RISK MANAGEMENT FOR ENTERPRISES AND INDIVIDUALS Chapter 21 Employment-Based and Individual Longevity Risk Management

1 - 2 © 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Learning Objectives  In this chapter, we elaborate on the following:  Distinguishing aspects of qualified retirement plans  Various qualified plans available through employers or on an individual basis  Key features of annuities  Employer’s pension plan funding options

1 - 3 © 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. The Nature of Qualified Pension Plans  Qualified plan: Type of retirement plan where  Employer contributions to an employee’s pension during the employee’s working years are deductible as a business expense and not taxable income to the employee until they are received as benefits.  Investment earnings on funds held by the trustee for the plan are not subject to income taxes as they are earned.

1 - 4 © 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. The Nature of Qualified Pension Plans  Nonqualified plan  Does not allow employer funding contributions to be deducted as business expenses unless classified as compensation to the employee  Investment fund earnings are also subject to taxation  Retirement benefits are deductible business expenses when paid to the employee (if not previously classified as compensation)

1 - 5 © 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. ERISA Requirements for Qualified Pension Plans  To be qualified, a plan must fulfill specific requirements enforced by the United States Internal Revenue Service, the United States Department of Labor, and the Pension Benefit Guaranty Corporation (PBGC).

1 - 6 © 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. ERISA Requirements for Qualified Pension Plans  The main items covered by ERISA and subsequent laws and amendments are:  Employee rights  Reporting and disclosure rules  Participation coverage  Vesting; Funding  Fiduciary responsibilities  Amounts contributed or withdrawn  Nondiscrimination  Tax penalties

1 - 7 © 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Eligibility and Coverage Requirements  Under ERISA, the minimum eligibility requirements are the attainment of age 21 and one year of service.  The Age Discrimination in Employment Act eliminates all maximum age limits for eligibility.  ERISA has coverage requirements that are designed to improve participation by nonhighly compensated employees.

1 - 8 © 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Retirement Age Limits  Normal retirement age: The age at which full retirement benefits become available to retirees; age 65 in most private retirement plans.  Early retirement may be allowed, but that option must be specified in the pension plan description.

1 - 9 © 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Vesting Provisions  Vesting specifies the extent of employee’s right to benefits for which the employer has made contributions, subject to ERISA, EGTRRA 2001, TRA86, and other federal requirements.  Vesting schedules for defined contribution and defined benefit plans are cliff vesting and graded vesting.

© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Nondiscrimination Tests  The employer’s plan must meet one of the following coverage requirements:  Percentage ratio test  Average benefit test

© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Distributions  Distributions are benefits paid out to participants or their beneficiaries, usually at retirement.  Tax penalties are imposed on plan participants who receive distributions (except for disability benefits) prior to age 59½.  The longest time period over which benefits may extend is the participant’s life expectancy.  ERISA requires that pension plan design make spousal benefits available through preretirement survivor annuity and joint and survivor annuity.

© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Loans  The loan provisions require that an employee can take only up to 50 percent of the vested account balance for not more than $50,000.  The number of loans is not limited as long as the total amount is within the required limits.

© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Figure Retirement Plans by Type Limits as of 2009

© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Defined Benefit Plans  Type of pension plan that assures employees of a certain amount at retirement, leaving all risk to the employer to meet the specified commitment; accumulated funds for all participants are managed in one account.  Traditional defined benefit plan  Cash balance plan

© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc.  Features of defined benefit plans  All defined benefit plans may provide for adjustments to account for inflation during the retirement years.  Many plans integrate the retirement benefit with Social Security benefits.  Defined benefit cost factors  Normal costs  Supplemental costs Defined Benefit Plans

© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Defined Contribution Plans  A defined contribution (DC) plan is a qualified pension plan in which the contribution amount is defined but the benefit amount available at retirement varies.  The most common type of defined contribution plan is the money purchase plan.  Other Qualified Defined Contribution Plans  Profit sharing plans  401(k) Plans

© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc.  403(b) and 457 plans  Keogh plans  Simplified employee pension plans  Simple plans  Traditional IRA and Roth IRA  Roth 401(k) and Roth 403(b) plans Other Qualified Plans

© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Annuities  Life annuity: Contract in which the duration of payment from an annuity depends upon the expected length of a life or lives.

© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Parties to an Annuity  Owner: The person or entity that purchases an annuity.  Annuitant: The person on whose life expectancy payments are based.  Beneficiary: The person or entity who receives any death benefits due at the death of the annuitant.

© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Mechanics of Annuities  Accumulation Versus Liquidation  Fixed-dollar annuity  Variable annuity  Premium Payments  Commencement of Benefits  Immediate annuity  Deferred annuity  Level of Benefits

© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Settlement Options  Lump-sum cash payment  Fixed period payment  Fixed amount payment  Life annuity  Refund annuity  Temporary life annuity  Period-certain life annuity  Joint life annuity  Joint-and-survivor annuity

© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Types of Contracts  Annuities commonly used to help fund retirement include the following:  Flexible premium annuity  Single premium deferred annuity  Single premium immediate annuity  All are available with fixed-dollar guarantees, as a variable or as index annuities.  In the variable annuity, two types of units are employed: accumulation units and annuity units.

© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Taxation of Annuities  When an annuity is purchased separately from any pension plan by individuals, the premiums paid are from after-tax income.  For annuities that are bought with after-tax money by individuals, ordinary income taxes are paid on the return of (previously untaxed) investment earnings.

© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Taxation of Annuities  Exclusion ratio: Expression of annuity payments during distribution as taxable and nontaxable portions and calculated as: investment in contract divided by expected return.

© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Pension Plan Funding Techniques  Noninsured trust plan  The employer creates a trust to accumulate funds and disburse benefits  The trustee may be an individual, a bank, a trust company, an insurer, or some combination of cotrustees whose responsibilities are to invest funds contributed by the employer to the trust, accumulate earnings, and pay benefits to eligible employees.

© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Insured Plans  Group deferred annuity: Contract between insurer and employer to provide for the purchase of specified amounts of deferred annuity for employees each year.  Deposit administration: Requires the employer to make regular payments (as determined by actuaries) to the insurance company on behalf of employees, and these contributions accumulate at interest.

© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Insured Plans  Immediate participation guarantee (IPG) contract: A form of deposit administration whereby the employer makes regular deposits to a fund managed by the insurance company and the insurer receives deposits and makes investments.  Separate account plans: Designed to give the insurer greater investment flexibility; contributions are not commingled with the insurer’s other assets and not subject to the same investment limitations.

© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Insured Plans  Guaranteed investment contracts (GICs): Insured pension funding arrangements used by insurers to guarantee competitive rates of return on large, lump-sum transfers (usually $100,000 or more) of pension funds, usually from another type of funding instrument.

© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Summary  Qualified employee retirement plans allow tax- deductible contributions for employees and tax deferral for employees.  Defined benefit plans require the greatest degree of employer commitment by guaranteeing specified retirement benefits for employees.  Defined contribution plans require less employer commitment by guaranteeing only contribution amounts toward employees’ retirement accounts.

© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Summary  Other qualified plans allowing tax-deferred contributions include 403(b), Section 457, Keogh, SEP, and SIMPLE.  There are different types of annuities, which act as retirement investment and distribution vehicles.  Funding of pension plans can be insured through several options.