Chapter 17 Suggested Questions: 2, 3, 5, 7 Retirement Plans Chapter 17 Suggested Questions: 2, 3, 5, 7

Overview of Retirement Plans Methods of receiving income during retirement: Private savings. CPP/OAS. Savings through employment based retirement plans (focus of this chapter). Advantages Disadvantages Favourable tax treatment Can only be used for retirement. Employee incentives Regulations (plan may earn low rate of return) Chapter 17 BU353

Overview of Retirement Plans Two basic types: Defined benefit. Defined contribution. BU353 Chapter 17

Essential Characteristics of Defined Benefit Plans Retirement benefit defined by a formula (often a function of years of service and salary). Employer and perhaps workers contribute to a fund. Contributions + investment earnings are accumulated to pay the promised benefit. Employer bears most of the investment risk. BU353 Chapter 17

Defined Benefit Formulas Examples of monthly benefit formulas: Benefit = $50 x (years of service). Benefit = 0.02 x (years of service) x (avg. salary during last five years of service). Second is more common with salaried workers. Illustration: .02x10x5000 .02x10x10,000 50 x 10 Service Average monthly salary Monthly benefit under formula 1 2 10 $5,000 $500 $1,000 $10,000 $2,000 Chapter 17 BU353

Replacement Rates Definition: Retirement benefit as a % of final salary. Previous examples of defined benefit plans. 500/5000 500/10,000 200/10,000 1000/5000 Service Average monthly salary Replacement Rates under Formula 1 2 10 $5,000 10% 20% $10,000 5% Chapter 17 BU353

Effect of Switching Employers on Benefits - Example Benefit = 0.02 x service x (final salary). Monthly salary after 15 years = $4,000. Monthly salary after 25 years = $6,000. Calculate the retirement benefits and replacement rates for the following two employees. Scenario 1: 25 years service with one employer. Scenario 2: 15 years of service with first employer and 10 years of service with second. BU353 Chapter 17

Funding of Defined Benefit Plans Defined benefit plans have assets and liabilities. Liabilities = present value of promised benefits. Over-funded plans. Pension assets > pension liabilities. Contribution holidays; Pension asset reversion. Under-funded plans. Pension assets < pension liabilities. BU353 Chapter 17

Pension Benefit Guaranty Fund (PBGF) Insures defined benefit plans in Ontario. PBGF pays benefits of terminated under-funded plans. Insurance is compulsory. Guarantees only $1000/month per employee. BU353 Chapter 17

Essential Characteristics of Defined Contribution Plans Employer and perhaps workers contribute to a fund based on a formula. Retirement benefit = accumulated value of contributions + investment earnings. Workers bear most of the investment risk. Defined contribution have grown in popularity. BU353 Chapter 17

Types of Defined Contribution Plans Money purchase plans: Contributions usually equal a percentage of employee’s salary. Profit sharing plans: Contributions based on firm’s profits either via explicit formula or at board discretion. BU353 Chapter 17

Growth in Defined Contribution Plans Why the movement toward defined contribution plans? Regulatory compliance costs of defined benefit plans higher. Defined benefit plans exhibit economies of scale, defined contribution plans do not. Regulations make defined benefit plans less effective for employee incentive purposes. Less demand for stable workforces. BU353 Chapter 17

Employee Stock Ownership Plans (ESOPs) Invests primarily in employer’s stock. Can improve incentives. But employees hold undiversified portfolios. Can borrow money. ESOPs can be used to raise capital. Have special tax treatment. BU353 Chapter 17

Individual Retirement Plans Registered Retirement Savings Plans: Must have earned income. Contributions are tax deductible up to the limit. Carry forward provision. Max age of 70 for contributing, then must withdraw. Spousal RRSPs. BU353 Chapter 17

Tax Advantages of Retirement Plans Registered plans receive tax advantages. Main tax features: Contributions are not taxable as personal income until the benefits are received. Earnings on assets are not taxed until they are received. Together  employee can earn the before-tax rate of return in a qualified plan. Lower personal tax rates during retirement increases advantages of tax deferral. BU353 Chapter 17

Example Suppose Ken is enrolled in a defined contribution plan in which the employer contributes 10% of his salary each year. Ken is earning $60,000 this year and his tax rate is 30%. Assume that the before tax rate of return is 8%. What is the additional amount of funds that Ken will have when he reaches retirement in 10 years as a result of this year’s contribution? BU353 Chapter 17

Example con’t Suppose that Ken’s employer is stopping its contributions to the defined contribution plan. Ken’s only opportunity to save for retirement is in a non-registered plan. How much would Ken need to receive in additional salary (which he would then save) to achieve his objective? Would Ken be just as happy if his employer increased his salary by 10% instead? BU353 Chapter 17

Comparing Different Methods of Saving Consider an individual with an annual tax rate of t who invests $1 of before-tax wages for N years in an account that earns r. How much accumulates: Outside of a qualified plan. In a tax deferred account. In a registered plan. BU353 Chapter 17

Employer-sponsored Plans Can Increase Productivity Promote effort & reduce unwanted turnover by making retirement benefits contingent on good performance and long service. Participation requirements. Vesting requirements. Backend loading of benefits for defined benefit plans. BU353 Chapter 17

Employer Sponsored Plans Affect Retirement Decision Backend loading of benefits creates incentive for employees to NOT retire. Plans include provisions to induce retirement: Benefits stop accruing after a normal retirement age. Early retirement provisions. BU353 Chapter 17