8/9/2015copyright macminn.org 1 Retirement plans Richard MacMinn

8/9/2015copyright macminn.org 2 Objectives Describe pension plans and the emerging issues Describe pension plans and the emerging issues Note the common features of pension plans Describe the methods used to finance private pension funds Describe the methods used to finance private pension funds Describe the risks associated with pension plans Describe the risks associated with pension plans

8/9/2015copyright macminn.org 3 Private pension plans Coverage Plans – Defined Benefit Defined Benefit – Defined Contribution International comparison International Emerging issues – Life expectancy and the changing age distribution – Sources of income Sources of income

8/9/2015copyright macminn.org 4 Emerging issues Age distribution Fertility rates Fertilityrates Labor force participation Labor force participation

8/9/2015copyright macminn.org 5 Plan design preliminaries The impact of legislation – Income tax law Tax law is favorable to qualified pension plans – Employer contributions are tax deductible – Investment earnings of qualified plans are exempt from income tax until benefits are paid – Employer contributions are not taxable until received as benefit payments Requirements of a qualified planqualified plan – Employee retirement income security act (ERISA)ERISA Limitations on contributions and benefits – Letting A denote the average compensation in the last three years of employment and K be $130,000, the benefit must not exceed min{K, A}. – Letting k = $30,000 and S the compensation, the annual contribution to the account may not exceed min{k,.25 S} Prohibited transactions – Plan assets must be legally separated from those of the employer – Plan may be held in trust or by an insurer Fiduciary responsibility – Prudent person standard Prudent person standard

8/9/2015copyright macminn.org 6 Plan design Coverage Retirement age Benefit formulas – Defined benefit – Defined contribution Maximum benefits Supplemental benefits Employee contributions Vesting Methods of distribution Coverage provisions may vary based on length of service, minimum age, etc. The IRC 401(a)(26) requires that defined benefit plans cover min{50,.4 n} where n denotes the number of employees.

8/9/2015copyright macminn.org 7 Plan finance Funding procedure – Benefit allocation – Cost allocation – Funding requirements ERISA imposes funding requirements that are generally limited to defined benefit plans Pension Benefit Guarantee Corporation (PBGC)PBGC – Bethlehem Steel Bethlehem Steel – United Airlines United Airlines – IBM IBM Two funding methods for benefits are the unit credit and the projected unit credit methods. Both of these methods are individual calculation methods with past service liabilities. In the projected unit credit method, the current year’s service and the past service liability is the present value of the participants projected retirement benefit attributable to service earned prior to the calculation date. In this method the total benefits to be paid to an employee are estimated and the amount required to pay the benefits is accumulated through level amounts contributed over the remaining year of service. The calculation is similar to that for a level premium. If the rate of compensation or benefits increases then an adjustment in the amount of insurance is made and the funding of the increase in benefits is accomplished by a separate and additional level premium payable from the date of increase and based on the employee’s age at that time.

8/9/2015copyright macminn.org 8 Plan finance Pension costs – The following factors affect pension costs Mortality Interest Expense of operations Turnover Disability Age of retirement Changes in compensation

8/9/2015copyright macminn.org 9 Plan finance Pension finance vehicles – Fully insured These rely on insurance contracts to fund the plan – Non-insured These are self administered and require the creation of a trust The employer is self insuring the fund The employee faces credit risk The PBGC insures the defined benefit plans – Split funded This plan relies partially on insurance A maturity funding contract is an example – A bank holds and invests the active life fund – Funds are moved to insurer to provide guaranteed annuities as employees retire

8/9/2015copyright macminn.org 10 Pension contract risks What are the risks for the insurer? – More individuals may live to retire than the mortality tables used anticipate – Those who retire may live longer than the mortality tables used anticipatelive longer – The rate of interest earned on investments may fall below the anticipated levelrate of interest – There may be defaults in the investment portfolio – Plan expenses may be higher than anticipated

8/9/2015copyright macminn.org 11 Insured pension contracts Single premium annuity contracts Level premium annuity Single premium deferred annuity Deposit administration contracts Immediate participation guarantee contract (IPG) Immediate participation guarantee contract (IPG) Special investment arrangements Guaranteed investment contract (GIC)

8/9/2015copyright macminn.org 12 Other plans Profit sharing plan Stock bonus plan Employee stock ownership plan (ESOP) Employee savings plan Thrift plans – Thrift plan – 401(k) 401(k) Simplified employee pension plans (SEP)SEP Tax-shelter annuities (TSA) – 403(b) Self-employed pension plans – Individual retirement account (IRA)IRA