Pension Plan

Pension Plan
• Is a retirement plan that requires an employer to
make contributions into a pool of funds set aside
for a worker's future benefit.
• The pool of funds is invested on the employee's
behalf, and the earnings on the investments
generate income to the worker upon retirement.
• In addition to an employer's required
contributions, some pension plans have a
voluntary investment component.
• A pension plan may allow a worker to contribute
part of his current income from wages into an
investment plan to help fund retirement.
 Types of Pension Plan
• In a defined-benefit plan, the employer guarantees
that the employee receives a definite amount of
benefit upon retirement, regardless of the
performance of the underlying investment pool.
• The employer is liable for a specific flow of pension
payments to the retiree (the dollar amount is
determined by a formula, usually based on earnings
and years of service), and if the assets in the pension
plan are not sufficient to pay the benefits, the
company is liable for the remainder of the payment.
• About 90% of public employees, and roughly 10% of
private employees, in the U.S are covered by a
defined-benefit plan today.
 Types of Pension Plan
• In a defined-contribution plan, the employer makes
specific plan contributions for the worker, usually
matching to varying degrees the contributions made
by the employees.
• The final benefit received by the employee depends
on the plan's investment performance: The company’s
liability to pay a specific benefit ends when the
contributions are made.
• Because this is much less expensive than the
traditional pension, when the company is on the hook
for whatever the fund can't generate, a growing
number of private companies are moving to this type
of plan and ending defined-benefit plans.
 Are Pension Plans Taxable?
• Employers get a tax break on the contributions
they make to the plan for their employees.
Contributions they make to the plan are taken out
of their gross income. That effectively reduces
their taxable income.
• Funds placed in a retirement account then grow at
a tax-deferred rate, meaning no tax is due on them
as long as they remain in the account.
• Both types of plans allow the worker to defer tax
on the retirement plan’s earnings until withdrawals
begin, and this tax treatment allows the employee
to reinvest dividend income, interest income and
capital gains, which generates a much higher rate
of return before retirement.
 What is a Pension Fund?
• When a defined-benefit plan is made up of pooled
contributions from employers, unions or other
organizations, it is referred to as a pension fund.
• Run by a financial intermediary and managed by
professional fund managers on behalf of a company
and its employees, pension funds control relatively
large amounts of capital and represent the largest
institutional investors in many nations; their actions
can dominate the stock markets in which they are
invested.
• Pension funds are typically exempt from capital gains
tax. Earnings on their investment portfolios are tax
deferred or tax exempt.
 Advantages of a Pension Fund
• A pension fund provides a fixed, preset benefit for
employees upon retirement, helping workers plan
their future spending.
• The employer makes the most contributions and
cannot retroactively decrease pension fund benefits.
• Voluntary employee contributions allowed as well.
• Since benefits do not depend on asset returns,
benefits remain stable in a changing economic climate.
• Businesses can contribute more money to a pension
fund and deduct more from their taxes than with a
defined-contribution plan.
• A pension fund helps subsidize early retirement for
promoting specific business strategies.
 Disadvantages of a Pension Fund
• However, a pension plan is more complex and costly to
establish and maintain than other retirement plans.
• Employees have no control over investment decisions.
• An excise tax applies if the minimum contribution
requirement is not satisfied or if excess contributions
are made to the plan.
• An employee’s payout depends on his salary and
length of employment with the company.
• No loans or early withdrawals are available from a
pension fund. In-service distributions are not allowed
to a participant before age 65. Taking early retirement
generally results in a smaller monthly payout.
 Monthly Annuity or Lump Sum?
• With a defined-benefit plan, you usually have
two choices when it comes to distribution:
periodic (usually monthly) payments for the rest
of your life or a lump sum distribution.
• Some plans allow you to do both, i.e., take out
some of the money in a lump sum, and use the
rest to generate periodic payments.
• There will likely be a deadline by which you have
to decide, and your decision will be final.
• There are several things to consider when
choosing between a monthly annuity and a lump
sum.
 Monthly Annuity or Lump Sum?
• Annuity. Monthly annuity payments are typically
offered as a single life annuity for you only for the rest
of your life – or as a joint and survivor annuity for you
and your spouse.
• Lump Sum. If you take a lump sum, you avoid the
potential (if unlikely) problem of your pension plan
going broke, or losing some or all of your pension if
the company files for bankruptcy.
• Plus, you can invest the money, keeping it working for
you – and possibly earning a better interest rate, too.
• If there is money left when you die, you can pass it
along as part of your estate.
 Which Yields More Money?
• To figure out the discount or future expected
interest rate for the annuity payments, think
about how you might invest the lump sum
payment and then use that interest rate to
discount back the annuity payments.
• A reasonable approach to selecting the ‘discount
rate’ would be to assume that the lump sum
recipient invests the payout in a diversified
investment portfolio of 60% equity investments
and 40% bond investments.
• Using historical averages of 9% for stocks and 5%
for bonds, the discount rate would be 7.40%.
 Which Yields More Money?
• Imagine that Sarah was offered $80,000 today or
$10,000 per year for the next 10 years. On the surface,
the choice appears clear: $80,000 versus $100,000
($10,000 x 10 years): Take the annuity.
• But the choice is impacted by the expected return (or
discount rate) Sarah expects to receive on the $80,000
over the next 10 years.
• Using the discount rate of 7.40%, calculated above, the
annuity payments are worth $68,955.33 when
discounted back to the present, whereas the lump-
sum payment today is $80,000.
• Since $80,000 is greater than $68,955.33, Sarah would
take the lump-sum payment.
 Other Deciding Factors
• Your age. One who accepts a lump sum at age 50 is obviously
taking more of a risk than one who receives a similar offer at
age 67. Younger clients face a higher level of uncertainty than
older ones, both financially and in other ways.
• Your current health and projected longevity. If your family
history shows a pattern of predecessors dying of natural
causes in their late 60s or early 70s, then a lump-sum
payment may be the way to go.
• Conversely, someone who is projected to live to age 90 will
quite often come out ahead by taking the pension.
• Remember that most lump sum payouts are calculated based
on charted life expectancies, so those who live past their
projected age are, at least mathematically, likely to beat the
lump sum payout.
• You might also consider whether health insurance benefits
are tied to the pension payouts in any way.
 Other Deciding Factors
• Your current financial situation. If you are in dire straits
financially, then the lump-sum payout may be necessary.
• Your tax bracket can also be an important consideration; if
you are in one of the top marginal tax brackets, then the bill
from Uncle Sam on a lump-sum payout can be murderous.
• And if you are burdened with a large amount of high-interest
obligations, it may be wiser to simply take the lump sum to
pay off all of your debts rather than continue to pay interest
on all of those mortgages, car loans, credit cards, student
loans and other consumer liabilities for years to come.
• A lump-sum payout may also be a good idea for those who
intend to continue working at another company and can roll
this amount into their new plan, or for those who have
delayed their Social Security until a later age and can count
on a higher level of guaranteed income from that.
 Other Deciding Factors
• The projected return on the client’s portfolio from a
lump-sum investment. If you feel confident your
portfolio will be able to generate investment returns
that will approximate the total amount that could have
been received from the pension, then the lump sum
may be the way to go.
• Of course, you need to use a reasonable payout factor
here, such as 3%, and don’t forget to take drawdown
risk into account in your computations.
• Current market conditions and interest rates will also
obviously play a role, and the portfolio that is used
must fall within the parameters of your risk tolerance,
time horizon and specific investment objectives.
 Other Deciding Factors
• Safety. If you have a low risk tolerance, prefer
the discipline of annuitized income, or simply
don't feel comfortable managing large sums of
money, then the annuity payout is probably the
better option because it’s a safer bet.
• In case of a company plan going bankrupt, along
with the protection of the PBGC, state
reinsurance funds often step in to indemnify all
customers of an insolvent carrier up to perhaps
two or three hundred thousand dollars.
 Other Deciding Factors
• The cost of life insurance. If you're in relatively
good health, then the purchase of a competitive
indexed universal life insurance policy can
effectively offset the loss of future pension
income and still leave a large sum to use for
other things.
• This type of policy can also carry accelerated
benefit riders that can help to cover the costs for
critical, terminal or chronic illness or nursing
home care.
• However, if you are medically uninsurable, then
the pension may be the safer route.
 Other Deciding Factors
• Inflation protection. A pension payout option
that provides a cost-of-living increase each
year is worth far more than one that does not.
• The purchasing power from pensions without
this feature will steadily diminish over time, so
those who opt for this path need to be
prepared to either lower their standard of
living in the future or else supplement their
income from other sources.
 Other Deciding Factors
• Estate planning considerations. If you want to
leave a legacy for children or other heirs, then an
annuity is out.
• The payments from these plans always cease at
the death of either the retiree or the spouse, if a
spousal benefit option was elected.
• If the pension payout is clearly the better option,
then a portion of that income should be diverted
into a life insurance policy, or provide the body of
a trust.
 Pension Fund in Financial Markets
• PFs are major participants in stock and bond
offerings and thereby finance corporate
expansion.
• They are also major participants in bond
offerings by the Treasury and municipalities
and thereby finance government spending.
• Because PF portfolios are normally
dominated by stocks and bonds, the
participation of PF managers in the stock
and bond markets is obvious.
 Pension Fund in Financial Markets
• PF managers also participate in
money and mortgage markets to fill
out the remainder of their portfolios
• They sometimes utilize the futures and
options markets as well in order to
partially insulate their portfolio
performance from interest rate and/ or
stock market movements.
 Pension Fund in Financial Markets
• PF managers maintain a small proportion of
liquid money market securities that can be
liquidated when they wish to increase
investment in stocks, bonds, or other alternatives
• At least 25 percent of a PF portfolio is typically
allocated to bonds. Portfolios of defined-benefit
plans usually have a higher concentration of
bonds than defined-contribution plans.
• Pension portfolios frequently contain some
mortgages, although the relative proportion is
low compared with bonds and stocks.
 Pension Fund in Financial Markets
• At least 30 percent of a pf portfolio is typically
allocated to stocks. In general, defined
contribution plans usually have a higher
concentration of stocks than defined-benefit
plans.
• Some PFs use futures contracts on debt
securities and on bond indexes to hedge the
exposure of their bond holdings to interest rate
risk.
• In addition, some pension funds use futures on
stock indexes to hedge against market risk. Other
pension funds use futures contracts for
speculative purposes.
 Pension Fund in Financial Markets
• Some PFs use stock options to hedge against
movements of particular stocks. They may
also use options on futures contracts to
secure downside protection against bond
price movements.
• PFs commonly engage in interest rate swaps
to hedge the exposure of their bond and
mortgage portfolios to interest rate risk.