Learning Objectives (part 1 of 2)

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Chapter 17
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Learning Objectives (part 1 of 2)

• Describe the basic components of the Social
  Security program
• Compute the Social Security taxes for any
  paycheck
• Describe who qualifies for various Social
  Security benefits
• Compute a Social Security retirement benefit

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Learning Objectives (part 2 of 2)

• Describe how a spouse's Social Security
  retirement benefits are determined
• Compare and contrast the two major types of
  pension programs
• Estimate a person's pension benefit from each
  program
• Explain why the PBGC is important to people with
  DB pensions

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Basic Components of the Social Security Program

• Retirement Benefits
• Disability Income Benefits
• Survivors Benefits
• Medicare

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Social Security Taxes (1 of 2)

• Split between employer employee
• Self-employed folks pay both shares
• Two aspects to the tax
• Maximum amount of income that is taxed
• Marginal tax rate

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Social Security Taxes (2 of 2)

• Employee pays 7.65 on first 84,900 in 2002, and
  1.45 on all wage income over 84,900
• Example 1 Wage income 40,000
• SS tax40,000x7.653,060
• Example 2 Wage income 100,000
• SS tax84,900x7.6515,100x1.45
• 6,713.80

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Qualification for SS Benefits (1 of 2)

• Qualification based on quarters of coverage
• Maximum of 4 quarters credit per year
• In 2002, need 870 of income in a quarter for
  credit, or 3,480 in the year for 4 quarters of
  credit

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Qualification for SS Benefits (2 of 2)

• To qualify for retirement benefits, need 40
  quarters of credit
• To qualify for survivors benefits, 40 is
  sufficient, but could be less
• To qualify for disability benefits
• If younger than 24 gt 6 quarters
• If older than 61 gt need 40 quarters
• If in between, complex formula used

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How to compute a SS retirement benefit (1 of 4)

• Step 1 For each year worked, determine the
  lesser of wage income or income subject to
  retirement tax
• Step 2 Multiply the income figure in step 1 for
  each year by an index number which adjusts the
  income for that year for inflation

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How to compute a SS retirement benefit (2 of 4)

• Step 3 Sum the best 35 years of income (use
  zeros if did not work at least 35 years)
• Step 4 Divide the sum in step 3 by 420 ( of
  months in 35 years). This produces ones average
  indexed monthly earnings

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How to compute a SS retirement benefit (3 of 3)

• Step 5 Using the bend points for the year of
  retirement, multiply the components of the
  average indexed monthly earnings by the marginal
  replacement rates of 90, 32, and 15

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How to compute a SS retirement benefit (3 of 4)

• Step 6 Sum the products in step 5 to determine
  ones primary insurance amount (normal retirement
  income)
• Step 7 Adjust the figure in Step 6 up or down if
  a person retires before age 62 or after their
  normal retirement age
• Step 8 After retirement, cost of living
  adjustments applied each year

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Spousal SS Retirement Benefits

• Spouse of a retiring worker may claim what he or
  she has earned in own name
• Or, spouse may claim one-half of retiring
  workers benefit
• If take the latter, then if retired worked dies
  first, can step up to his or her full check
• Ex-spouses may also qualify

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Pension plans key features

• Qualified vs. non-qualified
• Qualified gt contributions from an employees
  paycheck are tax-deductible, which means
  retirement income fully taxed
• Non-qualified gt employees contributions are not
  deductible, so some of retirement income is tax
  exempt
• Vesting gt an employees claim on the employers
  contributions

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Defined Benefit Pension

• Pension benefit based on a formula
• Employee may contribute to pension
• Employer obligated to make sure pension has
  enough cash to make retirement payments

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Example of DB Pension

• Employer pays 1.5 of final average salary per
  year worked, for up to 30 years
• Final average salary could be average of last 5
  years of employment
• If final avaerage salary 60,000, employee
  worked 30 years, annual pension benefit 27,000

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Defined Contribution Pensions

• The amount contributed to the pension each year
  is fixed by formula (e.g., 12 of base salary)
• Contribution could be split between employer
  (e.g., 10) and employee (e.g., 2)
• Employee selects investment portfolio
• Employee bears full investment risk

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Example of DC Pension

• Employee works for 30 years at one employer
• Sum of employees and employers contributions
  plus investment gains provides an account of
  1,000,000
• At time of retirement, this would provide an
  annual income of 80,000

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Which is better DB or DC?

• No simple answer as it depends on details of the
  pension program
• Employee has direct investment risk with DC
  pension
• Employee has indirect investment risk with DB
• Younger employees would generally prefer DC,
  older ones DB

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Pension Benefit Guarantee Corporation (PBGC)

• Government agency created under ERISA act of 1974
• Charges premiums to DB pension plans
• If employer of DB plan fails, the PBGC takes over
  responsibility for guarantee of pension
• PBGC has upper limits on pensions it will pay