Chapter 9 Pension FundsChapter 9 Pension FundsChapter 9 Pension FundsChapter 9 Pension Funds

• Background

• Types

• Assets

• Regulation

• Social Security

• Background

• Types

• Assets

• Regulation

• Social Security

BackgroundBackgroundBackgroundBackground

• defined by function

-- payment of retirement benefits tax treatment

-- tax exempt earnings

& contributions or benefits

• defined by function

-- payment of retirement benefits tax treatment

-- tax exempt earnings

& contributions or benefits

Pension plan sponsorPension plan sponsorPension plan sponsorPension plan sponsor

• private or public employers

• unions

• individuals

• private or public employers

• unions

• individuals

Pension plan administratorPension plan administratorPension plan administratorPension plan administrator

• employer

• insurance company

• investment company

• commercial banks

• employer

• insurance company

• investment company

• commercial banks

Federal lawFederal lawFederal lawFederal law

• does NOT require pension plans

• but regulates existing pension plans• does NOT require pension plans

• but regulates existing pension plans

I. TypesI. TypesI. TypesI. Types

• Defined benefit plans

• Defined contribution plans

• Hybrid plans

• Defined benefit plans

• Defined contribution plans

• Hybrid plans

Defined benefit plansDefined benefit plansDefined benefit plansDefined benefit plans

• employer promised employee monthly payments during retirement

-- life contingent

-- choice of survivor benefits

• employer promised employee monthly payments during retirement

-- life contingent

-- choice of survivor benefits

How is payment determined?How is payment determined?How is payment determined?How is payment determined?

• formula salary

-- average last several years

-- average of best years years of service with sponsor

• formula salary

-- average last several years

-- average of best years years of service with sponsor

VestingVestingVestingVesting

• minimum years of service necessary to receive benefits complex federal rules about

vesting 5-7 years max for full vesting

• minimum years of service necessary to receive benefits complex federal rules about

vesting 5-7 years max for full vesting

Advantages Advantages Advantages Advantages

• (for employee)

• limited investment risk payments promised reguardless of

portfolio return but sponsor bankruptcy could

affect payment size

• (for employee)

• limited investment risk payments promised reguardless of

portfolio return but sponsor bankruptcy could

affect payment size

• no risk of outliving assets payments life contingent,

NOT lump sum

• no risk of outliving assets payments life contingent,

NOT lump sum

DisadvantagesDisadvantagesDisadvantagesDisadvantages

• lack of portability from job to job largest benefits accrue after 20

years DB plans encourage loyalty

• lack of portability from job to job largest benefits accrue after 20

years DB plans encourage loyalty

• lack of control how pension funds are invested is sponsor investing enough?

-- is pension fully funded?

• lack of control how pension funds are invested is sponsor investing enough?

-- is pension fully funded?

example:example:example:example:

• salary base average of best 5 years

• pay % of salary, based on years of service 5 years, 25% 20 years, 60% 30 years, 85%

• salary base average of best 5 years

• pay % of salary, based on years of service 5 years, 25% 20 years, 60% 30 years, 85%

Defined Contribution PlansDefined Contribution PlansDefined Contribution PlansDefined Contribution Plans

• employee/individual contributes funds employer may match contributions

• employee chooses among investment options range of choice varies among

sponsors

• employee/individual contributes funds employer may match contributions

• employee chooses among investment options range of choice varies among

sponsors

• amount accumulated at retirement depends on investment performance

• lump sum at retirement decision about spending possible purchase an annuity

• amount accumulated at retirement depends on investment performance

• lump sum at retirement decision about spending possible purchase an annuity

types of DC planstypes of DC planstypes of DC planstypes of DC plans

• employer sponsored 401(k), 403(b), 414(h), 457 $12,000 contribution limit 2003

• individual IRA, Roth IRA $3000 contribution limit 2003

• employer sponsored 401(k), 403(b), 414(h), 457 $12,000 contribution limit 2003

• individual IRA, Roth IRA $3000 contribution limit 2003

Advantages (employee)Advantages (employee)Advantages (employee)Advantages (employee)

• portability value accumulates steadily balance rolled over to new plans

• cash value build up cash out (tax penalty) borrow against survivor benefits

• portability value accumulates steadily balance rolled over to new plans

• cash value build up cash out (tax penalty) borrow against survivor benefits

DisadvantagesDisadvantagesDisadvantagesDisadvantages

• employee bears investment risk

• retiree risks outliving assets• employee bears investment risk

• retiree risks outliving assets

exampleexampleexampleexample

• I contribute 3% of gross salary (pretax) SUNY matches 9%

• I choose investments through TIAA-CREF growth, index, international, bonds,

etc.

• quarterly statements

• I contribute 3% of gross salary (pretax) SUNY matches 9%

• I choose investments through TIAA-CREF growth, index, international, bonds,

etc.

• quarterly statements

Cash balance planCash balance planCash balance planCash balance plan

• hybrid plan features of both DB, DC plans

• fixed employer contribution % of salary (5%)

• guaranteed annual return on balance Treasury rate

• hybrid plan features of both DB, DC plans

• fixed employer contribution % of salary (5%)

• guaranteed annual return on balance Treasury rate

DB featuresDB featuresDB featuresDB features

• employer bears investment risk must make up difference if actual

return lower than promised return but keeps potential surplus

• employer bears investment risk must make up difference if actual

return lower than promised return but keeps potential surplus

DC featuresDC featuresDC featuresDC features

• each employee monitors own account

• vested benefits portable

• each employee monitors own account

• vested benefits portable

controversycontroversycontroversycontroversy

• conversion from DB to CB younger employees better off older employees often worse off

-- DB plans get most of value in last 5-10 years of service

• conversion from DB to CB younger employees better off older employees often worse off

-- DB plans get most of value in last 5-10 years of service

exampleexampleexampleexample

• IBM 1999 announced conversion to CB older employees stood to lose

over 50% of expected benefits

• after EEOC inquiry, lawsuits, IBM allowed older workers to choose their plan

• IBM 1999 announced conversion to CB older employees stood to lose

over 50% of expected benefits

• after EEOC inquiry, lawsuits, IBM allowed older workers to choose their plan

II. AssetsII. AssetsII. AssetsII. Assets

• Defined benefit plans 75% U.S. stocks, bonds unions less likely to hold

international assets

• Defined benefit plans 75% U.S. stocks, bonds unions less likely to hold

international assets

• corporate defined contribution plans hold over 25% of assets as own

company stock

-- Enron 60%

-- Anheuser Bush, Coca Cola,

McDonald’s over 74% big lack of diversification

-- but easier to match 401(k) contributions w/ stock than w/cash

• corporate defined contribution plans hold over 25% of assets as own

company stock

-- Enron 60%

-- Anheuser Bush, Coca Cola,

McDonald’s over 74% big lack of diversification

-- but easier to match 401(k) contributions w/ stock than w/cash

• 401ks invested heavily in company stock have led to huge losses Enron, Lucent, Xerox

• 401ks invested heavily in company stock have led to huge losses Enron, Lucent, Xerox

III. RegulationIII. RegulationIII. RegulationIII. Regulation

• tax treatment tax exempt contributions

-- DB, 401k, IRA, CB tax deferred earnings

-- all tax exempt withdrawals

-- Roth IRA

• tax treatment tax exempt contributions

-- DB, 401k, IRA, CB tax deferred earnings

-- all tax exempt withdrawals

-- Roth IRA

• early withdrawal of funds (DC, CB) before age 59.5 taxable AND extra 10% penalty

-- exceptions for

-- medical bills

-- education

-- disability

-- home buyers

• early withdrawal of funds (DC, CB) before age 59.5 taxable AND extra 10% penalty

-- exceptions for

-- medical bills

-- education

-- disability

-- home buyers

ERISA (1974)ERISA (1974)ERISA (1974)ERISA (1974)

• set funding standards DB plans must be fully funded not

“pay-as-you-go” sponsors must set aside funds for

employees, not pay obligations out of current income

• set funding standards DB plans must be fully funded not

“pay-as-you-go” sponsors must set aside funds for

employees, not pay obligations out of current income

• set vesting standards 5-7 years max for full vesting

• federal insurance for DB pensions PBGC vested benefits up to a limit no COLA trustee to over 2500 plans

• set vesting standards 5-7 years max for full vesting

• federal insurance for DB pensions PBGC vested benefits up to a limit no COLA trustee to over 2500 plans

• guidelines for pension fund mgmt. both DB, DC plans plan must provide prudent,

investing options Enron lawsuit

-- must show stock was not a prudent option

• guidelines for pension fund mgmt. both DB, DC plans plan must provide prudent,

investing options Enron lawsuit

-- must show stock was not a prudent option

• How long can employer keep 401k contributions before investing? old rule: 90 days since 1997: 15 days after end of

month of payday

• How long can employer keep 401k contributions before investing? old rule: 90 days since 1997: 15 days after end of

month of payday

IV. Social SecurityIV. Social SecurityIV. Social SecurityIV. Social Security

• established 1935

• DB plan supported by payroll tax 6.2% employee & employer tax wages up to $87,000

• established 1935

• DB plan supported by payroll tax 6.2% employee & employer tax wages up to $87,000

• benefits based on age of retirement # years worked income annual COLAs based on CPI

• benefits based on age of retirement # years worked income annual COLAs based on CPI

• SS is pay-as-you-go retirees today paid with current

payroll taxes right now

payroll tax revenue

> benefits

this surplus is “invested” in Treasury IOUs

• SS is pay-as-you-go retirees today paid with current

payroll taxes right now

payroll tax revenue

> benefits

this surplus is “invested” in Treasury IOUs

Problems w/ SSProblems w/ SSProblems w/ SSProblems w/ SS

• U.S. population is aging too many collecting benefits

relative to how many paying taxes 3.4 payer-to-receiver today 2 payer-to-receiver in 2030

• U.S. population is aging too many collecting benefits

relative to how many paying taxes 3.4 payer-to-receiver today 2 payer-to-receiver in 2030

• today revenue > benefits

• by 2015 benefits > revenues draw on Treasury IOUs

• by 2040 assets exhausted must supplement with other tax

revenue

• today revenue > benefits

• by 2015 benefits > revenues draw on Treasury IOUs

• by 2040 assets exhausted must supplement with other tax

revenue

Solutions?Solutions?Solutions?Solutions?

• increase retirement age already increased from 65 to 67 for

those born after 1960

• increase payroll tax regressive tax already risen from 2% to 12.4%

• increase retirement age already increased from 65 to 67 for

those born after 1960

• increase payroll tax regressive tax already risen from 2% to 12.4%

• investing surplus in assets other than Treasury IOUs higher return BUT higher risk government stock ownership is

problematic

-- corporate control

-- price volatility

• investing surplus in assets other than Treasury IOUs higher return BUT higher risk government stock ownership is

problematic

-- corporate control

-- price volatility

• Private retirement accounts allow % of payroll tax for workers

to invest in choice of investments how to deal with risk? do workers have investment

savvy? disability/survivor benefits? how to transition?

• Private retirement accounts allow % of payroll tax for workers

to invest in choice of investments how to deal with risk? do workers have investment

savvy? disability/survivor benefits? how to transition?