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

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Personal Finance: a Gospel Perspective

Retirement Planning 3:

Employer Qualified Plans

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Objectives

A. Understand Employer Qualified Retirement Plans

B. Understand Defined Benefit Plans

C. Understand Defined Contribution Plans

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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?

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A. Understand Employer Qualified Retirement Plans

Employer Funded Pension Plans

(Defined Benefit Plans)

Employer Sponsored Retirement Plans

(Defined Contribution Plans)

Two Kinds of Plans

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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

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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)

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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

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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

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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

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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

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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.

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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?

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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

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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)

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• 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

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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

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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

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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

Salary Reduction Plans

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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

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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

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Type Funding Contribution EligibilityLoan

Privilege

Money Purchase Plans

EmployerEmployer contributes to plan based on a formula that covers all participating employees

All eligible compnay employees NO

Profit Sharing Plans

EmployerEmployer contributes percentage of profits; some plans are based on total profits; while others use a sliding scale

All eligible compnay employees YES

Employee Stock Ownership Plans

EmployerEmployer contributes stock or subsidizes employee purchase as stock

Employees of stock-issuing businesses NO

Thrift or Savings Plans

Employer and Employee

Employer matches some or all of the amount an employee defers from pre-tax salary into the plan

Federal employees and emplyees of companies offering plans

YES

401 (k) PlansEmployer and Employee

Employee contributes pre-tax salary to the plan; employer may, and often does, contribute an amount based on an announced formula

All employees of businesses that sponsor plans YES

403 (b) PlansEmployer and Employee

Emplyee contributes pre-tax salary to the plan; employer may and often does, contribute an additional amount

Restricted to employees of non-profit, tax-exempt employers

YES

Section 457 Plans

EmployeeEmployee contributes pre-tax salary to the plan

Restricted to state and municipal workers. YES

Source: Wall Street Journal Guide to Planning Your Financial Future

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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?

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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

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401(k), 403(b), and 457 Plan annual contribution limits will increase as follows:

Year Contribution Limit Catch Up Contr.*

2004 13,000 3,000

2005 14,000 4,000

2006 15,000 5,000

2007 Indexed 5,000

* Catch up contribution is for those over age 50

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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

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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

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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

Payout/Distribution Options (continued)

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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?

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

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