18-1

Reasons for the Retirement Risk

1. Retirement risk arises from uncertainty concerning the time of death

2. It is influenced by physiological and cultural hazards

• people tend to live longer today

• people are retiring earlier

18-2

Risks Associated with Superannuation

Two parts to the retirement risk

• individual will not have accumulated sufficient assets by the time retirement arrives

• assets that have been accumulated will not last for the remainder of his or her lifetime

18-3

Retirement Risk Alternatives

1. Some people attempt to avoid the retirement risk by not retiring.

2. Continuing employment does not totally avoid the risk, since the probability of disability increases with age.

3. The risk of outliving an accumulation can be transferred to an insurer.

4. Some individuals transfer the retirement risk to their children or to society by not preparing for retirement.

18-4

An Overview of Retirement Planning Process

1. Estimate future income need

2. Determine how the funds required to meet the need will be accumulated

3. Plan the manner in which the accumulation will be consumed

18-5

Sources of Retirement Funding

1. The first leg: Social Security

2. The second leg:Qualified pensions

and profit sharing plans

3. The third leg:Personal savings

18-6

Annuities

1. Reverse application of the law of large numbers as it is used in life insurance.

2. Law of averages permits a lifetime guaranteed income to each annuitant.

3. Persons who live longer than average offset those who live a shorter-than-average period.

4. Every payment to annuitant is part interest, part principal, and part survivorship benefit.

18-7

Annuities

Classification of annuities

1. Individual versus Group

2. Fixed versus Variable

3. Immediate versus Deferred

4. Single Premium versus Installment

5. Single Life versus Two or More Lives

6. Pure Life Annuity versus Annuity Certain

18-8

Tax Treatment of Annuities

Investment NontaxablePayment X in Contract = Return of Expected Return Capital

$6,000 = $60,000 = $60,000

($500 X 12) X 15 $90,000

$6,000 X $60,000 = $4,000 $90,000

18-9

Specialized Annuities

Single-Premium Deferred Annuity

1. Increased popularity since TRA-86 eliminated many tax shelters.

2. Currently taxed same as other annuities:earnings accumulate on tax-deferred basis.

3. Some insurers sell SPDAs with deposit premium as low as $2,500, but more common minimum is $10,000.

18-10

Variable Annuity

1. Designed as means of coping with inflation.

2. Premiums invested in common stocks or similar investments.

3. Based on assumption that the value of a diversified portfolio of common stocks will change in the same direction as price level.

4. Variable annuity may be variable during accumulation period and fixed during payout period or variable during both accumulation and payout period.

18-11

Annuities as Investments for Retirement

1. Return earned over life of an annuity depends on several features.

2. Most important determinants of the rate of return are:

• interest rate

• surrender charge

• administrative expenses

18-12

Qualified Retirement Plans

Qualified plans are those that conform to the requirements of federal tax laws and for which the law provides favorable tax treatment.

1. Employee contributions are tax deductible when they are made.

2. Employee is not taxed on employer’s contribution or investment earnings until benefits are distributed.

18-13

ERISA

Employee Retirement Income Security Act of 1974 (ERISA) establishes federal standards for qualified retirement plans:

1. Prescribes which employees must be included.

2. Establishes minimum vesting standards.

3. Sets minimum funding standards.

4. Requires extensive reporting and disclosure information about pensions and other employee welfare programs.

18-14

Qualification Requirements

1. Designed for exclusive benefit of employees.2. In writing and communicated to employees.3. Must meet one of several vesting schedules.4. Cannot discriminate in favor of officers, stock-

holders or highly compensated employees.5. Must provide for definite contributions by

employer or definite benefits at retirement.6. Life insurance included only on an incidental

basis.7. Top-heavy plans are subject to special

vesting and contribution requirements.

18-15

Vesting Requirements (specified in plan documents)

1. No vesting for 5 years, 100% vested after 5 years.

2. 20% vested after 3 years with 20% per year thereafter so employee is 100% vested at the end of 7 years.

3. For top-heavy plans:

• 100% in three years, or

• 20% per year after first year

18-16

Types of Qualified Plans (corporations)

1. Defined Benefit Pension Plans

2. Defined Contribution Pension Plans

3. Qualified Profit-sharing Plans

4. Employee Stock Ownership Plans

5. Section 401(k) Plans

18-17

Factors Influencing Benefit Levels

Benefit received by employees at retirement is based on a formula applicable to all employees.

1. All plans fall into one of two benefit formula categories

• defined contribution

• defined benefit.

2. Plans may be contributory (with employee contributions) or noncontributory (where employer bears the entire cost).

18-18

Amount of Benefits or Contributions

Defined Contribution Plans

1. Work exactly as the name implies: employer’s contribution is set by the employment agreement

2. Contribution is usually a percentage of compensation, such as 5% or 10% of employee wages

18-19

Amount of Benefits or Contribution

Defined Benefit Plans

1. In defined benefit plan, amount of benefits employee will receive is specified in the benefit formula

2. In most benefit formulas, retirement benefit is a function of employee’s salary, the benefit accrual rate, and employee’s years of service

3. Most plans are final average salary plans but some are career average salary plans.

18-20

Amount of Benefits or Contributions

FINAL AVERAGE SALARY PLAN

Benefit depends on salary earned in final years of employment and number of years worked

• example: 1% of average monthly salary during final three years of employment for each year employed

• an employee with 35 years employment would receive 35% of average monthly employment in the final three years

18-21

Amount of Benefits or Contributions

CAREER AVERAGE SALARY PLAN

Benefit depends on salary earned in all years of employment and number of years worked

• example: 1% of average monthly salary during all years of employment for each year employed,

• an employee with 35 years employment would receive 35% of average monthly employment over employment career.

18-22

Amount of Benefits and Contributions

Defined Contribution Plans

1. Maximum allowable contribution to a defined contribution plan varies with the type of plan

2. For a defined contribution pension plan, the limit is 25% of year’s earnings, subject to a dollar maximum that is adjusted for inflation

3. Dollar maximum was set at $30,000 in 1986 and will be adjusted for inflation when dollar maximum for defined benefit plans reaches $120,000

18-23

Amount of Benefits or Contributions

Defined Benefit Plans

1. Maximum benefit in a defined benefit plan is 100% of employee’s earnings in three consecutive years of highest earnings.

2. Dollar maximum for defined benefit was set at $90,000 in 1988 and is adjusted for inflation since that time.

18-24

Contribution for Keogh Plans

1. Keogh plans are subject to essentially the same limitations, deductions and benefits as applicable to corporate pension and profit-sharing plans.

2. A special definition of earned income is used to make contributions by self-employed persons correspond to those for a common-law employee.

3. Percentage limitations apply after the contribution to the plan is deducted from income.

18-25

Keogh Plan Contribution Illustrated

Partnership establishes a defined contribution plan with 25% of employee compensation.

Partner earns $100,000.

Partner’s contribution is limited to 25% of income after the contribution:

Taxable Nontaxable Income Contribution Total

Employee $40,000 $10,000 $50,000Owner 80,000 20,000 100,000

18-26

Maximum Contribution 401(k) Plans

1. Permit pretax contributions (called “elective deferrals”) by employees.

2. Employees elect to contribute to a profit-sharing plan and instruct employer to make contributions on their behalf.

3. I.R.C. treats contributions as if they were made by employer rather than by employee.

4. Limit on employee deferrals to 401(k) plan or SEP is the lesser of 25% of compensation or a dollar maximum (set at $7,000 in 1988 and indexed for inflation since that time).

18-27

Nature of the Employer’s Promise

INVESTMENT RISK

Under defined contribution plan, employer promises to make contributions to an account that earns investment income.

• Since benefits depend on contributions and investment income, the employee bears the investment risk in defined contribution plans.

• Because the employee bears the investment risk, he or she is likely to have some say in how funds are invested.

18-28

Nature of the Employer’s Promise

INVESTMENT RISK

In a defined benefit plan, the employer promises to provide a certain level of retirement benefits to the employee.

• Employer therefore bears the investment risk in a defined benefit plan.

18-29

Advantages to Younger and Older Employees

1. A higher proportion of ultimate retirement benefits are earned in early years of participation in a defined contribution plan.

2. Present value of benefits promised to younger workers under a defined benefit plan tends to be small compared with present value of benefits promised when the worker is closer to retirement.

18-30

Distribution Requirements

1. Commencement of benefits: April 1 after year in which individual reaches age 70 1/2 or the date of retirement, if later.

2. Distribution must be made over

• the life of the participant or joint lives of participant and spouse (i.e., an annuity).

• the life expectancy of the participant and his or her beneficiary.

18-31

Premature Distributions

10% penalty prior to age 59 1/2 except for

• deductible medical expenses

• in form of lifetime annuity

• at age 55 by worker who meets plan requirements for retirement

18-32

Taxation of Distributions

1. Retirement benefits traditionally paid to participants in form of a lifetime annuity.

2. Installment distributions taxable only to the extent they exceed employee’s investment in the contract.

3. Lump-sum distributions may be rolled-over into an annuity and taxed under installment rules.

4. Lump-sum distributions that are not rolled-over may be subject to five-year averaging.

18-33

Individual Retirement Accounts (traditional IRA)

1. A person who is not covered by an employer-sponsored plan can make tax-deductible contribution to an IRA of $2,000 annually.

2. Persons covered by an employer plan may be entitled to same deduction, a partial deduction, or no deduction, depending on income.

3. Persons not eligible for deduction may make a nondeductible contribution.

4. New rules under TRA-97 allow a full $2,000 deductible contribution by a spouse who is not employed outside the home.

18-34

Individual Retirement Accounts (traditional)

Adjusted Gross Income Phase Out Levels

$25,000 to $35,000 for single taxpayers

$40,000 to $50,000 for married filing jointly

0 to $10,000 for married filing jointly

TRA-97 gradually increases AGI phase-out levels to double the present level by 2007.

18-35

IRA Taxation Formula

TotalNondeductible Tax-Free

Amount Contributions All _

WithdrawalsDistributed

X Years to IRAs in Prior Years

From IRA Fair Market Value Amount Distributed

During Year of all IRAs at + From IRA DuringEnd of Year the Year

18-36

The New Roth IRA

Beginning in January of 1998, contributions permitted to Roth IRA contributions only on a non-deductible basis. earnings tax-free when the funds are

withdrawn for retirement (i.e., after age 59½). annual contributions of $2,000 (100% of

compensation) per individual. AGI phase-out $95,000 single $150,000 joint. no requirement for withdrawals at 70½ and

contributions may continue after age 70½. $2,000 limit for Traditional IRA and a Roth

IRA.

18-37

Education IRA

Introduced by TRA-97 - despite its designation, has nothing to do with retirement. designed for saving for higher education. up to $500 annually per student (to age 18). phased out for joint filers - $150,000 to $160,000,

$95,000 and $110,000 for single taxpayers. nondeductible, but earnings tax-free. distributions under age 30 not taxable if used for

qualified higher education expenses. distributions in excess of qualified education

expenses taxable with a 10% penalty. Education IRA contributions are in addition to

Roth IRA Plus and traditional IRAs.