Chapter 4 – Retirement – Evolution and Design
Thomas E. Murphy
On the road? Feed the pigeons?
November 3, 2010 2Thomas E. Murphy
Total Retirement Income
Employer
Plan
Personal
Savings
Social
Security
November 3, 2010 3Thomas E. Murphy
 Social Security – the
safety net
 Employer
sponsored
retirement
 Personal savings
and investments
 Objective: provide...
Who bears the risk? Employer or employee?
 Longevity
 Investment
 Inflation
November 3, 2010
Will I have
enough? How
ma...
 What are the design features of a Defined
Benefit Plan (DBP)?
 What is a final pay plan?
 What are typical benefit for...
Unit Benefit Flat Benefit
 Modify the definition of
“Final Pay.”
 Unit Benefit – multiply
a set dollar amount
times year...
DCP Private
(61%)
DBP Public
90%
DBP Private
(21%)
November 3, 2010 8Thomas E. Murphy
 Demographics of workforce
 Age and sex of workforce
 Financing of benefits
 Use of capital markets to finance
 Alloc...
 The Benefits Model?
 Let’s look at DBP
design features and
see how Benefits
Model applies?
November 3, 2010
Encourage r...
You Must Know these! Drivers: Fig. 4.2 at 90.
 Coverage
 Eligibility
 Vesting
 Calculating the benefit
 Typical Final...
The Choices Adverse Selection Risk?
 Annuity
 Named beneficiary
 Lump sum (Discount
rate and Present Value)
 Disabilit...
 What is covered compensation?
 Social security integration and offsets (101)
 Restoration benefit
 Breaks in service ...
 Maximum Pension-
$195,000
 Maximum
Compensation to
be included in
formula- $245,000
 And more . . .
November 3, 2010 1...
 And, what about
ACTUARIAL
REDUCTIONS?
 How and why do
they apply to a
DBP?
 How are DBPs
administered?
 Let’s do some...
 How to allocate risks?
 Should employer be
sole source of
financing?
 Aggressive use of
capital markets?
 Funding wit...
401(k) Profit Sharing
ESOP SIMPLE
November 3, 2010 17Thomas E. Murphy
Your $
Employer
$
Your
Benefit
$$
November 3, 2010 18Thomas E. Murphy
November 3, 2010 19Thomas E. Murphy
Longevity
Investment
Inflation
November 3, 2010 20Thomas E. Murphy
 What was driving
force leading to
transition to DCP?
 What is relative
contribution of
employers?
 Simplicity,
portabi...
 Coverage
 Eligibility
 Portability
 Vesting
 Employer matches
 Why no Actuarial
reductions?
 §415 limits on
contri...
 Elective deferrals -
$16,500
 Catch –ups over 50
years - $5,500
 Maximum total
contribution -
$49,000
November 3, 2010...
Note: fiduciary liability Note: restrictions
 Investment choices-
self directed
 What is employer’s
obligation here?
 W...
Retiring early? Retiring later?
 Will I have enough?
 What’s my number?
 Impact of recession
 Will I have to get a
par...
 Early and minimum
distribution rules of IRS
 Discrimination testing!
What is this?
 What is non-elective
enrollment?
...
Risks
DBPs
MoreRisks
DCPs
LessRisks
Cash
Balance
Plans
November 3, 2010 27Thomas E. Murphy
 What would result if the pension formula were
based upon current pay instead of final pay?
 It’s a Cash Balance Plan
 ...
No actuarial reductions
Employee receives his
account balance!
 Employer calculates a
benefit annually and
credits to acc...
 No employee contributions
 Employer can pool account balances and
invest and obtain higher yields than those
annual inv...
 What happens in a conversion from a DBP to a
Hybrid (cash balance plan)?
 Who goes into new plan and who stays in
DBP?
...
 Query: how would
you change design
of CBP to
encourage longer
service?
 The Pension
Protection Act
resolves many legal
...
November 3, 2010 33Thomas E. Murphy
 There are profit sharing cash and profit
sharing retirement plans.
 The retirement plan is essentially a DCP!
 It is a...
 Favorable tax treatment
 There are limits on total amount allocated to
plan and to individuals.
 What about Benefits M...
What about Risks? Benefits Model?
 No monies distributed
until retirement.
 Can use age or service
enhancements
 Early ...
What about Risks? Benefits Model?
 ESOPS
 Company Stock is
allocated to employee
retirement account.
 Expected to creat...
Bank loans to ESOP
ESOP buys shares
Employer puts cash
into ESOP
ESOP puts shares in
retirement account
Employer uses cash...
November 3, 2010 39Thomas E. Murphy
 Nos. 1-21at
pages130-131.
 Read the Blog and
look especially at
efforts to
ameliorate the risks
in DCPs.
 Should the
g...
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Benefits and beyond, c. 4 retirement

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Benefits and beyond, c. 4 retirement

  1. 1. Chapter 4 – Retirement – Evolution and Design Thomas E. Murphy
  2. 2. On the road? Feed the pigeons? November 3, 2010 2Thomas E. Murphy
  3. 3. Total Retirement Income Employer Plan Personal Savings Social Security November 3, 2010 3Thomas E. Murphy
  4. 4.  Social Security – the safety net  Employer sponsored retirement  Personal savings and investments  Objective: provide retirement income for life.  Tax favored treatment  Who assumes the three risks? November 3, 2010 4Thomas E. Murphy
  5. 5. Who bears the risk? Employer or employee?  Longevity  Investment  Inflation November 3, 2010 Will I have enough? How many years do I have? 5Thomas E. Murphy
  6. 6.  What are the design features of a Defined Benefit Plan (DBP)?  What is a final pay plan?  What are typical benefit formulae for a DBP?  What HR strategies does a final pay plan serve? November 3, 2010 DBPs R Not Dead 6Thomas E. Murphy
  7. 7. Unit Benefit Flat Benefit  Modify the definition of “Final Pay.”  Unit Benefit – multiply a set dollar amount times years of service. ($50 per month X 30 years of service = $$1500 per month)  Flat Benefit: Set amount per month is paid once employee has requisite age and years of service. (Reach age 60 with 30 years of service, benefit is $2500 per month) November 3, 2010Thomas E. Murphy 7
  8. 8. DCP Private (61%) DBP Public 90% DBP Private (21%) November 3, 2010 8Thomas E. Murphy
  9. 9.  Demographics of workforce  Age and sex of workforce  Financing of benefits  Use of capital markets to finance  Allocation of risks (longevity, investment, and inflation)  Job tenure – encourage or not relevant?  Tax qualified status and fund protection  Legal compliance issues (ERISA, IRC, PPA November 3, 2010 9Thomas E. Murphy
  10. 10.  The Benefits Model?  Let’s look at DBP design features and see how Benefits Model applies? November 3, 2010 Encourage retention? Sufficient retirement income? Competitive? Fair? Cost effective? 10Thomas E. Murphy
  11. 11. You Must Know these! Drivers: Fig. 4.2 at 90.  Coverage  Eligibility  Vesting  Calculating the benefit  Typical Final Average Pay Formula  COLA?  Separated vested  Funding and Protection  Investment strategy  Beneficiaries  Calculating participating service  Normal and Early retirement ages  Distribution options*  Death before retirement November 3, 2010 11Thomas E. Murphy
  12. 12. The Choices Adverse Selection Risk?  Annuity  Named beneficiary  Lump sum (Discount rate and Present Value)  Disability Retirement (103)  Deferred Benefit  Level Income Option (Table 4.2, at 102)  10-15 year certain (98) November 3, 2010 12Thomas E. Murphy
  13. 13.  What is covered compensation?  Social security integration and offsets (101)  Restoration benefit  Breaks in service (102)  What You Should Know about Your Retirement Plan! (U.S. DOL. See site below)  http://www.dol.gov/ebsa/publications/wyskapr. html  Disability retirement (103)  Non-portability (104)  §415 limits on income and benefit  Cap on years of participating service? November 3, 2010 13Thomas E. Murphy
  14. 14.  Maximum Pension- $195,000  Maximum Compensation to be included in formula- $245,000  And more . . . November 3, 2010 14Thomas E. Murphy
  15. 15.  And, what about ACTUARIAL REDUCTIONS?  How and why do they apply to a DBP?  How are DBPs administered?  Let’s do some calculations! November 3, 2010 15Thomas E. Murphy
  16. 16.  How to allocate risks?  Should employer be sole source of financing?  Aggressive use of capital markets?  Funding with other assets?  What is a reasonable income replacement goal?  Can we measure the effectiveness of our retention and loyalty objective?  What are design levers we can use to adjust? (See: Exercises Nos. 3, 4, 6, 7, 8, 13 (pp.129- 131) November 3, 2010Thomas E. Murphy 16
  17. 17. 401(k) Profit Sharing ESOP SIMPLE November 3, 2010 17Thomas E. Murphy
  18. 18. Your $ Employer $ Your Benefit $$ November 3, 2010 18Thomas E. Murphy
  19. 19. November 3, 2010 19Thomas E. Murphy
  20. 20. Longevity Investment Inflation November 3, 2010 20Thomas E. Murphy
  21. 21.  What was driving force leading to transition to DCP?  What is relative contribution of employers?  Simplicity, portability, and ownership oriented employee  Very favorable tax treatment!  Advantage of compounding  Portability  No actuarial reductions! November 3, 2010 21Thomas E. Murphy
  22. 22.  Coverage  Eligibility  Portability  Vesting  Employer matches  Why no Actuarial reductions?  §415 limits on contributions November 3, 2010 22Thomas E. Murphy
  23. 23.  Elective deferrals - $16,500  Catch –ups over 50 years - $5,500  Maximum total contribution - $49,000 November 3, 2010 23Thomas E. Murphy
  24. 24. Note: fiduciary liability Note: restrictions  Investment choices- self directed  What is employer’s obligation here?  What are lifestyle, target funds?  What about too much company stock?  Loans and withdrawals  Plan administration and fees  How are funds distributed? Lump sum or Annuity?  What about retirement age?  Early and Minimum Distribution Rules (see infra) November 3, 2010 24Thomas E. Murphy
  25. 25. Retiring early? Retiring later?  Will I have enough?  What’s my number?  Impact of recession  Will I have to get a part-time job after retirement? November 3, 2010 25Thomas E. Murphy
  26. 26.  Early and minimum distribution rules of IRS  Discrimination testing! What is this?  What is non-elective enrollment?  What is a “safe harbor” plan? (See chapter 9 and Blog)  BIG ISSUE: are employees saving enough for retirement? November 3, 2010 Happy Birthday: Age 59.5 and 70.5 26Thomas E. Murphy
  27. 27. Risks DBPs MoreRisks DCPs LessRisks Cash Balance Plans November 3, 2010 27Thomas E. Murphy
  28. 28.  What would result if the pension formula were based upon current pay instead of final pay?  It’s a Cash Balance Plan  How does this change the risk allocation?  What impact would this have on length of service?  Don’t forget to apply the Benefits Model November 3, 2010 28Thomas E. Murphy
  29. 29. No actuarial reductions Employee receives his account balance!  Employer calculates a benefit annually and credits to account  Credited amount is based upon a percentage of current pay  Account earns employer established rate of annual interest  Account balance can be viewed by employee  Account is portable  Vesting applies (3 year cliff)  Benefit paid in lump sum or annuity  Favorable tax treatment November 3, 2010 29Thomas E. Murphy
  30. 30.  No employee contributions  Employer can pool account balances and invest and obtain higher yields than those annual investment returns promised to participants  Risks – investment risk is on the employer but is nominal (short term). Longevity and inflation risks are on the employee.  Do these plans encourage long term or mid term service? (See: key design features at p.120 of the text) November 3, 2010 30Thomas E. Murphy
  31. 31.  What happens in a conversion from a DBP to a Hybrid (cash balance plan)?  Who goes into new plan and who stays in DBP?  What is opening balance?  Do such conversions violate Age Discrimination laws?  What about “wear away” and “whipsawing?”  (See: text pp 121, 122.)  How do CBPs comport with Benefits Model? November 3, 2010 31Thomas E. Murphy
  32. 32.  Query: how would you change design of CBP to encourage longer service?  The Pension Protection Act resolves many legal issues. November 3, 2010 32Thomas E. Murphy
  33. 33. November 3, 2010 33Thomas E. Murphy
  34. 34.  There are profit sharing cash and profit sharing retirement plans.  The retirement plan is essentially a DCP!  It is a unique concept – results based funding of a retirement plan.  If the company does well, so will you.  Reserves maximum flexibility to employer – unlike a DBP  How would you assess the risk allocation? November 3, 2010 34Thomas E. Murphy
  35. 35.  Favorable tax treatment  There are limits on total amount allocated to plan and to individuals.  What about Benefits Model?  The distribution occurs at retirement.  How is the employee’s amount typically calculated: (W-2 Earnings of employee ÷ total earnings) × Annual Profit $$ allocated.  Or, it may involve % of salary, or age and service weighted November 3, 2010 35Thomas E. Murphy
  36. 36. What about Risks? Benefits Model?  No monies distributed until retirement.  Can use age or service enhancements  Early and mandatory distribution rules apply  Vesting  Frequently company stock is placed into account.  Employee is given diversification option at age 55.  Stock price and dividends increase so does account balance. November 3, 2010 36Thomas E. Murphy
  37. 37. What about Risks? Benefits Model?  ESOPS  Company Stock is allocated to employee retirement account.  Expected to create alignment.  Vesting  Minimum and Early distribution rules apply  Contributions made regardless of profits  Favorable tax treatment.  If leveraged ESOP it is even better for employer. November 3, 2010 37Thomas E. Murphy
  38. 38. Bank loans to ESOP ESOP buys shares Employer puts cash into ESOP ESOP puts shares in retirement account Employer uses cash to pay off loan Tax favored treatment of interest and principal Employees have right to diversify at age 55 Query: does this plan produce alignment? Issues: vesting, risk, formula for deposit of shares November 3, 2010 38Thomas E. Murphy
  39. 39. November 3, 2010 39Thomas E. Murphy
  40. 40.  Nos. 1-21at pages130-131.  Read the Blog and look especially at efforts to ameliorate the risks in DCPs.  Should the government sponsor a GRA? November 3, 2010Thomas E. Murphy 40

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