Chapter 9 Pension Funds Background Types Assets Regulation Social Security Background Types Assets Regulation Social Security

BackgroundBackground defined by  function -- payment of retirement benefits  tax treatment -- tax exempt earnings & contributions or benefits defined by  function -- payment of retirement benefits  tax treatment -- tax exempt earnings & contributions or benefits

Pension plan sponsor private or public employers unions individuals private or public employers unions individuals

Pension plan administrator employer insurance company investment company commercial banks employer insurance company investment company commercial banks

Federal law does NOT require pension plans but regulates existing pension plans does NOT require pension plans but regulates existing pension plans

I. Types Defined benefit plans Defined contribution plans Hybrid plans Defined benefit plans Defined contribution plans Hybrid plans

Defined benefit plans employer promised employee monthly payments during retirement -- life contingent -- choice of survivor benefits employer promised employee monthly payments during retirement -- life contingent -- choice of survivor benefits

How is payment determined? formula  salary -- average last several years -- average of best years  years of service with sponsor formula  salary -- average last several years -- average of best years  years of service with sponsor

VestingVesting minimum years of service necessary to receive benefits  complex federal rules about vesting  5-7 years max for full vesting minimum years of service necessary to receive benefits  complex federal rules about vesting  5-7 years max for full vesting

AdvantagesAdvantages (for employee) limited investment risk  payments promised reguardless of portfolio return  but sponsor bankruptcy could affect payment size (for employee) limited investment risk  payments promised reguardless of portfolio return  but sponsor bankruptcy could affect payment size

no risk of outliving assets  payments life contingent, NOT lump sum no risk of outliving assets  payments life contingent, NOT lump sum

DisadvantagesDisadvantages lack of portability from job to job  largest benefits accrue after 20 years  DB plans encourage loyalty lack of portability from job to job  largest benefits accrue after 20 years  DB plans encourage loyalty

lack of control  how pension funds are invested  is sponsor investing enough? -- is pension fully funded? lack of control  how pension funds are invested  is sponsor investing enough? -- is pension fully funded?

example:example: salary base  average of best 5 years pay % of salary, based on years of service  5 years, 25%  20 years, 60%  30 years, 85% salary base  average of best 5 years pay % of salary, based on years of service  5 years, 25%  20 years, 60%  30 years, 85%

Defined Contribution Plans employee/individual contributes funds  employer may match contributions employee chooses among investment options  range of choice varies among sponsors employee/individual contributes funds  employer may match contributions employee chooses among investment options  range of choice varies among sponsors

amount accumulated at retirement depends on investment performance lump sum at retirement  decision about spending  possible purchase an annuity amount accumulated at retirement depends on investment performance lump sum at retirement  decision about spending  possible purchase an annuity

types of DC plans employer sponsored  401(k), 403(b), 414(h), 457  $12,000 contribution limit 2003 individual  IRA, Roth IRA  $3000 contribution limit 2003 employer sponsored  401(k), 403(b), 414(h), 457  $12,000 contribution limit 2003 individual  IRA, Roth IRA  $3000 contribution limit 2003

Advantages (employee) portability  value accumulates steadily  balance rolled over to new plans cash value build up  cash out (tax penalty)  borrow against  survivor benefits portability  value accumulates steadily  balance rolled over to new plans cash value build up  cash out (tax penalty)  borrow against  survivor benefits

DisadvantagesDisadvantages employee bears investment risk retiree risks outliving assets employee bears investment risk retiree risks outliving assets

exampleexample I contribute 3% of gross salary (pretax)  SUNY matches 9% I choose investments through TIAA- CREF  growth, index, international, bonds, etc. quarterly statements I contribute 3% of gross salary (pretax)  SUNY matches 9% I choose investments through TIAA- CREF  growth, index, international, bonds, etc. quarterly statements

Cash balance plan hybrid plan  features of both DB, DC plans fixed employer contribution  % of salary (5%) guaranteed annual return on balance  Treasury rate hybrid plan  features of both DB, DC plans fixed employer contribution  % of salary (5%) guaranteed annual return on balance  Treasury rate

DB features employer bears investment risk  must make up difference if actual return lower than promised return  but keeps potential surplus employer bears investment risk  must make up difference if actual return lower than promised return  but keeps potential surplus

DC features each employee monitors own account vested benefits portable each employee monitors own account vested benefits portable

controversycontroversy conversion from DB to CB  younger employees better off  older employees often worse off -- DB plans get most of value in last 5-10 years of service conversion from DB to CB  younger employees better off  older employees often worse off -- DB plans get most of value in last 5-10 years of service

exampleexample IBM 1999  announced conversion to CB  older employees stood to lose over 50% of expected benefits after EEOC inquiry, lawsuits, IBM allowed older workers to choose their plan IBM 1999  announced conversion to CB  older employees stood to lose over 50% of expected benefits after EEOC inquiry, lawsuits, IBM allowed older workers to choose their plan

II. Assets Defined benefit plans  75% U.S. stocks, bonds  unions less likely to hold international assets Defined benefit plans  75% U.S. stocks, bonds  unions less likely to hold international assets

corporate defined contribution plans  hold over 25% of assets as own company stock -- Enron 60% -- Anheuser Bush, Coca Cola, McDonald’s over 74%  big lack of diversification -- but easier to match 401(k) contributions w/ stock than w/cash corporate defined contribution plans  hold over 25% of assets as own company stock -- Enron 60% -- Anheuser Bush, Coca Cola, McDonald’s over 74%  big lack of diversification -- but easier to match 401(k) contributions w/ stock than w/cash

401ks invested heavily in company stock have led to huge losses  Enron, Lucent, Xerox 401ks invested heavily in company stock have led to huge losses  Enron, Lucent, Xerox

III. Regulation tax treatment  tax exempt contributions -- DB, 401k, IRA, CB  tax deferred earnings -- all  tax exempt withdrawals -- Roth IRA tax treatment  tax exempt contributions -- DB, 401k, IRA, CB  tax deferred earnings -- all  tax exempt withdrawals -- Roth IRA

early withdrawal of funds (DC, CB)  before age 59.5  taxable AND extra 10% penalty -- exceptions for -- medical bills -- education -- disability -- home buyers early withdrawal of funds (DC, CB)  before age 59.5  taxable AND extra 10% penalty -- exceptions for -- medical bills -- education -- disability -- home buyers

ERISA (1974) set funding standards  DB plans must be fully funded not “pay-as-you-go”  sponsors must set aside funds for employees, not pay obligations out of current income set funding standards  DB plans must be fully funded not “pay-as-you-go”  sponsors must set aside funds for employees, not pay obligations out of current income

set vesting standards  5-7 years max for full vesting federal insurance for DB pensions  PBGC  vested benefits up to a limit  no COLA  trustee to over 2500 plans set vesting standards  5-7 years max for full vesting federal insurance for DB pensions  PBGC  vested benefits up to a limit  no COLA  trustee to over 2500 plans

guidelines for pension fund mgmt.  both DB, DC plans  plan must provide prudent, investing options  Enron lawsuit -- must show stock was not a prudent option guidelines for pension fund mgmt.  both DB, DC plans  plan must provide prudent, investing options  Enron lawsuit -- must show stock was not a prudent option

How long can employer keep 401k contributions before investing?  old rule: 90 days  since 1997: 15 days after end of month of payday How long can employer keep 401k contributions before investing?  old rule: 90 days  since 1997: 15 days after end of month of payday

IV. Social Security established 1935 DB plan supported by payroll tax  6.2% employee & employer  tax wages up to $87,000 established 1935 DB plan supported by payroll tax  6.2% employee & employer  tax wages up to $87,000

benefits based on  age of retirement  # years worked  income  annual COLAs based on CPI benefits based on  age of retirement  # years worked  income  annual COLAs based on CPI

SS is pay-as-you-go  retirees today paid with current payroll taxes  right now payroll tax revenue > benefits this surplus is “invested” in Treasury IOUs SS is pay-as-you-go  retirees today paid with current payroll taxes  right now payroll tax revenue > benefits this surplus is “invested” in Treasury IOUs

Problems w/ SS U.S. population is aging  too many collecting benefits relative to how many paying taxes  3.4 payer-to-receiver today  2 payer-to-receiver in 2030 U.S. population is aging  too many collecting benefits relative to how many paying taxes  3.4 payer-to-receiver today  2 payer-to-receiver in 2030

today revenue > benefits by 2015 benefits > revenues  draw on Treasury IOUs by 2040 assets exhausted  must supplement with other tax revenue today revenue > benefits by 2015 benefits > revenues  draw on Treasury IOUs by 2040 assets exhausted  must supplement with other tax revenue

Solutions?Solutions? increase retirement age  already increased from 65 to 67 for those born after 1960 increase payroll tax  regressive tax  already risen from 2% to 12.4% increase retirement age  already increased from 65 to 67 for those born after 1960 increase payroll tax  regressive tax  already risen from 2% to 12.4%

investing surplus in assets other than Treasury IOUs  higher return BUT higher risk  government stock ownership is problematic -- corporate control -- price volatility investing surplus in assets other than Treasury IOUs  higher return BUT higher risk  government stock ownership is problematic -- corporate control -- price volatility

Private retirement accounts  allow % of payroll tax for workers to invest in choice of investments  how to deal with risk?  do workers have investment savvy?  disability/survivor benefits?  how to transition? Private retirement accounts  allow % of payroll tax for workers to invest in choice of investments  how to deal with risk?  do workers have investment savvy?  disability/survivor benefits?  how to transition?