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

2. 1 - 2 © 2010 Flat World Knowledge, Inc. 21 - 2 © 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

3. 1 - 3 © 2010 Flat World Knowledge, Inc. 21 - 3 © 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.

4. 1 - 4 © 2010 Flat World Knowledge, Inc. 21 - 4 © 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)

5. 1 - 5 © 2010 Flat World Knowledge, Inc. 21 - 5 © 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).

6. 1 - 6 © 2010 Flat World Knowledge, Inc. 21 - 6 © 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and disclosure rules  Participation coverage  Vesting; Funding  Fiduciary responsibilities  Amounts contributed or withdrawn  Nondiscrimination  Tax penalties

7. 1 - 7 © 2010 Flat World Knowledge, Inc. 21 - 7 © 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.

8. 1 - 8 © 2010 Flat World Knowledge, Inc. 21 - 8 © 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.

9. 1 - 9 © 2010 Flat World Knowledge, Inc. 21 - 9 © 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.

10. 1 - 10 © 2010 Flat World Knowledge, Inc. 21 - 10 © 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

11. 1 - 11 © 2010 Flat World Knowledge, Inc. 21 - 11 © 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.

12. 1 - 12 © 2010 Flat World Knowledge, Inc. 21 - 12 © 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.

13. 1 - 13 © 2010 Flat World Knowledge, Inc. 21 - 13 © 2010 Flat World Knowledge, Inc. Figure 21.2 - Retirement Plans by Type Limits as of 2009

14. 1 - 14 © 2010 Flat World Knowledge, Inc. 21 - 14 © 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

15. 1 - 15 © 2010 Flat World Knowledge, Inc. 21 - 15 © 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

16. 1 - 16 © 2010 Flat World Knowledge, Inc. 21 - 16 © 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

17. 1 - 17 © 2010 Flat World Knowledge, Inc. 21 - 17 © 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

18. 1 - 18 © 2010 Flat World Knowledge, Inc. 21 - 18 © 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.

19. 1 - 19 © 2010 Flat World Knowledge, Inc. 21 - 19 © 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.

20. 1 - 20 © 2010 Flat World Knowledge, Inc. 21 - 20 © 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

21. 1 - 21 © 2010 Flat World Knowledge, Inc. 21 - 21 © 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

22. 1 - 22 © 2010 Flat World Knowledge, Inc. 21 - 22 © 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.

23. 1 - 23 © 2010 Flat World Knowledge, Inc. 21 - 23 © 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.

24. 1 - 24 © 2010 Flat World Knowledge, Inc. 21 - 24 © 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.

25. 1 - 25 © 2010 Flat World Knowledge, Inc. 21 - 25 © 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.

26. 1 - 26 © 2010 Flat World Knowledge, Inc. 21 - 26 © 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.

27. 1 - 27 © 2010 Flat World Knowledge, Inc. 21 - 27 © 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.

28. 1 - 28 © 2010 Flat World Knowledge, Inc. 21 - 28 © 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.

29. 1 - 29 © 2010 Flat World Knowledge, Inc. 21 - 29 © 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.

30. 1 - 30 © 2010 Flat World Knowledge, Inc. 21 - 30 © 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.