Rpa 1 - Retirement Plan Design

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Tripod of economic security
Three-legged stool

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Needed

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Economic problems of old age

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Needed

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Reverse Anniity

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n

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Economic growth and tax relief reconciliation act of 2001 (EGTRRA)

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n

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Increase in logevity and changing demography

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n

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reasons for growth of private pensions

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n

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tax advantages of qualified pension plan

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n

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Human depreciation concept

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n

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Business expediency

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n

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Deferred wage concept

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n

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Employee Retirement Income Security Act of 1974 (ERISA)

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n

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Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA)

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n

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Tax Reform Act of 1986

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n

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Pension Protection Act of 2006

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n

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Basic characteristics of Social Security program

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n

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Groups covered under Social Security program

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n

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Social Security’s primary insurance amount

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n

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Social Security’s earnings test

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n

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Concept of retirement

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The concept of retirement describes the phase of life that follows an extended period where individuals engage in some form of work activity attributable to labor. Most forms of work result in income generation, providing resources to sustain the necessities and amenities of
life. The notion of retirement involves the basic concept that individuals will work for a period of time during which they will set aside assets or become entitled to benefits. Following this period, individuals will then cease working and use the assets or earned benefits to sustain
their material resource needs.

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Retirement risk

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risk of retirees finding themselves with having inadequate resources fortheir living needs either at the onset of their retirement or sometime during their retirement
years.

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Traditional retirement vs. phased retirement

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Many individuals traditionally have retired at a specific age (namely, age 65). Many people today are transitioning into retirement over an extended number of years, either through phased retirement programs offered by their employer, or by seeking and engaging in some
form of part-time employment or alternative income-generating work arrangement following departure from their previous full-time work arrangement.

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Contributors to retirement risk

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Resource shortfalls
cataclysmic events
environmental cahnges
loss of ability to independently manage risk and living needs

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Impact of shift to defined contribution (DC) plans

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Under a defined benefit plan, individuals who meet eligibility and service requirements are guaranteed a specific regular and recurring pension payment. That is not the case with a defined contribution plan which makes no benefit guarantees. A defined contribution plan
places the responsibility for risk management mostly with the individual plan participant.
Therefore, because the individual participant of a defined contribution plan is self-managing his or her account, he or she is often more at risk during market corrections and has fewer options to remedy the adverse conditions than an employer of a defined benefit plan. The employer can withstand downturns by holding investments until the market recovers; an individual may not be able to wait for the rebound if he or she has immediate income needs.

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Reasons for shortfalls

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Retirement accumulation shortfalls can occur for a variety of reasons. One source of inadequate resources in retirement can occur from poor planning and provision made during the income-earning years that precede the retirement years. For some individuals, the inadequacy is inevitable because of insufficient income during the income-earning years.
In other situations, the shortfalls are the result of individuals simply failing to plan adequately
even though they possess the necessary resources.
Other situations of shortfalls that cannot be attributed to poor planning exist. Asset erosion or elimination can occur because of unexpected occurrences including the changing nature of private pensions with investment risk shifting to plan participants.

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Greater risk of asset erosion or elimination

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Market conditions create a very disprate outcome in retirement replacement ratios

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Crisis of expectations

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Wall Street predicts the real crisis is unfufilled expectations.

Lower living standards or work longer bc they have saved more $$ but less %

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Market corrections’ disparate impact on defined contribution accounts

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n

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Impact of inflation on retirees’ purchasing power

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n

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Provisions of Pension Protection Act of 2006 promoting DC growth

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Some of the provisions of PPA make tangible efforts to better serve the interests of defined contribution plan participants. PPA expands the opportunities for plan sponsors to allow investment companies to provide financial advice to participants. PPA also clarifies that
defined contribution plan sponsors may automatically enroll participants in their plans and use default elections into more balanced investment portfolios. This clarification allows default investment elections so that long-term investment results will be superior to those that would
generally be expected to be attained by defaulting participants into less volatile money market
accounts. In the past, plan sponsors were reluctant to default plan participants into more risky investments fearing liability for a fiduciary breach if participants incurred investment losses.

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External shocks affecting retirement resources and needs

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Dramatic investment losses or the bankruptcy of a former employer that ends benefits coverage are threats that can dramatically alter the life situations of retirees. Economic cycles can result in periods of time where a number of businesses will experience bankruptcy.
Changes in global competition can render whole industries unprofitable. These occurrences
in the macroeconomy can have direct consequences for individual retirees whose pensions or benefit coverage may be reduced or eliminated.

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Environmental factors influence on the retirement plan design - 6

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The employer’s legal status. Historically, the employer’s legal status influenced pension plan design. Although the parity provisions of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) eliminated most of the distinctions in tax law that formerly applied to different forms of organizations (sole proprietorships, partnerships, Subchapter S corporations, nonprofit organizations and regular corporations), precedents established by prior practice and on account of prior law still may continue to influence plan design for some organizations.
(b) The basic characteristics of the employer and its industry are important in structuring benefit plans that will both meet employee needs and offer funding patterns compatible with the employer’s objectives and capabilities.
(c) The characteristics of the individuals employed by the employer can have significant implications in terms of the type of benefit provided, cost levels generated and similar matters.
(d) Employers with diversified operations must determine the appropriate degree of uniformity for the retirement program. (Nondiscrimination testing requirements can place constraints on an employer’s alternatives to create vastly different retirement programs unless these operations can be tested distinctly as qualified separate lines of business.)
(e) The size of the community in which the employer does business will determine whether
community goodwill should be factored into the design process.
(f) The presence of collective bargaining units can influence plan design, even for nonbargaining
unit employees.

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Income-maintenance vs. compensation-oriented approach

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a) An income-maintenance approach could suggest the choice of a defined benefit pension plan integrated to the maximum extent with Social Security benefits or the choice of a death benefit that provides an income benefit but only to survivors of the employee’s immediate family. Here the emphasis is on protection and continuation of a certain
income level when active employment ceases.
(b) A compensation-oriented approach, though, might suggest the use of a defined
contribution plan as the basic program for providing retirement benefits. Here the emphasis is on deferred compensation and the potential for asset accumulation.

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Employee cost sharing—direct and indirect participation

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n

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Investment risk and inflation risk

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The employer’s attitude on who should bear investment and inflation risks—the employer or the employees—can play a significant role in the choice between a defined benefit and a defined contribution pension plan. Under a defined benefit plan, these risks are assumed by the employer, although the risk of inflation can be tempered by the choice of a formula that is not pay related or by the choice of a career-pay formula, while the employee in effect assumes both of these risks under a defined contribution plan.

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Coordinating income replacement between a retirement plan and Social Security

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A great many employers believe that, because of the very nature of Social Security benefits and their relatively larger value for lower paid employees, it would be impossible to achieve an equitable balancing of benefits and costs for employees at all pay levels without integrating pension and disability income plans in some fashion with the benefits provided by Social Security. Others believe the communication and administrative difficulties associated with integrated plans are such that integration is not desirable.

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Strategic retirement plans for executives

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An increasing number of organizations believe the unique needs of executives cannot be met by plans that must meet the nondiscrimination requirements of federal tax law. For example, it may be difficult for a firm to recruit a needed executive in midcareer because of the loss
of pension benefits he or she would experience, since a large part of the executive’s benefits would be frozen at the pay levels achieved with the prior employer. In such a case, a need may exist for the employer to have a retirement arrangement that restores the benefits such
an executive might potentially lose. Similarly, an employer might find it desirable to provide executives with a supplemental pension that applies the basic pension plan formula to the executive’s incentive pay, if the basic pension applies to base compensation only. Due to the
nondiscrimination requirements, special benefits for executives such as those described cannot
be provided through a qualified, nondiscriminatory pension or profit-sharing plan. Instead, these benefits must be provided through some form of nonqualified supplemental pension arrangement.

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Attracting and retaining human resources with retirement plans

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Many employers believe the presence of an adequate benefit program is not a positive influence in their efforts to attract and retain employees—at least to any
significant extent. Rather, these employers reason the absence of such a program could have a negative effect on their recruiting and retention efforts. Put another
way, these employers are of the opinion that an inadequate program can hinder their efforts to recruit and retain employees, while an overly generous program will
not produce a corresponding increase in their ability to attract and hold desirable workers.

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Competitive standards for retirement plans

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Many employers have a preference for measuring their plans against industry standards. However, measuring against industry standards is most appropriate for skilled or professional workers and for management personnel—those whose capabilities are more related to the
employer’s own industry. For workers whose capabilities are more readily transferred from one industry to another, a more realistic standard would be those plans maintained by the local companies with which the employer competes on a local basis for human resources.
Therefore, most employers seek to compare their plans both on an industrywide and a geographic basis.

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Retirement plan cost considerations - 4

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(a) The need for contribution flexibility
(b) The employer’s willingness to assume the costs associated with future inflation
(c) The need for a cost-efficient retirement program
(d) The desire to maximize benefits and contributions within the limits permitted by federal
tax law.

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Plan design legal constraints

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n

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Maximizing retirement plan tax advantages - 6

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(a) The choice of benefit formulas
(b) The degree to which the plan is integrated with Social Security benefits
(c) The level of funding needed
(d) The funding instrument chosen
(e) The adoption of both a defined benefit and a defined contribution plan
(f) The use of a target benefit plan.

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Why are some income replacement objectives set below 100%?

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a) Some of the employee’s total retirement income consists of Social Security benefits.
(b) An employee’s personal savings, including equity in a home, can also be a source of
retirement income.
(c) The employer may maintain a supplemental profit-sharing or 401(k) plan that can be a
source of additional income.
(d) Some reduction in gross income can take place without causing a significant reduction in
a retiree’s standard of living.

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Postretirement tax considerations - 4

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(a) A retired employee is no longer paying a Social Security tax unless he or she is in receipt
of earned income.
(b) Social Security benefits are income tax-free for many individuals.
(c) The standard deduction for federal taxes is increased for individuals aged 65 or over.
(d) Retirement income is not subject to state or local taxes in many jurisdictions.

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Employee incentives created by retirement plans

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Profit-sharing plans and plans that involve ownership of employer securities are plans
that can create employee incentives and, as a result, improve productivity.

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Promoting corporate identification

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Profit-sharing plans, 401(k) plans with some employer stock and employee stock
ownership plans (ESOPs) can achieve the objective of corporate identification by having employees acquire an ownership interest in the firm. If all or part of an employee’s account is invested in employer securities, the employee is made aware of progress of the company and the importance of achieving satisfactory profit results.

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Benefit plan administrative objectives

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The issue of benefit plan administration should be considered as an employer establishes retirement plan objectives. It is particularly advantageous in administering a retirement plan if administrative involvement and cost can be minimized. The consideration of administrative
complexity and cost is especially important given government regulations and requirements
that impact on plan design and funding choices. Employers should assess their own internal capabilities and the capabilities of external vendors as they design a plan.

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Under deffered wage concept, private pensions are viewed as

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Part of a wage package that is composed of cash wages and employee benefits

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What is a tax advantage to all qalified pension plans?

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1) Within limits, employer contributions are tax deductable
2) Investment income on plan assets accumulates tax free until distributed.

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All of the following are reasons for the growth of private pension plans - 4

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1) Desire by business for increased productivity
2) Favored tax status of qualified plans
3) demands of labor unions
4) sales effots of funding agencies

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What 2 qualities are important to facilitate decision making on managed retirement risks?

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Adequate information and mental capacity to manage risks

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Over short-time periods there can be substantial variation and diversion from
historical rate of return means for defined contribution holdings.

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Memorize

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Portfolios of assets that fail to outpace inflation cannot succeed in providing
adequate purchasing power to retirees.

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Memorize

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Longevity Risk

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Longevity risk can be described as the situation where a person’s extended life span exceeds
expectations and results in the depletion of resources expected to be sufficient to meet the material needs of retirement. The issue of longevity is not just an individual problem, it is also a societal problem since increased longevity and the aging of the population places increased
strains on social insurance systems.

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Resource Shortfalls may occur from

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1. Inadequate planning and provision for resource needs
2. Resource erosion or elimination
3. Need expansion or enhancement
4. Longevity risk.

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Cataclysmic events are caused by

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1. Changes to existing family unit or system
2. Adverse health consequences
3. Need for long-term care services
4. Interruption of ability to live independently
5. Major shocks to retirement resource systems.

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Environmental Cahnges include

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1. Changes in tax structure
2. Alterations in social insurance systems
3. Modifications of employer or self-maintained benefit programs
4. Adaptations in the economy or investment risk.

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Loss of ability to independently manage risk and living needs brought about by

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1. Ongoing difficulties or lack of adequate skill sets
2. Deterioration of abilities (either rapidly occurring or progressive in nature)
3. Cataclysmic events affecting ability to function independently.

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Components of retirement risks - 4

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(a) Financial and economic risks
(b) Business and employment risks
(c) Public policy risks
(d) Risks related to longevity, outliving assets and changes in family structure.

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What events can increase needs for retirment financial resources?

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Catastrophic health event
Divorce orJob loss of grown children
death or divorce of a spouse in retirement

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What government actions can have implicaitons for the financial status of retirees?

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One area of tremendous importance to retirees involves tax law. Defined contribution plans
provide retirees preferential tax treatment; Social Security benefits are free of income taxation if the retiree’s income is below a certain level; and certain retirement savings vehicles make distributions that are entirely tax free if certain conditions have been met. Any revision to tax
codes at the federal, state or local level that affects private retirement system benefits or the tx treatment of payments from social insurance programs can have a significant effect inaltering the financial well-being of retirees. Apart from modification of the tax treatment
of social programs, more substantive alteration of these programs in terms of eligibility requirements or actual benefits paid can have major implications for retirees and their
dependents.

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Life Care community

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A life care community generally is a living arrangement that encompasses housing and meal arrangements and offers contracts that cover all health care services from assisted living to hospital care and physician’s visits, which are usually already covered by a resident’s private
health insurance and/or Medicare.

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Critical Factors for the sucess of a defined contribution type of retirement system

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A successful defined contribution type of retirement system depends on a number of critical factors. Among these factors are adequacy of contributions, the right array of investment options, financial education for plan participants, plan features that assist in protecting
against poor decision making by participants, and important policies and practices related to eventual distribution of plan assets.

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What choices are avaliable to supplement employer-sponsored retirement account?

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Individuals who decide to supplement their employer-sponsored retirement savings programs by saving outside the employer plan on their own are confronted with a whole series of decisions to be made in terms of the appropriate retirement savings vehicle to use as a
supplement. Individuals may qualify for an individual retirement account where they can make contributions on a tax-deductible basis. lternatively, individuals may qualify to contribute to a Roth IRA, where the contributions are made on an after-tax basis but the
ultimate future distributions are disbursed on a totally tax-free basis.

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What best describes the effect of stock market corrections have on defined contribution plans?

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Losses from downturns that occur at the commencement of retirement income disbursements are difficult to recoup in future years.

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What are critical facotrs upon a sucessful defined congtribution type of retirement system depends?

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Adequacy of contributions
The right array of investment options
Financial education for plan participants

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All of the following are true of retirement risk

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B. It can be diminished with the purchase of insurance and financial products.
C. It is exacerbated by inflation.
D. It is likely greater for participants of defined contribution plans than for those
participating in defined benefit plans.
E. It can be exacerbated by longevity.

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What factors are considered in income replacement objectives? 4

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(a) They usually take the employee’s (but not the spouse’s) Social Security benefits into
account.
(b) The objectives usually are higher for lower paid employees than for higher paid
employees.
(c) The objectives usually are set for the employee’s pay level during the final year of
employment or over a three- or five-year average just prior to retirement, when the
employee’s earnings are highest.
(d) Full income-replacement objectives are set only for individuals who have completed
what the employer considers to be a “career” of employment.

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At one time, it was not uncommon for an employer to have a single incomereplacement
objective for employees at all pay levels. However, it was soon
recognized that lower income employees need a higher level of income replacement
simply because of minimum income needs. Moreover, it was reasoned that higher
paid employees could accept lower income amounts without incurring a major
reduction in living standards.

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memorize

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How can employer achieve total comp objectives by intergrating benefit plans and direct-pay programs?

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An employer’s selection of a benefit program often is viewed as an integral component of a total compensation program. An employer that has adopted a policy of paying high wages and salaries may choose a liberal benefit program as well. Alternatively, an employer may
offer highly competitive wages and salaries but modest benefits to keep total compensation costs at an acceptable level. Another approach would be for an employer to use a reverse compensation strategy mix. Here an employer would offer a liberal benefit program with direct cash compensation that is not fully competitive. This compensation mix often is found in governmental employers since cash compensation is sometimes capped by law. (In the context of retirement plans, a defined contribution retirement plan is typically associated with
the total compensation approach while a defined benefit plan is associated with the incomemaintenance
approach discussed next.)

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List 2 alternative forms for employees to share in the cost of meeting their own economic security needs.

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Employee involvement can take the form of direct employee contributions; or it can be recognized in indirect ways such as when income-replacement objectives in a noncontributory pension plan are consciously set below what might otherwise be desired levels.

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A high degree of concern on the part of an employer about the need for maintaining
controls over future cost levels might lead to the selection of a career-pay or a
defined contribution retirement plan. (Question 3 of Assignment 5 discusses the
implications of career-pay versus final-pay plans for employees.)

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Memorize

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Describe the 3 techniques that may be used to establish the relative standing of carious retirement plans.

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(1) Compare the benefits actually payable to representative employees under different
circumstances under the various plans.
(2) Compare actual costs to the employer for the different retirement plans.
(3) Measure plans on a basis that uses uniform actuarial methods and assumptions and
focuses on the relative value of the different benefits provided.

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Give 4 choices for employers to comply with legal requirements.

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The Age Discrimination in Employment Act (ADEA) prevents discrimination in employment for employees aged 40 and over. However, this does not require all benefit plans to treat all employees alike regardless of age. It is possible, for example, to reduce life insurance coverage for active employees by reason of age (but only within cost-justified limits).
Although it is no longer possible to terminate pension accruals in a defined benefit plan or to discontinue allocations in a defined contribution plan after an active employee has attained the age of 65, a plan may limit the amount of benefit provided under the plan or the number of years of service or plan participation taken into account. An employer should establish basic objectives on how its over-65, active employees will be treated
and whether compliance with this law should be at or above the minimum level. The employer’s decision is, of course, influenced by other objectives and attitudes, such as whether it is desirable to encourage earlier or deferred retirements, its public relations posture, and the like.
(2) Employers may include all employees in their plans or may seek to exclude the maximum number possible. With a retirement plan, it is permissible to exclude employees who have less than one year of service or who are under the age of 21.
(3) An employer may wish to establish a defined benefit pension plan that includes incentive compensation for executives as part of the compensation base used to determine plan benefits, but may not want to include overtime pay and shift differentials paid to other
employees. The employer may satisfy the nondiscrimination requirements of federal tax
laws by instituting a nonqualified, supplemental executive retirement plan (SERP) that
applies the base plan formula to incentive pay.
(4) Securities and Exchange Commission requirements that a plan that invests in employer
securities must be registered can be avoided if employer securities are purchased only with employer contributions.

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Good retirement plans identifies all sources of benefits. What plans should be considered as potential source of benefits?

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The primary plan is, of course, the employer’s retirement plan. However, Social Security can be a major source of additional retirement income. Supplemental retirement income also can be provided by the employer’s 401(k) or profit-sharing plan, if such a plan exists. The employer’s group life insurance and medical expense plan may be a source of additional benefits for a retired employee. Looking at these plans as an integrated whole can affect the choice of specific benefits and benefit levels. (Under the Pension Protection Act of 2006, employees considering phasing into retirement have the option of
accessing additional income from pension plans prior to termination under certain conditions. They
can do so without incurring penalties for early distribution or jeopardizing the plan’s qualified status.)

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Income replacement objectives typically are set with the following factors in mind

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Full income-replacement objectives typically are set only for individuals who have completed what the employer considers to be a “career” of employment.

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List techniques that may be used to establis the relative standing of various retirement plans.

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I. A comparison of the benefits actually payable to representative employees
under different circumstances
II. A comparison of actual cost to the employer
III. A comparison of the relative values of the different benefits provided, based
on uniform actuarial methods and assumptions

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All of the following tax considerations may apply ro retired employees except

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A. A retired employee is no longer paying a Social Security tax unless he or she is in receipt
of earned income.
B. Social Security benefits are income tax-free for many individuals.
C. Increased standard deductions for federal tax purposes are provided for individuals aged
65 or over.
E. Retirement income provided by pension plans is not subject to state or local taxes in many
jurisdictions.