1. Personal Finance: a Gospel Perspective
Retirement Planning 3:
Employer Qualified Plans

2. Objectives A. Understand Employer Qualified Retirement Plans
B. Understand Defined Benefit Plans
C. Understand Defined Contribution Plans

3. Applications #1
Bill, married with two kids, will be graduating in April with his bachelors degree, and has two similar offers from companies both located in San Francisco, California. Both companies are companies he would be content to stay with for 30 years. Company A has a 401k with a 100% match up to 4% of his salary. Company B has a 401k with no match, but a Defined Benefit Plan with the formula based on average salary, a factor of 1.5%, and years of service up to 30 years. Assuming the salary is $50,000 for either firm, which has the more attractive retirement package for Bill? Can Bill participate in other retirement plans?

4. Understand Employer Qualified Retirement Plans
Two Kinds of Plans
Employer Funded Pension Plans
(Defined Benefit Plans)
Employer Sponsored Retirement Plans
(Defined Contribution Plans)

5. Employer Qualified Plans (EQPs)
There has been a shift in EQPs
With defined benefit plans, the risk of funding a specific amount each year is with the company
With defined contribution plans, the risk of funding a specific amount each year is with the employee
We are seeing fewer (or a reduction in the benefit) defined benefit plans
Risk has been essentially shifted from the company to the employee

6. A. Understanding Defined Benefit Plans
What is a defined benefit plan (DBP)?
A retirement plan funded entirely by the employer in which the payout amount is guaranteed
What are the characteristics of a DBP?
Employees don’t contribute
Employees receive a “promise” of a defined payout at retirement
Payout is generally based on formula
Formula variables include:
Average salary level (x), factor percentage (y), and years of service (z)

7. Defined Benefit Plans (continued)
What is a payout formula?
A formula which determines how much you will receive at retirement
Example for XYZ corporation:
Calculate average of five highest annual salaries within the last ten years
Multiply final “average” salary by a company determined factor of 1.5%, and
Multiple this by years in service (to a maximum of 33)
For XYZ Corporation: $60,000 x .015 x 25 yrs = $22,500 or 37.5% of final salary

8. Defined Benefit Plans (continued)
Advantages
Some plans provide 30% to 50% of final salary
Employees do not contribute and bear no risk
Benefits can be extended to spouse
Disadvantages
Benefits are considered taxable income
Firms can change policies even after you retire
Lack of portability and vesting is required
Most do not provide for inflation (no COLA)
Some plans are unfunded

9. Cash-Balance Plans What are cash-balance plans?
A type of DBP in which workers are credited with a certain percentage of their salary (generally 4-7%) each year, plus a low but guaranteed rate of investment earnings
How is this different from a DCP?
Accounts grow at a predetermined rate, regardless of how much is in the account
Employees do not make any investment decisions

10. Cash-Balance Plans (continued)
Advantages
Employees do not contribute
Rate of return is a constant
Retirement benefits are easier to track
Cash-balance plans are portable
Cash-balance plans are cheaper for the company
Disadvantages
Actual payouts may be less than the basic defined benefit plans

11. Distributions/Payout Options (Example: BYU Defined Benefit Plan)
10 year certain & life, 15 year certain & life, 20 year certain & life
Life annuity
Joint & survivor 100 percent annuity (10 year certain)
Joint & survivor 75 percent annuity (10 year certain)
Joint & survivor 50 percent annuity (10 year certain)
Special joint & survivor two-thirds annuity (10 year certain)
Qualified joint & survivor annuity (50% and no term certain)
Note: If employee dies prior to retirement, surviving spouse is restricted to QJSA option.

12. Important Questions to ask when Considering Employment Opportunities
What salary is your pension based: average compensation, final year’s salary, or some other amount?
What is the vesting period?
What is the formula for calculating benefits?
What’s the normal retirement age? What happens to your pension amount if you retire sooner?
Any advantage to working past age 65?
Is there a COLA?

13. C. Understand Defined Contribution Plans
What is a defined contribution plan (DCP)?
A retirement plan where the employer contributes a specific amount to the employee’s retirement funds while the employee is working and then has no responsibilities once the employee retires
What are the characteristics of a DCP?
Employer contributes to a fund, and then has no additional obligation when the employee retires
Employee may also contribute to the fund
Pension is determined by how much is invested by both the employer and employee, and how fast it grows

14. Defined Contribution Plans (continued)
What are the different types of defined contribution plans (DCPs)?
Money Purchase Plans
Plan where employer contributes a percentage of employee salary each year
Profit Sharing Plans
Plan where employer contributions vary year-to-year depending on firm profitability (it may be zero if the firm is not profitable)

15. Defined Contribution Plans (continued)
Thrift and Savings Plans
Plan where employer matches a percentage of employee contributions to a specific amount (i.e., free money)
Employee Stock Options Plan
Plan where retirement funds are invested in company stock—a very risky and non-diversified plan, but often at a discount to the current price

16. Defined Contribution Plans (continued)
Salary Reduction Plans
Employees contribute before tax dollars reducing their taxable income
Earnings accumulate tax deferred
55 million employees participate in 401(k) plans
89% of 401(k) plans have matching contributions

17. Defined Contribution Plans (continued)
Types of Salary Reduction Plans
401k Plans
Plan where employees contribute a percent of salary up to a specified amount ($13,000 in 2004). Employers may contribute a matching amount (free money) to encourage participation
403b Plans
Same as 401k but for non-profit tax-exempt companies and institutions (i.e., schools)
457 Plans
Same as 401k but for state and municipal workers

18. Salary Reduction Plans
Employees direct the funds into different financial asset options including:
Mutual funds, index funds, fixed income, equities, money market funds, and GICs (guaranteed investment contracts)
Companies have their list of approved investment assets
Employees choose where to invest their assets subject to the company list

19. Defined Contribution Plans (continued)
Advantages to Employees
May offer strong growth potential
Greater sense of control and portability
Tax advantages from tax deferred contribution and earnings
Disadvantages to employees
No guarantee of actual amounts available at retirement
Risk is shifted from the employer to the employee

20. Defined Contribution Plans (continued)
Advantages to Employers
Easier to administer
Less government regulation
Greater employee investment choice
Shifts investment decisions to employee
Many varieties
Disadvantages
Takes time and resources to administer

21. Defined Contribution Plans (continued)

22. Defined Contribution Plans (continued)
Thoughts on Defined Benefit/Contribution Plans
75% of plan balances are invested in equities
Mutual funds still provide bulk of investment opportunities, although some firms are forming brokerage links for stocks
Most plans typically provide 10+ options
Other important issues:
What are annual or administration expenses?
Are there any transfer fees to go from one fund to another?
How often can I reallocate my assets? Costs?

23. Defined Contribution Plans (continued)
What is vesting?
Vesting is the process whereby funds contributed by the employer actually become the property of the employee.
What is the vesting schedule of most plans?
100% of employee deferrals are vested immediately
Generally vesting schedules apply only to employer contributions, i.e., 60% after 2 years, 80% after 3 years, and 100% after 4 years

24. Defined Contribution Plans (continued)
401(k), 403(b), and 457 Plan annual contribution limits will increase as follows:
Year Contribution Limit Catch Up Contr.*
,000 3,000
,000 4,000
,000 5,000
Indexed ,000
* Catch up contribution is for those over age 50

25. Tax Considerations What are the tax considerations of DCPs?
All retirement income, including capital gains, are taxed as ordinary income
10% penalty rule applies for early withdrawals before 59½ , with some exceptions
There is a 20% withholding requirement
Certain loan provisions may apply
Mandatory annual distributions begins after age 70½

26. Payout/Distribution Options?
What are my payout or distribution options?
Payout/distribution options are ways the employee can receive your money at retirement
Lump Sum Distribution
Pros: Control over investing, spending, gifting
Cons: Tax due immediately
Cons: No assurance of lifetime income
Annuity (can purchase contract inside or outside)
Pros: Stable payments usually for life
Cons: Generally no COLA
Cons: Tax due on amount received each year

27. Payout/Distribution Options (continued)
Periodic Payments
Pros: Regular payments at regular intervals
Pros: Relatively large payments
Cons: No assurance of lifetime income
Cons: Tax rate may be high due to high income
IRA Rollover (Be careful and don’t touch the funds)
Pros: Defer taxes until you withdraw funds
Pros: Can direct investment to different assets
Pros: Enjoy tax deferred growth
Cons: Must begin withdrawals at 70½ or penalty

28. Review of Objectives
A. Do you understand Employer Qualified Retirement Plans?
B. Do you understand Defined Benefit Plans?
C. Do you understand Defined Contribution Plans?