19

Pension Plans and Finance Companies

Pension Plans and Finance Companies

Chapter 19

© 2003 South-Western/Thomson Learning

Learning ObjectivesLearning Objectives Various kinds of pension plans and finance

companies

Benefits provided by pension plans and

finance companies

Principal sources and uses fo funds for both

of these financial intermediaries

Primary regulations and regulatory agencies

with which both of these FIs must comply

Recent changes in way these FIs do business

Pension PlansPension Plans First in U.S. were created to provide

income for disabled American veterans of Revolutionary War

In early 1800s, benefits were extended to retired veterans

First private pension plan in U.S. was offered in 1875 by American Express company

Railroads followed by adding pensions in 1880s

Labor unions added them in early 1900s

Types of Pension PlansTypes of Pension Plans

Contributory Plans Both employee and employer contribute

Noncontributory Plans Only the employer contributes


Public Pension Plans Can be sponsored publicly (governmental

units) U.S. retirement plan assets One-third assets managed by public

pension plans sponsored by: State and local government employees Federal civilian employees Railroad retirement Social Security’s Old-Age, Survivor and

Disability Insurance program


Private Pension Plans Sponsored by single corporation, union,

small business or individual Two-thirds of all pension assets

sponsored and managed by: Private pension funds Mutual funds Banks Brokerage firms Life insurers


SIMPLE Plans (Savings Incentive Match Plan for Employees of Small Employers) Simplified defined-contribution plans

created by Congress in 1996 Assist small businesses in offering

salary deductions and matching contributions to fund retirement savings for their workers

Types of Pension PlansTypes of Pension Plans Individually Sponsored and Self-Employed

Private Pension Plans Individual Retirement Accounts (IRAs)

Tax advantaged saving accounts Administered by insurance companies,

pension funds, and other intermediaries Purpose to accumulate wealth for

retirement Roth IRA

Contributions are taxed Earnings accumulated within account are tax-

exempt

Types of Pension PlansTypes of Pension Plans Individually Sponsored and Self-Employed

Private Pension Plans Keogh PlansKeogh Plans

Tax advantaged saving accounts Administered by banks and other financial

intermediaries For retirement needs of self-employed people

Simplified Employee Pensions (SEPs)Simplified Employee Pensions (SEPs) Small-business pension plans Fewer reporting requirements Less administrative complexity and costs than

traditional pension plans

Types of Pension PlansTypes of Pension Plans Defined-Benefit PlansDefined-Benefit Plans

Contract promising specific level of income upon retirement based on worker’s years of service and level of earnings

Benefit calculations can be specified in variety of ways for eligible employees

Plan may state benefit as a percentage of salary and years of service 2% of final pay, times years of service,

for example, 2% x $40,000 x 30 = $24,000 annually

In some cases, specific percentage of employee’s highest 5-year average earnings

Ex., 68% x $40,000 = $27,200 annually


Defined-Benefit PlansDefined-Benefit Plans The calculation may be based on

specific dollar amount and years of service For example, $70 per month at retirement

times the number of years worked

$70 x 12 x 30 = $25,200

Some firms offer retiree the option to take lump-sum payment at retirement based on similar sorts of calculations


Defined-Contribution Plan Contract specifying that a particular and

periodic share of employee’s wages will be contributed by employers, employees, or both

Recent Trends in Private PensionsRecent Trends in Private Pensions

Decrease in share of employment at large, unionized manufacturing companies, traditionally the largest users of defined-benefit plans

Legislation passed in the 1980s to ensure adequate reserves were set aside in defined-benefit plans

401(k) Plans introduced in 1981 Special type of defined-contribution plan Allows for greater flexibility in employer and

employee contributions

This trend away from defined-benefit plans is explained by three main factors:

Pension Plan Regulation and InsurancePension Plan Regulation and Insurance

Employee Retirement Income Security Act (EIRSA) -

Established first federal standards for financing and operation of private, defined-benefit plans

Pension Plan Regulation and InsurancePension Plan Regulation and Insurance

Plan’s sponsor must make minimum contributions such that projected benefit payments are actuarially sound

All contributions must be invested in prudent manner Plans must have minimum vesting requirements Plans must increase disclosure of information to

employees regarding the contents and financial health of their plans

Department of Labor named as primary regulator to enforce EIRSA’s provisions

Act created Pension Benefit Guarantee Corporation (PBGC)

Social SecuritySocial Security

Old Age Survivors and Disability Insurance (OASDI) Core program of social security Funded by payroll taxes to pay retirement

and disability payments to eligible individuals and their dependents

Federal government program that provides retirement and survivors pensions, and

disability and health insurance benefits to qualifying individuals.

Social Security: Plans for ReformSocial Security: Plans for Reform

Increase revenues coming into the system

Raising tax rate Increasing tax base on which it is

applied Reduce benefits

To ensure that Social Security meets 100% of its future payment commitments:

Social Security: Plans for ReformSocial Security: Plans for Reform Turn system into true pension system

Partial or total “privatization” Using system’s funds to purchase

corporate securities Three main approaches:

Allow portion of workers’ payroll taxes to be invested in IRAs

Have federal government use current S surplus to purchase stocks and bonds

Encourage workers to contribute to personal accounts in addition to their FICA contributions

Finance CompaniesFinance Companies

Second type of specialized, nondepository financial intermediary that lend funds to: Households to finance consumer purchases Businesses to finance inventories and

accounts receivable and purchase of machinery/equipment

Both consumers and businesses for real estate loans

Three main types: Consumer finance companies Business finance companies Real estate loan companies

Consumer Finance CompaniesConsumer Finance Companies

Offer personal loans to consumers to purchase (or lease) motor vehicles, mobile homes, furniture and appliances

Provide credit card services Assist in refinancing of debts Consumers can apply for “in-store credit”

Once loan approved, store originates loan Immediately sells the paper or loan at a

discount to finance company Benefits store (generates sales, eliminates

store’s exposure to default risk, keeps store out of bill processing and collections

Consumer Finance CompaniesConsumer Finance Companies

In case of default, finance company retains right to repossess property (repossession) Lender takes back assets used to secure

loan Two types:

Ordinary finance companies Make secured loans for variety of different products or

firms

Sales finance companies Make loans to consumers so they can purchase product

from particular manufacturer or retailer

Business Finance CompaniesBusiness Finance Companies

Equipment leasing and loans Loans for retail and wholesale motor

vehicle loans and leases Loans on accounts receivables or factored

commercial accounts Floor-Plan Loans

Dealers of automobiles, boats and construction equipment use inventory as collateral for loans repaid when vehicles are sold

Factoring Companies Specialized finance companies purchase

accounts receivables of other firms at discount

Real Estate Loan CompaniesReal Estate Loan Companies

Specialize in second mortgages Homeowner takes out additional mortgage

loan against the accrued equity in property Make home purchase and commercial real

estate loans Home Equity Loans

Mortgage loans of specific amount Private residence serves as collateral

Home Equity Lines of Credit Credit cards secured by second mortgage on

one’s home

Finance Companies: TrendsFinance Companies: Trends

Industry grew steadily Real estate receivables grew Securitization of automobile loans and

leases for consumers and businesses steadily increased

Composition of finance company sources and uses of funds continue to evolve

Finance Companies: TrendsFinance Companies: Trends

Subprime Lending High-fee, high-interest-rate loans Made to borrower with blemished or

nonexistent credit records Manufactured Housing Lending

High-fee, high-interest-rate loans Made to homebuyers whose homes

were built in factories instead of on site

Finance Companies Regulation Finance Companies Regulation

Finance companies face credit, interest rate, and liquidity risk

Face less regulation Do not accept deposits Federal regulators have less reason

to restrict their activities

19

Business

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