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Pension Plans and Finance Companies

Pension Plans and Finance Companies. Chapter 19. © 2003 South-Western/Thomson Learning. Learning Objectives. Various kinds of pension plans and finance companies Benefits provided by pension plans and finance companies

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Pension Plans and Finance Companies

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  1. Pension Plans and Finance Companies Chapter 19 © 2003 South-Western/Thomson Learning

  2. Learning 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

  3. Pension 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

  4. Types of Pension Plans • Contributory Plans • Both employee and employer contribute • Noncontributory Plans • Only the employer contributes

  5. Types of Pension Plans • 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

  6. Types of Pension Plans • 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

  7. Types of Pension Plans • 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

  8. Types 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

  9. Types of Pension Plans • Individually Sponsored and Self-Employed Private Pension Plans • Keogh Plans • Tax advantaged saving accounts • Administered by banks and other financial intermediaries • For retirement needs of self-employed people • Simplified Employee Pensions (SEPs) • Small-business pension plans • Fewer reporting requirements • Less administrative complexity and costs than traditional pension plans

  10. Types of Pension Plans • Defined-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

  11. Types of Pension Plans • Defined-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

  12. Types of Pension Plans • Defined-Contribution Plan • Contract specifying that a particular and periodic share of employee’s wages will be contributed by employers, employees, or both

  13. Recent Trends in Private Pensions This trend away from defined-benefit plans is explained by three main factors: • 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

  14. Pension Plan Regulation and Insurance • Employee Retirement Income Security Act (EIRSA) - • Established first federal standards for financing and operation of private, defined-benefit plans

  15. Pension 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)

  16. Social Security Federal government program that provides retirement and survivors pensions, and disability and health insurance benefits to qualifying individuals. • 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

  17. Social Security: Plans for Reform To ensure that Social Security meets 100% of its future payment commitments: • Increase revenues coming into the system • Raising tax rate • Increasing tax base on which it is applied • Reduce benefits

  18. Social 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

  19. Finance 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

  20. Consumer 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

  21. Consumer 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

  22. Business 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

  23. Real 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

  24. Finance 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

  25. Finance 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

  26. 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

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