1. Pension Funds 1 Copyright 2014 by Diane Scott Docking

2. Learning Objectives Learn about the history of pension funds Understand the difference between a private pension fund and a public pension fund Distinguish between and calculate the benefits from a defined benefit and a defined contribution pension fund. Identify the characteristics of the different types of private pension funds. Identify the different types of public pension funds Examine the main regulations governing pension funds. Copyright 2014 by Diane Scott Docking 2

3. History of Pension Funds Pension funds (PFs) offer savings plans through which participants accumulate tax deferred savings during their working years before withdrawing them in their retirement years funds invested are exempt from current taxation (i.e., during working years) tax payments are not made until funds are withdrawn by the participant (i.e., during retirement) PFs were first established in the U.S. in 1759 to benefit the widows and children of church ministers The first corporate PF was established by American Express Co. in 1875 Copyright 2014 by Diane Scott Docking 3

4. History of Pension Funds (cont.) By 1940, approximately 400 PFs existed most were for employees in the railroad, banking, and public utilities industries By 2010, over 700,000 PFs existed 36% of U.S. households’ financial assets were in PFs compares to just over 5% in 1950 The financial crisis reduced global pension assets from $25 trillion to $20 trillion U.S. retirement accounts fell by $2 trillion, causing many to postpone retirement and reduce spending to save more Copyright 2014 by Diane Scott Docking 4

5. Private vs. Public Pension Funds There are two distinct PF sectors Private PFs are funds administered by private corporations (e.g., insurance companies or mutual funds) 401(k) 403(b) IRAs – Traditional & Roth Keogh, Simple, and SEP Public PFs are funds administered by federal, state, or local governments State and local government PFs Federal government PFs Social Security Copyright 2014 by Diane Scott Docking 5

6. Pension Fund Administration Pension funds may be either insured or noninsured an insured pension fund is a PF administered by a life insurance company a noninsured pension fund is a PF administered by a financial institution other than a life insurance company $8,108.5 billion in total financial assets in 2010 insurance companies administer $2,410.6 billion (29.7%) mutual funds administer $1,930.8 billion (23.8%) other financial institutions (e.g., banks) administer $3,767.1 billion (46.5%) Pension funds may be either insured or noninsured an insured pension fund is a PF administered by a life insurance company a noninsured pension fund is a PF administered by a financial institution other than a life insurance company $8,108.5 billion in total financial assets in 2010 insurance companies administer $2,410.6 billion (29.7%) mutual funds administer $1,930.8 billion (23.8%) other financial institutions (e.g., banks) administer $3,767.1 billion (46.5%) Copyright 2014 by Diane Scott Docking 6

7. Defined Benefit vs. Defined Contribution Plans Defined benefit plans employer agrees to provide the employee with a specific cash benefit upon retirement a flat benefit formula PF pays a flat amount for every year of employment a career average formula PF pays benefits based on the employee’s average salary over the entire period of employment a final pay formula PF pays benefits based on a percentage of the average salary during a specified number of years at the end of the employee’s career times the number of years of service Defined contribution plans employer agrees to make a specified contribution to the pension fund during the employee’s working years fixed-income funds offer a guaranteed rate of return variable-income funds, all profits and losses on the underlying securities are passed through to the fund participants Copyright 2014 by Diane Scott Docking 7

8. Plan Funding for Defined benefit plans Fully funded PF has sufficient funds available to meet all future payment obligations Underfunded PF does not have sufficient funds available to meet all future promised payments Overfunded PF has more than enough funds available to meet the required future payouts Fully funded PF has sufficient funds available to meet all future payment obligations Underfunded PF does not have sufficient funds available to meet all future promised payments Overfunded PF has more than enough funds available to meet the required future payouts Copyright 2014 by Diane Scott Docking 8

9. Pension Fund Growth: DB vs DC Copyright 2014 by Diane Scott Docking 9 Source: http://www.federalreserve.gov/releases/z1/current/accessible/l117.htm

10. Pension Fund Growth: DB vs DC Copyright 2014 by Diane Scott Docking 10

11. Example: Defined Benefit Plans An employee works 20 years for a firm. Her average salary over her entire career with the firm was $65,000 and $75,000 over the last five years. Find the annual retirement benefit for various defined benefit plans: 1)Flat benefit plan of $2,000 x # years worked 2)Career average plan with flat % = 60% of average salary 3)Career average plan with flat % = 4% of average salary adjusted by years of service 4)Final pay plan with flat % = 4% of the last five years of salary adjusted for years of service An employee works 20 years for a firm. Her average salary over her entire career with the firm was $65,000 and $75,000 over the last five years. Find the annual retirement benefit for various defined benefit plans: 1)Flat benefit plan of $2,000 x # years worked 2)Career average plan with flat % = 60% of average salary 3)Career average plan with flat % = 4% of average salary adjusted by years of service 4)Final pay plan with flat % = 4% of the last five years of salary adjusted for years of service Copyright 2014 by Diane Scott Docking 11

12. Example: Defined Benefit Plans 1) Flat benefit of $2,000 per year worked: $2,000  20 years = $40,000 annual pension 2)Career average, flat percentage of 60% of average salary: $65,000  0.60 = $39,000 annual pension 3)Career average, flat percentage of 4% of average salary adjusted by years of service: $65,000  0.04  20 years = $52,000 annual pension 4)Final pay: A flat percentage amount of 4% of the last five years of salary adjusted for years of service: $75,000  0.04  20 years = $60,000 annual pension 1) Flat benefit of $2,000 per year worked: $2,000  20 years = $40,000 annual pension 2)Career average, flat percentage of 60% of average salary: $65,000  0.60 = $39,000 annual pension 3)Career average, flat percentage of 4% of average salary adjusted by years of service: $65,000  0.04  20 years = $52,000 annual pension 4)Final pay: A flat percentage amount of 4% of the last five years of salary adjusted for years of service: $75,000  0.04  20 years = $60,000 annual pension Copyright 2014 by Diane Scott Docking 12

13. Private Pension Funds 401(k) 403(b) IRAs – Traditional & Roth Keogh and SEP Copyright 2014 by Diane Scott Docking 13

14. 401(k) and 403(b)plans 401(k) and 403(b) plans are employer-sponsored plans that supplement a firm’s basic retirement plan allows for both employer and employee contributions 401(k) plans are offered to employees of taxable firms 403(b) plans are offered to employees of tax exempt employers contributions are made on a pretax basis most plans are transferable if the employee changes jobs participants generally make their own choice of the allocation of assets from both employee and employer contributions 401(k) and 403(b) plans are employer-sponsored plans that supplement a firm’s basic retirement plan allows for both employer and employee contributions 401(k) plans are offered to employees of taxable firms 403(b) plans are offered to employees of tax exempt employers contributions are made on a pretax basis most plans are transferable if the employee changes jobs participants generally make their own choice of the allocation of assets from both employee and employer contributions Copyright 2014 by Diane Scott Docking 14

15. IRAs – Traditional vs. Roth Copyright 2014 by Diane Scott Docking 15 Roth IRATraditional IRA Tax benefits Tax-free growth Tax-free qualified withdrawals Tax-deferred growth Contributions may be tax-deductible Eligibility: AgeAny age with employment compensation Under age 70½ with employment compensation Eligibility: IncomeIncome limits to make contributionsNo income limits to make contributions Taxation at withdrawal Contributions are always withdrawn tax- free. Earnings are federally tax-free after the five-year aging requirement has been satisfied and certain conditions are met. Withdrawals of pre-tax contributions and any earnings are taxable when distributed. Penalties at withdrawal A non-qualified distribution is subject to taxation of earnings and a 10% additional tax unless an exception applies. Withdrawals before 59½ may be subject to a 10% early withdrawal penalty unless an exception applies. Minimum required distributions (MRDs) Not subject to minimum required distributions during the lifetime of the original owner MRDs starting at 70

16. Keogh & SEP Plans Keogh Plans A tax deferred pension plan available to self-employed individuals for retirement purposes. Keogh Plans cannot be used for “self-employed” individuals who work in the capacity of an independent contractor. Keogh Plans are applicable to self-employed individuals who own their own unincorporated business (sole proprietorships, partnerships & LLC.). Contributions are generally tax deductible up to 25% of annual income with a limit of $52,000 (as of 2014). Copyright 2014 by Diane Scott Docking 16

17. Keogh & SEP Plans SEP Plans (Simplified Employee Pension) Plan A retirement plan that an employer or self-employed individuals can establish. The employer is allowed a tax deduction for contributions made to the SEP plan and makes contributions to each eligible employee's SEP IRA on a discretionary basis. Contributions are generally tax deductible up to 25% of annual income with a limit of $52,000 (as of 2014). Copyright 2014 by Diane Scott Docking 17

18. Public Pension Funds State or local government pension funds “pay as you go” in that current employee contributions fund current retiree benefits because of an increasing number of retirees relative to workers, some funds’ current payments exceed current contributions Federal government pension funds civil service funds cover all federal employees not in the armed forces such employees are not covered by Social Security a military pension fund covers career military personnel military personnel are also covered by Social Security military personnel are eligible after 20 years of military service State or local government pension funds “pay as you go” in that current employee contributions fund current retiree benefits because of an increasing number of retirees relative to workers, some funds’ current payments exceed current contributions Federal government pension funds civil service funds cover all federal employees not in the armed forces such employees are not covered by Social Security a military pension fund covers career military personnel military personnel are also covered by Social Security military personnel are eligible after 20 years of military service Copyright 2014 by Diane Scott Docking 18

19. Public Pension Funds Social Security, aka Old Age and Survivors Insurance Fund provides benefits to almost all employees and self-employed individuals in the U.S. established in 1935 to provide a minimum level of retirement income to all retirees funded on a “pay as you go” basis historically, contributions have exceeded disbursements For 2014 FICA contributions are 6.2% of the first $117,00 earned (which is also matched by an employer contribution of 6.2%) Self-employed individuals pay the full 12.4% disbursements are expected to exceed contributions by 2024 system is expected to be bankrupt by 2037 If born after 1960, full retirement age is 67. Social Security, aka Old Age and Survivors Insurance Fund provides benefits to almost all employees and self-employed individuals in the U.S. established in 1935 to provide a minimum level of retirement income to all retirees funded on a “pay as you go” basis historically, contributions have exceeded disbursements For 2014 FICA contributions are 6.2% of the first $117,00 earned (which is also matched by an employer contribution of 6.2%) Self-employed individuals pay the full 12.4% disbursements are expected to exceed contributions by 2024 system is expected to be bankrupt by 2037 If born after 1960, full retirement age is 67. Copyright 2014 by Diane Scott Docking 19

20. Pension Fund Regulation The Employee Retirement Income Security Act (ERISA) of 1974 focused on five areas of reform: pension plan funding vesting of benefits fiduciary responsibilities of fund administrators pension fund transferability pension fund insurance The Employee Retirement Income Security Act (ERISA) of 1974 focused on five areas of reform: pension plan funding vesting of benefits fiduciary responsibilities of fund administrators pension fund transferability pension fund insurance Copyright 2014 by Diane Scott Docking 20

21. Pension Fund Regulation Funding prior to ERISA, regulation did not require PFs to be adequately funded ERISA established guidelines for funding and set penalties for fund deficiencies contributions must be sufficient to meet all annual costs and expenses PFs must fund any unfunded historical liabilities over a 30-year period any new underfunding must be funded over a 15-year period has led many defined benefit plans to switch over to a defined contribution structure Funding prior to ERISA, regulation did not require PFs to be adequately funded ERISA established guidelines for funding and set penalties for fund deficiencies contributions must be sufficient to meet all annual costs and expenses PFs must fund any unfunded historical liabilities over a 30-year period any new underfunding must be funded over a 15-year period has led many defined benefit plans to switch over to a defined contribution structure Copyright 2014 by Diane Scott Docking 21

22. Pension Fund Regulation Vesting of benefits a vested employee is an employee who is eligible to receive pension benefits because he or she has worked for a stated period of time prior to ERISA, vesting could take up to 25 years ERISA set the maximum vesting period at 10 years Fiduciary responsibility a PF fiduciary is a trustee or investment advisor that manages a PF ERISA requires that PF contributions be invested with the same diligence, skill, and care as a “prudent person” the sole objective of PF management is to provide the promised benefits to the plan participants Vesting of benefits a vested employee is an employee who is eligible to receive pension benefits because he or she has worked for a stated period of time prior to ERISA, vesting could take up to 25 years ERISA set the maximum vesting period at 10 years Fiduciary responsibility a PF fiduciary is a trustee or investment advisor that manages a PF ERISA requires that PF contributions be invested with the same diligence, skill, and care as a “prudent person” the sole objective of PF management is to provide the promised benefits to the plan participants Copyright 2014 by Diane Scott Docking 22

23. Pension Fund Regulation Transferability ERISA allows employees to transfer pension credits from one employer to another when switching jobs Insurance ERISA established the Pension Benefit Guarantee Corporation (PBGC) PBGC insures participants of defined benefit pension plans employers paid $1 in premiums per employee when PBGC was created in 1974 Transferability ERISA allows employees to transfer pension credits from one employer to another when switching jobs Insurance ERISA established the Pension Benefit Guarantee Corporation (PBGC) PBGC insures participants of defined benefit pension plans employers paid $1 in premiums per employee when PBGC was created in 1974 Copyright 2014 by Diane Scott Docking 23

24. Pension Fund Regulation The Pension Protection Act of 2006 increased annual premiums from $19 to $30 per employee for fully funded firms, now $35 in 2010 underfunded plans now pay $9 per $1,000 of underfunding gives companies only 5 years to make up shortfalls in their defined benefit pension plans requires companies to tell investors and employees well before plans become significantly underfunded The Pension Protection Act of 2006 increased annual premiums from $19 to $30 per employee for fully funded firms, now $35 in 2010 underfunded plans now pay $9 per $1,000 of underfunding gives companies only 5 years to make up shortfalls in their defined benefit pension plans requires companies to tell investors and employees well before plans become significantly underfunded Copyright 2014 by Diane Scott Docking 24