9-1 Deferred Compensation Plans In Chapter 8, we compared salary to deferred compensation through nonqualified deferral plans Typically not funded, may be discriminatory Employee taxed when payments received, employer deduction when paid Rabbi trusts  Used to minimize risk to employees by transferring assets of a nonqualified retirement plan to trust

9-2 Qualified Pension Plans Deferral may also be accomplished through qualified pension plans Benefits of qualified plans: Employer obtains a current deduction for amounts paid into trust Earnings on the funds while held by the trust are tax-exempt Employees not taxed until funds are withdrawn upon retirement

9-3 Salary versus Pension Contributions Employer preferences: Indifferent between paying $1 of current compensation and a $1 dollar contribution to a pension fund Employee preferences: Employee prefers to receive $1 of current salary rather than receiving $1 of pension contribution if  $1(1-t p0 )(1+r pn ) n > $1(1+R pen ) n (1-t pn )  Or (1+R pen ) n < (1-t po ) (1+r pn ) n (1-t pn )

9-4 Salary versus Pension Contributions continued  Where r pn is the employee’s annualized after-tax rate of return on investments of n periods  R pen is the pension fund’s annualized before-tax rate of return on investments of n period  t p0 is the employee’s tax rate today  t pn is the employee’s tax rate in n periods So employee will generally prefer pension contributions when R pen > r pn and t p0 > t pn

9-5 Example: Salary versus Pension Contribution Charlie is 25 years old and plans to retire at age 60. He can elect to defer $10,000 of salary in a qualified pension plan or take payment currently. If Charlie’s current tax rate is 40%, his expected tax rate at age 60 is 30%, his annualized after-tax rate of return on personal investments is 7%, and the pension fund earns a before-tax rate of return of 11%, calculate the future accumulated after-tax value of a current pension contribution.

9-6 Example continued Compare the after-tax value of a pension contribution to Charlie’s potential accumulation from saving a like amount of after-tax earnings in a nonqualified investment account. At what before-tax rate of return in the pension fund is Charlie indifferent between the two forms of savings?

9-7 Pension Contributions versus Other Deferred Compensation Recall that employer is indifferent between paying $1 of current compensation (or qualified pension contribution) and paying D n dollars of deferred compensation in n periods, where  D n = (1+r cn ) n (1-t c0 )/(1-t cn )  r cn is the employer’s annualized after-tax rate of return on investments of n periods  t c0 is the employer’s tax rate today  t cn is the employer’s tax rate in n periods

9-8 Pensions versus Other Deferred Comp continued Employee prefers to receive $1 of pension contribution rather than receiving D n dollars of deferred compensation in n periods, if  $1(1+R pen ) n (1-t pn ) > $1(1-t c0 )(1+r cn ) n (1-t pn ) (1-t cn )  Or (1+R pen ) n > (1-t c0 ) (1+r cn ) n (1-t cn )  Note that this comparison depends on the employer’s after-tax rate of return and tax rates, not the employee’s. Why?

9-9 Example: Pensions versus Other Deferred Compensation Refer to the previous example Charlie’s employer has a current tax rate of 25%, an expected future tax rate of 40%, and an annualized after-tax rate of return of 10%. At what value of D n (where n = 35 years) is Charlie’s employer indifferent between $10,000 of pension contribution and other deferred compensation? Which would Charlie prefer? What if the employer’s annualized after-tax rate of return is only 9%?

9-10 Requirements for Qualified Plans Written, permanent plan, administered in trust form with an independent trustee Created for exclusive benefit of employees and their beneficiaries Must not discriminate in favor of highly paid employees or stockholder-employees Must provide non-forfeitable right to benefits after no more than 5 years (cliff vesting) or 7 years (graded vesting) service

9-11 Requirements continued All employees at least 21 years old must be eligible to participate after 1 year of service (2 years with immediate vesting) Complex coverage requirements - plan must generally cover lesser of 70% of non-highly compensated employees or at least 70% of covered employees must be non-highly compensated Must be funded Minimum distribution requirements

9-12 Distributions from Qualified Plans Typically distributed when employee quits, retires, or dies lump sum  tax may be computed under 10- or 5-year averaging lifetime annuity 10% penalty on distributions before age 59 1/2 - can be avoided by rollover of distribution into IRA or another qualified plan

9-13 Types of Qualified Plans Defined Benefit Typical pension plan Defined Contribution Profit-sharing plans Stock bonus plans Employee Stock Ownership plans (ESOPs) 401(k) plans - employee allowed to contribute pre-tax dollars

9-14 Employer Contributions to Qualified Plans Recall that the employer’s contributions to a qualified plan are deductible for tax purposes in the year paid into the plan Amount of employer deduction: Defined contribution plan – lesser of 25% of employee compensation or $30,000 Defined benefit plan – actuarially determined contribution necessary to fund the promised benefits, given assumptions about employee attrition, retirement, future salary, plan rate of return, etc.

9-15 Incentives to Over- or Under- Fund Defined Benefit Plans Over funded plan: market value of plan assets exceeds PV of expected liability to employees May occur because fund investment perform better than expected Employers have incentive to ‘frontload’ (defer) contributions when marginal tax rates are falling (increasing)  Accomplished by altering assumptions used in calculating required contributions If employer terminates the plan to retrieve excess investment, an excise tax applies in addition to regular income tax