Personal Finance: a Gospel Perspective

1. Personal Finance: a Gospel Perspective Retirement Planning 3: Employer Qualified Plans

2. Objectives A. Understand Employer Qualified Retirement Plans B. Understand Defined Benefit Plans C. Understand Defined Contribution Plans

3. Applications #1 • Bill, married with two kids, will be graduating in April with his bachelors degree, and has two similar offers from companies both located in San Francisco, California. Both companies are companies he would be content to stay with for 30 years. Company A has a 401k with a 100% match up to 4% of his salary. Company B has a 401k with no match, but a Defined Benefit Plan with the formula based on average salary, a factor of 1.5%, and years of service up to 30 years. Assuming the salary is $50,000 for either firm, which has the more attractive retirement package for Bill? Can Bill participate in other retirement plans?

4. Two Kinds of Plans Understand Employer Qualified Retirement Plans Employer Funded Pension Plans (Defined Benefit Plans) Employer Sponsored Retirement Plans (Defined Contribution Plans)

5. Employer Qualified Plans (EQPs) • There has been a shift in EQPs • With defined benefit plans, the risk of funding a specific amount each year is with the company • With defined contribution plans, the risk of funding a specific amount each year is with the employee • We are seeing fewer (or a reduction in the benefit) defined benefit plans • Risk has been essentially shifted from the company to the employee

6. A. Understanding Defined Benefit Plans • What is a defined benefit plan (DBP)? • A retirement plan funded entirely by the employer in which the payout amount is guaranteed • What are the characteristics of a DBP? • Employees don’t contribute • Employees receive a “promise” of a defined payout at retirement • Payout is generally based on formula • Formula variables include: • Average salary level (x), factor percentage (y), and years of service (z)

7. Defined Benefit Plans (continued) • What is a payout formula? • A formula which determines how much you will receive at retirement • Example for XYZ corporation: • Calculate average of five highest annual salaries within the last ten years • Multiply final “average” salary by a company determined factor of 1.5%, and • Multiple this by years in service (to a maximum of 33) • For XYZ Corporation: $60,000 x .015 x 25 yrs = $22,500 or 37.5% of final salary

8. Defined Benefit Plans (continued) • Advantages • Some plans provide 30% to 50% of final salary • Employees do not contribute and bear no risk • Benefits can be extended to spouse • Disadvantages • Benefits are considered taxable income • Firms can change policies even after you retire • Lack of portability and vesting is required • Most do not provide for inflation (no COLA) • Some plans are unfunded

9. Cash-Balance Plans • What are cash-balance plans? • A type of DBP in which workers are credited with a certain percentage of their salary (generally 4-7%) each year, plus a low but guaranteed rate of investment earnings • How is this different from a DCP? • Accounts grow at a predetermined rate, regardless of how much is in the account • Employees do not make any investment decisions

10. Cash-Balance Plans(continued) • Advantages • Employees do not contribute • Rate of return is a constant • Retirement benefits are easier to track • Cash-balance plans are portable • Cash-balance plans are cheaper for the company • Disadvantages • Actual payouts may be less than the basic defined benefit plans

11. Distributions/Payout Options(Example: BYU Defined Benefit Plan) • 10 year certain & life, 15 year certain & life, 20 year certain & life • Life annuity • Joint & survivor 100 percent annuity (10 year certain) • Joint & survivor 75 percent annuity (10 year certain) • Joint & survivor 50 percent annuity (10 year certain) • Special joint & survivor two-thirds annuity (10 year certain) • Qualified joint & survivor annuity (50% and no term certain) Note: If employee dies prior to retirement, surviving spouse is restricted to QJSA option.

12. Important Questions to ask when Considering Employment Opportunities • What salary is your pension based: average compensation, final year’s salary, or some other amount? • What is the vesting period? • What is the formula for calculating benefits? • What’s the normal retirement age? What happens to your pension amount if you retire sooner? • Any advantage to working past age 65? • Is there a COLA?

13. C. Understand Defined Contribution Plans • What is a defined contribution plan (DCP)? • A retirement plan where the employer contributes a specific amount to the employee’s retirement funds while the employee is working and then has no responsibilities once the employee retires • What are the characteristics of a DCP? • Employer contributes to a fund, and then has no additional obligation when the employee retires • Employee may also contribute to the fund • Pension is determined by how much is invested by both the employer and employee, and how fast it grows

14. Defined Contribution Plans (continued) • What are the different types of defined contribution plans (DCPs)? • Money Purchase Plans • Plan where employer contributes a percentage of employee salary each year • Profit Sharing Plans • Plan where employer contributions vary year-to-year depending on firm profitability (it may be zero if the firm is not profitable)

15. Defined Contribution Plans (continued) • Thrift and Savings Plans • Plan where employer matches a percentage of employee contributions to a specific amount (i.e., free money) • Employee Stock Options Plan • Plan where retirement funds are invested in company stock—a very risky and non-diversified plan, but often at a discount to the current price

16. Defined Contribution Plans (continued) • Salary Reduction Plans • Employees contribute before tax dollars reducing their taxable income • Earnings accumulate tax deferred • 55 million employees participate in 401(k) plans • 89% of 401(k) plans have matching contributions

17. Defined Contribution Plans (continued) • Types of Salary Reduction Plans • 401k Plans • Plan where employees contribute a percent of salary up to a specified amount ($13,000 in 2004). Employers may contribute a matching amount (free money) to encourage participation • 403b Plans • Same as 401k but for non-profit tax-exempt companies and institutions (i.e., schools) • 457 Plans • Same as 401k but for state and municipal workers

18. Salary Reduction Plans • Employees direct the funds into different financial asset options including: • Mutual funds, index funds, fixed income, equities, money market funds, and GICs (guaranteed investment contracts) • Companies have their list of approved investment assets • Employees choose where to invest their assets subject to the company list

19. Defined Contribution Plans (continued) • Advantages to Employees • May offer strong growth potential • Greater sense of control and portability • Tax advantages from tax deferred contribution and earnings • Disadvantages to employees • No guarantee of actual amounts available at retirement • Risk is shifted from the employer to the employee

20. Defined Contribution Plans (continued) • Advantages to Employers • Easier to administer • Less government regulation • Greater employee investment choice • Shifts investment decisions to employee • Many varieties • Disadvantages • Takes time and resources to administer

21. Defined Contribution Plans (continued)

22. Defined Contribution Plans (continued) • Thoughts on Defined Benefit/Contribution Plans • 75% of plan balances are invested in equities • Mutual funds still provide bulk of investment opportunities, although some firms are forming brokerage links for stocks • Most plans typically provide 10+ options • Other important issues: • What are annual or administration expenses? • Are there any transfer fees to go from one fund to another? • How often can I reallocate my assets? Costs?

23. Defined Contribution Plans (continued) • What is vesting? • Vesting is the process whereby funds contributed by the employer actually become the property of the employee. • What is the vesting schedule of most plans? • 100% of employee deferrals are vested immediately • Generally vesting schedules apply only to employer contributions, i.e., 60% after 2 years, 80% after 3 years, and 100% after 4 years

24. Defined Contribution Plans(continued) • 401(k), 403(b), and 457 Plan annual contribution limits will increase as follows: Year Contribution Limit Catch Up Contr.* 2004 13,000 3,000 2005 14,000 4,000 2006 15,000 5,000 2007 Indexed 5,000 * Catch up contribution is for those over age 50

25. Tax Considerations • What are the tax considerations of DCPs? • All retirement income, including capital gains, are taxed as ordinary income • 10% penalty rule applies for early withdrawals before 59½ , with some exceptions • There is a 20% withholding requirement • Certain loan provisions may apply • Mandatory annual distributions begins after age 70½

26. Payout/Distribution Options? • What are my payout or distribution options? • Payout/distribution options are ways the employee can receive your money at retirement • Lump Sum Distribution • Pros: Control over investing, spending, gifting • Cons: Tax due immediately • Cons: No assurance of lifetime income • Annuity (can purchase contract inside or outside) • Pros: Stable payments usually for life • Cons: Generally no COLA • Cons: Tax due on amount received each year

27. Payout/Distribution Options (continued) • Periodic Payments • Pros: Regular payments at regular intervals • Pros: Relatively large payments • Cons: No assurance of lifetime income • Cons: Tax rate may be high due to high income • IRA Rollover (Be careful and don’t touch the funds) • Pros: Defer taxes until you withdraw funds • Pros: Can direct investment to different assets • Pros: Enjoy tax deferred growth • Cons: Must begin withdrawals at 70½ or penalty

28. Review of Objectives A. Do you understand Employer Qualified Retirement Plans? B. Do you understand Defined Benefit Plans? C. Do you understand Defined Contribution Plans?