Chapter 9 Pension Funds

• Pension funds are defined by their tax treatment and function.
• They exist for the eventual payment of retirement benefits
• Qualified plans have tax exempt contributions and earnings
• Pension plan sponsors can be private companies, government employers, unions or individuals
• they are administered by employers, insurance companies or investment companies and typically involve the assets of insurance or investment companies.
• No employer is required under federal law to offer a pension plan, but if they do, they must abide by state and federal laws

I.  Types of Pension Plans

• Defined Benefit Plans
• employer promises a specified payments monthly during retirement
• based on salary and years of service
• the employee may or may not have to contribute to this plan
• to receive benefits an employee must be vested; vesting refers to the minimum years of service necessary to receive any benefits (5-7 yrs maximum for full vesting under federal law)
• the advantages of this type of plan from the employee perspective include a limited investment risk for the employee, no risk of outliving assets
• the disadvantages of this type of plan include a lack of portability from job to job and a lack of control over how pension contributions are invested, or even if the employer is contributing enough to meet the promised obligations
• example 1:
• average best 5 years of salary
• pay out a % of average depending on years of service
• 5 years, 25%; 20 years 60%; 30 yrs, 85%, 35 years, 100%

• Defined Contribution Plans
• employee/individual contributes some amount to investment fund
• which the employer may or may not match;
• the employee chooses how this money is invested based on choices offered by the plan;
• the amount available at retirement depends entirely on investment performance
• most employers are moving towards this type of plan; do not need employer to have this type of plan
• Federal Reserve Survey of Consumer Finances
• DC plans have gone from 15% (1983) to 59% (1998) of pension plan structures
• 401(k), 403(b), 414(h)  "qualified plans"
• employer sponsored (profit, nonprofit, public sector plans)
• contribution limits $12,000 in 2003
• SIMPLE IRA
• works like a 401k, but easier/less costly for small employers
• IRA, Roth IRA,
• for individuals
• contribution limits $3000 in 2003
• the advantages of this type of plan from the employee perspective include portability, control, and the cash value built up
• the disadvantages include the investment risk borne by the employee and the risk of outliving assets during retirement
• example: Me
• I pay 3% of my gross salary (pretax); SUNY matches 9%
• I chose investments through TIAA-CREF
• global stock fund, index fund, bonds
• amount at retirement depends on how well these funds do

• Cash Balance Plans
• hybrid plan that has features of defined benefit and defined contribution plans
• defined benefit features
• benefits based on (1) fixed employer contribution, (2) guaranteed annual return
• employer bears investment risk
• defined contribution features
• each employee has benefit account to monitor
• vested benefits may be withdrawn if employee leaves company
• benefits build uniformly
• unlike defined plans where benefits grow rapidly at end of worklife
• older workers unhappy with company shifts to cash balance plans
• some lawsuits alleging age discrimination

II.  Assets

• table 9-4
• defined benefit plans
• 75% U.S. stocks and bonds
• Unions less likely to hold international assets
• defined contribution plans sponsored by corporations invest over 25% in their own company stock on average
• for some employees this has led to huge losses
• Enron, Lucent, Xerox
• this last part is troubling because it represents a big lack of diversification; however it persists because it is easier for companies to match employee contributions with their own stock rather than cash

III. Regulation

• tax treatment
• the contributions to defined benefit plans and most defined contribution plans (EXCEPT Roth IRA) are pretax
• the gains in the pension funds are tax deferred (not taxed while money stays in the fund)
• the benefits of defined benefit and most defined contribution plans are taxable
• Roth IRA withdrawals are not taxable at this time
• early withdrawal from defined contribution plans (before age 59.5) are taxable plus a 10% penalty
• exceptions: medical expenses, education expenses, home downpayment
• ERISA 1974 (defined benefit plans)
• set funding standards, requiring that pensions be "fully funded" and not "pay-as-you-go"
• sponsor must set aside funds for employees, not pay obligations out of current income
• set minimum vesting standards
• 5-7 years maximum for full vesting
• created federal insurance for pensions--Pension Benefit Guarantee Corporation (PBGC)
• insures vested benefits up to a limit, but no COLAs
• trustee to over 2500 plans
• set guidelines for pension fund management for both DB and DC plans
• plan must provide prudent investing options

IV. Social Security

• established 1935
• Public defined benefit plan supported by payroll tax
• 6.2% employee, 6.2% employer
• up to salary of  about $87,000
• benefits based on
• age of retirement
• # years worked
• income earned
• COLAs every year based on CPI
• Social Security is pay-as-you-go
• retirees today paid with payroll taxes collected today
• Problems with Social Security
• as U.S. population ages, too many people collecting benefits relative to how many are paying benefits
• originally over 8 payers-to-retirees
• 3.4  payers-to-retirees today;  2 payers-to retirees 2030
• currently payroll tax revenue exceeds benefits
• surplus invested in Treasury IOUs
• after 2015 benefits will exceed revenues
• draw on Treasury IOUs
• after 2040 assets exhausted
• Solutions?
• decrease benefits
• increase retirement age
• increase payroll tax
• privatize Social Security accounts (more like a 401k)
• investing Social Security surplus in assets other than Treasury IOUs