit for Traditional IRA and a Roth
IRA.
18-36
Education IRA
Introduced by TRA-97 - despite its designation, has
nothing to do with retirement.
 designed for saving for higher education.
 up to $500 annually per student (to age 18).
 phased out for joint filers - $150,000 to $160,000,
$95,000 and $110,000 for single taxpayers.
 nondeductible, but earnings tax-free.
 distributions under age 30 not taxable if used for
qualified higher education expenses.
 distributions in excess of qualified education
expenses taxable with a 10% penalty.
 Education IRA contributions are in addition to
Roth IRA Plus and traditional IRAs.
18-37