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  1. 1. Pension Plans and Finance Companies Chapter 19 © 2003 South-Western/Thomson Learning
  2. 2. Learning Objectives <ul><li>Various kinds of pension plans and finance companies </li></ul><ul><li>Benefits provided by pension plans and finance companies </li></ul><ul><li>Principal sources and uses fo funds for both of these financial intermediaries </li></ul><ul><li>Primary regulations and regulatory agencies with which both of these FIs must comply </li></ul><ul><li>Recent changes in way these FIs do business </li></ul>
  3. 3. Pension Plans <ul><li>First in U.S. were created to provide income for disabled American veterans of Revolutionary War </li></ul><ul><li>In early 1800s, benefits were extended to retired veterans </li></ul><ul><li>First private pension plan in U.S. was offered in 1875 by American Express company </li></ul><ul><li>Railroads followed by adding pensions in 1880s </li></ul><ul><li>Labor unions added them in early 1900s </li></ul>
  4. 4. Types of Pension Plans <ul><li>Contributory Plans </li></ul><ul><ul><li>Both employee and employer contribute </li></ul></ul><ul><li>Noncontributory Plans </li></ul><ul><ul><li>Only the employer contributes </li></ul></ul>
  5. 5. Types of Pension Plans <ul><li>Public Pension Plans </li></ul><ul><ul><li>Can be sponsored publicly (governmental units) </li></ul></ul><ul><ul><li>U.S. retirement plan assets </li></ul></ul><ul><ul><li>One-third assets managed by public pension plans sponsored by: </li></ul></ul><ul><ul><ul><li>State and local government employees </li></ul></ul></ul><ul><ul><ul><li>Federal civilian employees </li></ul></ul></ul><ul><ul><ul><li>Railroad retirement </li></ul></ul></ul><ul><ul><ul><li>Social Security’s Old-Age, Survivor and Disability Insurance program </li></ul></ul></ul>
  6. 6. Types of Pension Plans <ul><li>Private Pension Plans </li></ul><ul><ul><li>Sponsored by single corporation, union, small business or individual </li></ul></ul><ul><ul><li>Two-thirds of all pension assets sponsored and managed by: </li></ul></ul><ul><ul><ul><li>Private pension funds </li></ul></ul></ul><ul><ul><ul><li>Mutual funds </li></ul></ul></ul><ul><ul><ul><li>Banks </li></ul></ul></ul><ul><ul><ul><li>Brokerage firms </li></ul></ul></ul><ul><ul><ul><li>Life insurers </li></ul></ul></ul>
  7. 7. Types of Pension Plans <ul><li>SIMPLE Plans (Savings Incentive Match Plan for Employees of Small Employers) </li></ul><ul><ul><li>Simplified defined-contribution plans created by Congress in 1996 </li></ul></ul><ul><ul><li>Assist small businesses in offering salary deductions and matching contributions to fund retirement savings for their workers </li></ul></ul>
  8. 8. Types of Pension Plans <ul><li>Individually Sponsored and Self-Employed Private Pension Plans </li></ul><ul><ul><li>Individual Retirement Accounts (IRAs) </li></ul></ul><ul><ul><ul><li>Tax advantaged saving accounts </li></ul></ul></ul><ul><ul><ul><li>Administered by insurance companies, pension funds, and other intermediaries </li></ul></ul></ul><ul><ul><ul><li>Purpose to accumulate wealth for retirement </li></ul></ul></ul><ul><ul><ul><li>Roth IRA </li></ul></ul></ul><ul><ul><ul><ul><li>Contributions are taxed </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Earnings accumulated within account are tax-exempt </li></ul></ul></ul></ul>
  9. 9. Types of Pension Plans <ul><li>Individually Sponsored and Self-Employed Private Pension Plans </li></ul><ul><ul><li>Keogh Plans </li></ul></ul><ul><ul><ul><li>Tax advantaged saving accounts </li></ul></ul></ul><ul><ul><ul><li>Administered by banks and other financial intermediaries </li></ul></ul></ul><ul><ul><ul><li>For retirement needs of self-employed people </li></ul></ul></ul><ul><ul><li>Simplified Employee Pensions (SEPs) </li></ul></ul><ul><ul><ul><li>Small-business pension plans </li></ul></ul></ul><ul><ul><ul><li>Fewer reporting requirements </li></ul></ul></ul><ul><ul><ul><li>Less administrative complexity and costs than traditional pension plans </li></ul></ul></ul>
  10. 10. Types of Pension Plans <ul><li>Defined-Benefit Plans </li></ul><ul><ul><li>Contract promising specific level of income upon retirement based on worker’s years of service and level of earnings </li></ul></ul><ul><ul><li>Benefit calculations can be specified in variety of ways for eligible employees </li></ul></ul><ul><ul><li>Plan may state benefit as a percentage of salary and years of service </li></ul></ul><ul><ul><ul><li>2% of final pay, times years of service, </li></ul></ul></ul><ul><ul><ul><li>for example, 2% x $40,000 x 30 = $24,000 annually </li></ul></ul></ul><ul><ul><li>In some cases, specific percentage of employee’s highest 5-year average earnings </li></ul></ul><ul><ul><ul><li>Ex., 68% x $40,000 = $27,200 annually </li></ul></ul></ul>
  11. 11. Types of Pension Plans <ul><li>Defined-Benefit Plans </li></ul><ul><ul><li>The calculation may be based on specific dollar amount and years of service </li></ul></ul><ul><ul><ul><li>For example, $70 per month at retirement times the number of years worked </li></ul></ul></ul><ul><ul><ul><li>$70 x 12 x 30 = $25,200 </li></ul></ul></ul><ul><ul><li>Some firms offer retiree the option to take lump-sum payment at retirement based on similar sorts of calculations </li></ul></ul>
  12. 12. Types of Pension Plans <ul><li>Defined-Contribution Plan </li></ul><ul><ul><li>Contract specifying that a particular and periodic share of employee’s wages will be contributed by employers, employees, or both </li></ul></ul>
  13. 13. Recent Trends in Private Pensions <ul><li>Decrease in share of employment at large, unionized manufacturing companies, traditionally the largest users of defined-benefit plans </li></ul><ul><li>Legislation passed in the 1980s to ensure adequate reserves were set aside in defined-benefit plans </li></ul><ul><li>401(k) Plans introduced in 1981 </li></ul><ul><ul><li>Special type of defined-contribution plan </li></ul></ul><ul><ul><li>Allows for greater flexibility in employer and employee contributions </li></ul></ul>This trend away from defined-benefit plans is explained by three main factors:
  14. 14. Pension Plan Regulation and Insurance <ul><li>Employee Retirement Income Security Act (EIRSA) - </li></ul><ul><li>Established first federal standards for financing and operation of private, defined-benefit plans </li></ul>
  15. 15. Pension Plan Regulation and Insurance <ul><ul><li>Plan’s sponsor must make minimum contributions such that projected benefit payments are actuarially sound </li></ul></ul><ul><ul><li>All contributions must be invested in prudent manner </li></ul></ul><ul><ul><li>Plans must have minimum vesting requirements </li></ul></ul><ul><ul><li>Plans must increase disclosure of information to employees regarding the contents and financial health of their plans </li></ul></ul><ul><ul><li>Department of Labor named as primary regulator to enforce EIRSA’s provisions </li></ul></ul><ul><ul><li>Act created Pension Benefit Guarantee Corporation (PBGC) </li></ul></ul>
  16. 16. Social Security <ul><li>Old Age Survivors and Disability Insurance (OASDI) </li></ul><ul><ul><li>Core program of social security </li></ul></ul><ul><ul><li>Funded by payroll taxes to pay retirement and disability payments to eligible individuals and their dependents </li></ul></ul>Federal government program that provides retirement and survivors pensions, and disability and health insurance benefits to qualifying individuals.
  17. 17. Social Security: Plans for Reform <ul><li>Increase revenues coming into the system </li></ul><ul><ul><ul><li>Raising tax rate </li></ul></ul></ul><ul><ul><ul><li>Increasing tax base on which it is applied </li></ul></ul></ul><ul><li>Reduce benefits </li></ul>To ensure that Social Security meets 100% of its future payment commitments:
  18. 18. Social Security: Plans for Reform <ul><li>Turn system into true pension system </li></ul><ul><ul><li>Partial or total “privatization” </li></ul></ul><ul><ul><li>Using system’s funds to purchase corporate securities </li></ul></ul><ul><ul><li>Three main approaches: </li></ul></ul><ul><ul><ul><li>Allow portion of workers’ payroll taxes to be invested in IRAs </li></ul></ul></ul><ul><ul><ul><li>Have federal government use current S surplus to purchase stocks and bonds </li></ul></ul></ul><ul><ul><ul><li>Encourage workers to contribute to personal accounts in addition to their FICA contributions </li></ul></ul></ul>
  19. 19. Finance Companies <ul><li>Second type of specialized, nondepository financial intermediary that lend funds to: </li></ul><ul><ul><li>Households to finance consumer purchases </li></ul></ul><ul><ul><li>Businesses to finance inventories and accounts receivable and purchase of machinery/equipment </li></ul></ul><ul><ul><li>Both consumers and businesses for real estate loans </li></ul></ul><ul><li>Three main types: </li></ul><ul><ul><li>Consumer finance companies </li></ul></ul><ul><ul><li>Business finance companies </li></ul></ul><ul><ul><li>Real estate loan companies </li></ul></ul>
  20. 20. Consumer Finance Companies <ul><li>Offer personal loans to consumers to purchase (or lease) motor vehicles, mobile homes, furniture and appliances </li></ul><ul><li>Provide credit card services </li></ul><ul><li>Assist in refinancing of debts </li></ul><ul><li>Consumers can apply for “in-store credit” </li></ul><ul><ul><li>Once loan approved, store originates loan </li></ul></ul><ul><ul><li>Immediately sells the paper or loan at a discount to finance company </li></ul></ul><ul><ul><li>Benefits store (generates sales, eliminates store’s exposure to default risk, keeps store out of bill processing and collections </li></ul></ul>
  21. 21. Consumer Finance Companies <ul><li>In case of default, finance company retains right to repossess property (repossession) </li></ul><ul><ul><li>Lender takes back assets used to secure loan </li></ul></ul><ul><ul><li>Two types: </li></ul></ul><ul><ul><ul><li>Ordinary finance companies </li></ul></ul></ul><ul><ul><ul><ul><li>Make secured loans for variety of different products or firms </li></ul></ul></ul></ul><ul><ul><ul><li>Sales finance companies </li></ul></ul></ul><ul><ul><ul><ul><li>Make loans to consumers so they can purchase product from particular manufacturer or retailer </li></ul></ul></ul></ul>
  22. 22. Business Finance Companies <ul><li>Equipment leasing and loans </li></ul><ul><li>Loans for retail and wholesale motor vehicle loans and leases </li></ul><ul><li>Loans on accounts receivables or factored commercial accounts </li></ul><ul><li>Floor-Plan Loans </li></ul><ul><ul><li>Dealers of automobiles, boats and construction equipment use inventory as collateral for loans repaid when vehicles are sold </li></ul></ul><ul><li>Factoring Companies </li></ul><ul><ul><li>Specialized finance companies purchase accounts receivables of other firms at discount </li></ul></ul>
  23. 23. Real Estate Loan Companies <ul><li>Specialize in second mortgages </li></ul><ul><ul><li>Homeowner takes out additional mortgage loan against the accrued equity in property </li></ul></ul><ul><li>Make home purchase and commercial real estate loans </li></ul><ul><li>Home Equity Loans </li></ul><ul><ul><li>Mortgage loans of specific amount </li></ul></ul><ul><ul><li>Private residence serves as collateral </li></ul></ul><ul><li>Home Equity Lines of Credit </li></ul><ul><ul><li>Credit cards secured by second mortgage on one’s home </li></ul></ul>
  24. 24. Finance Companies: Trends <ul><li>Industry grew steadily </li></ul><ul><li>Real estate receivables grew </li></ul><ul><li>Securitization of automobile loans and leases for consumers and businesses steadily increased </li></ul><ul><li>Composition of finance company sources and uses of funds continue to evolve </li></ul>
  25. 25. Finance Companies: Trends <ul><li>Subprime Lending </li></ul><ul><ul><li>High-fee, high-interest-rate loans </li></ul></ul><ul><ul><li>Made to borrower with blemished or nonexistent credit records </li></ul></ul><ul><li>Manufactured Housing Lending </li></ul><ul><ul><li>High-fee, high-interest-rate loans </li></ul></ul><ul><ul><li>Made to homebuyers whose homes were built in factories instead of on site </li></ul></ul>
  26. 26. Finance Companies Regulation <ul><li>Finance companies face credit, interest rate, and liquidity risk </li></ul><ul><li>Face less regulation </li></ul><ul><li>Do not accept deposits </li></ul><ul><li>Federal regulators have less reason to restrict their activities </li></ul>