Retirement Plans and the Fund Business

1
Chapter 8

• Retirement Plans and the Fund Business

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2
Structure of Tax-Qualified Retirement Plans

• Tax benefits of Qualified Retirement Plans
• The employers contributions are deductible in
  the tax year they are made
• Participants realize no taxable income
• Participants do not recognize any taxable income
  on their own contributions
• Earnings on contributions from both the employer
  and participants are accumulated tax free
• Participants realize taxable income only when
  they actually receive their retirement benefits

3
Basic Overview of Pensions

• Qualified Plan
• Qualifies for valuable federal tax benefits
• Most employees with pension are in qualified
  plans
• Design, funding, and administration must meet
  very complex set of federal statutory and
  regulatory requirements
• Non-qualified Plan any other retirement or
  deferred compensation
• Less regulation, but less favorable tax treatment
• Mainly used as a form of executive compensation

4
Tax-Qualified Plans

• Meet minimum age (gt18)and service standards and
  minimum coverage requirements (gt1 yr)
• Contribution or benefits do not discriminate in
  favor of highly compensated employees
• Contribution or benefits do not exceed certain
  employee contribution limits
• Meets minimum vesting standards
• Provides for automatic survivor benefits under
  certain circumstances.

5
Funding

• Qualified plan must be funded in advance of the
  employees retirement
• Can be done through
• Contributions to an irrevocable trust fund
• Under an insurance contract
• Funds must be under control of a fiduciary and
  managed solely for benefit of participants and
  beneficiaries

6
Payout Restrictions

• Tax penalty if withdrawn before early retirement,
  age 59½, disability or death
• Payouts must begin by April 1 of the year after
  the participant reaches 70½
• Minimum amounts specified by IRS
• Restrictions on loans

7
Tax Revenue Loss

• In general, contributions to qualified plans are
  not taxed until withdrawal
• According to the OMB, the cost to federal
  treasury in 1999 of preferential tax treatment
  for pensions is about 75 billion annually
• Sometimes called a tax expenditure
• Congress insists on furthering social goals

8
How Valuable is Tax Deferral?

• Invest 1000 today and hold for 30 years
• Before tax interest rate r .10
• Tax rate t .35 (assume same for all types of
  income)
• How much is deferral worth?

9
Types of Qualified Plans

• Two ways to classify plans
• DB versus DC
• Pension plans versus profit-sharing plans
• Pension provide income at retirement
• Profit sharing allow for deferral of income,
  perhaps based on corporations profitability, and
  may allow earlier access to funds

10
Defined Benefit versus Defined Contribution

• Defined benefit (DB) plan
• Employer promises to pay specified schedule of
  benefits to plan participant upon retirement
• Employer contributes to the plan regularly and
  controls investments
• Employer is responsible for any asset shortfall
  due to investment performance
• If employer goes bankrupt, federal insurance
  covers basic benefits

11
Overview of DB Formulas

• Formula specifies benefit to be paid to the
  employee
• Investment risk rests with plan sponsor
• Payment of benefit is obligation of the employer,
  and thus employer is required to fund the plan in
  advance so that the funds will be there to pay
• Typically insured by the PBGC (within limits)
• Formulas and funding can sometimes be complex

12
DB Formula Characteristics

• Employer objectives
• Provide reasonable income replacement ratio
• Maximize value of tax shelter for key employees
• Manage work force (e.g., encourage retention,
  incentives for early retirement, etc.)
• Two useful characteristics of DB formulas
• Benefit need not be function of total
  compensation
• Can design plan around desired retirement income
  for employee
• Permitted to favor employers who enter plan at
  later ages
• At plan inception, often favors key employees of
  closely held businesses

13
Allowable DB Formulas

• Flat-Benefit Formula
• Does not take into account years of service
• Flat-Amount Formula (10,000 per year during
  retirement)
• Flat-Percentage Formula (50 of final salary)
• Unit-Benefit Formula
• Benefit is based on length of service
• 10 per month x (Years of Service)
• Annual Benefit (2) x (Yrs. of Service) x
  (Final Salary)
• Role of Past service

14
Defined Benefit versus Defined Contribution
(cont.)

• Defined contribution (DC) plan
• Employers financial contribution is limited to
  any annual contribution
• Both employee and employer usually contribute to
  the plan
• Employee directs the investment of the plans
  assets
• Employee assumes the risk of asset shortfall due
  to investment performance
• No federal insurance

15
Growth of DB versus DC, 19922005
Source For 1992-1996, EBRI tabulations based on
U.S. Department of Labor, Pension, and Welfare
Benefits Administration, Private Pension Plan
Bulletin (Winter 1999-2000) for 1997-2005, EBRI
projections. Asset amounts shown exclude funds
held by life insurance companies under allocated
group insurance contracts for payment of
retirement benefits. These excluded funds make up
roughly 10 to 15 percent of total private funds
assets. From EBRI, Research Highlights
Retirement and Health Data. January 2001.
Reprinted by permission of Employee Benefit
Research Institute, Research Highlights,
Retirement Data, January 2001.
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Why Employers and Employees Prefer DC Plans

• Employer benefits under DC scheme
• Avoidance of long-term investment risk and future
  pension obligations
• Avoidance of un-funded pension liabilities on
  balance sheets
• Employee benefits under DC scheme
• Control over contributions and investment choices
• Ability to calibrate the amount of their
  contribution (and deduction)
• Opportunity for higher returns (and lower
  returns)
• DC plans tend to vest earlier than DB plans
• DC plans are more portable than DB plans
• In the case of employer bankruptcy, DC plan
  assets are not subject to creditor claims

17
How 401(k) Plans Work

• 401(k) is a section of the Internal Revenue Code
  governing cash or deferred arrangements
  (CODAs) that are part of a retirement plan
• Three principal types of contributions to a
  401(k) plan
• Elective Tax deferred employee contributions
  made by the plan sponsor on behalf of the
  employee in the form of salary reduction
• Matching Employer contributions that match
  employee contributions up to a flat dollar amount
  or percentage of salary contributed
• Nonelective Nonmatching contributions made by
  the plan sponsor from employer funds ( satisfy
  nondiscrimination tests)

18
How 401(k) Plans Work

• Contributions are made usually as percent of
  employees salary
• Employee currently has 13,000 pre-tax elective
  deferral limit (2004)
• Total limit is 40,000
• Employees over age 50 may make catch-up
  contributions each year. Currently 1,000 p.y.
  5,000 p.y from 2006.
• Anti-discrimination tests may limit overall
  contributions for some. Catch-up contribution
  is not subject to anti-discrimination rules

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Anti-Discrimination Test

• Design to ensure that highly compensated
  employees (HCE) do not contribute at a
  disproportionately higher rate than non-HCE.
• To pass the test
• HCEs contribute at an average rate no more than
  125 higher than that for nonHCEs, or
• Average contribution rate for HCEs is less than
  2 greater than the average rate for nonHCEs.
• If the plan fails the test, a portion of HCEs
  contributions must be returned so that the test
  can be passed.

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How 401(k) Plans Work (cont.)

• Participants choose investments from a retirement
  menu
• Plan sponsor designs the investment menu
• Participants may change their choices from time
  to time
• Employees retirement benefits based on plan
  contributions and investment performance

21
Why 401(k) Plans Became So Popular

• Pre-tax deferrals reduce current taxes
• Earnings on contributions grow tax deferred
• Employer usually matches some of employee
  contribution
• Direct payroll deduction of employee contribution
• Portability in the event of job change
• Participants gain control over retirement
  benefits

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Why Mutual FundsBecame Popular

• Services
• 800 access to account information
• Voice response units
• On-line employer access to account information
• Daily valuation and daily prices in the newspaper
• Participant communications
• Investment education
• Advice tools
• Broad investment selections
• Name brand funds
• Specialized products (e.g., lifestyle funds)

23
Mutual Fundsand 401(k) Plans

• Assets in 401(k) plans have increased, along with
  MF share of those assets
• 401(k) assets 2000 at 1.9T 2005 (exp) 3.2T
• Growth in participants 2000 at 41m 2005 (exp)
  55m
• Growth in 401(k) plans 2005 (exp) 435,000
• Growth in MF shares in 401(k) plans
• 1990 9 of assets in MF
• 199-00 45 assets in MF
• Prior to advent of 401(k), banks and insurance
  cos dominated retirement market predominantly
  DB.

24
Mutual Fundsand 401(k) Plans

• Investment options
• Employers must offer at least 3 core options to
  qualify for safe harbor
• Average number of options available is 10 (1999)
• Mutual funds are usually standard options
• Other options include
• GICS, employer stock, brokerage window, mutual
  fund window, commingled pools

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Mutual Fundsand 401(k) Plans (cont.)

• Mutual funds in 401(k) plans are almost always
  no-load
• Other services
• Daily processing (contribution, distribution,
  loans, etc.)
• Participant communication (statements, plan
  choices, telephone, internet, etc.)
• Services to plan sponsors

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SIMPLE (Small Employer) Plans

• Established as of January 1, 1997
• Created for small businesses (100 or fewer
  employees)
• Reduces administrative expenses to employer as
  compared to traditional 401(k) plans
• Financial institution responsible for majority of
  the work
• Employee
• Benefits from an employer-sponsored plan and
  automatic deduction
• Has 6,000 annual pre-tax deferral limit (in
  2001, rising to 10,000 by 2006)

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SIMPLE (Small Employer)Plans (cont.)

• Employer may either
• Match contributions dollar for dollar up to 3 of
  employees compensation
• Contribute 2 of each eligible employees
  compensation
• Trade-off for lowered matching/contributions is
  that SIMPLE plans are free from
  anti-discrimination tests that apply to 401(k)
  plans

28
Legal/Regulatory Issues

• 404(c) Regulation
• Scope
• Applies to virtually all participant-directed
  retirement plans
• Optional safe harbor for employers/sponsors
• Fiduciaries of plans that do comply will be
  relieved of liability for the results of their
  participants investment decision
• Conditions
• Offer at least three options with different
  risk/return characteristics
• Changes in investments permitted at least
  quarterly
• Participants must be given adequate information
  to make informed investment decisions

29
Legal/Regulatory Issues (cont.)

• DOL interpretative bulletin
• Limits the circumstances in which participant
  education programs would constitute investment
  advice by an ERISA fiduciary
• Examples of safe harbor information include
• Plan information
• General financial and investment information
• Asset allocation models
• Interactive investment materials

30
Mutual Fund Assets by Type of Retirement Plan
1991
2000
Source Investment Company Institute, Federal
Reserve Board, IRS, and Department of Labor
31
Expansion of Traditional IRAs

• Traditional IRAs provide tax deductions at the
  time of contribution for those that qualify (as
  fully phased in)
• Couples with income under 80,000
• Individuals with income under 50,000
• Spousal IRAs for non-working spouse (without W-2
  income)
• Eligible for own 3,000 contribution (2002 limit)
• Tax deduction at time of contribution if couples
  income lt150,000

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Expansion of Traditional IRAs (cont.)

• Individuals over age 50 may make catch-up
  contributions
• Lower-income workers able to receive a refundable
  tax credit of up to 1,000 per year
• Taxpayers qualifying for deductions at time of
  contribution must pay tax on contributions and
  earnings at time of distribution

33
Creation of Roth(back-end) IRA

• No tax deduction at time of contribution
• But earnings build up tax-free and are not taxed
  at the time of distribution if investor keeps
  assets in IRA
• For at least 5 years and
• Until age 59½
• Full eligibility for Roth IRA
• Individuals with income under 110,000
• Couples with income under 150,000

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Growth of IRAs and Benefits to Mutual Funds

• Expected to grow from 2.2 trillion in 1999 to
  gt6 trillion in 2010
• Keys to growth are
• Attracting new investors to contributory IRAs
• Continuing to attract 401(k) and other DC
  participants to rollover IRAs
• Rollover IRA is one established with assets
  rolled over from an employer-sponsored retirement
  plan (usually upon leaving)
• DC distributions rolled to IRAs are projected to
  reach 467 billion by 2010
• Although expected to grow, rollovers can now be
  rolled back to DC plans

35
Growth of IRAs and Benefits to Mutual Funds
(cont.)

• Reasons that mutual funds dominate the IRA
  marketplace
• IRA holders can control their investments through
  mutual fund selection
• There is a broad range of investments available
  under a mutual fund IRA
• Since IRAs are retail accounts, they benefit from
  all the retail services available to mutual fund
  customers
• Success of mutual funds in 401(k) marketplace has
  strengthened the attractiveness of mutual funds
  in the IRA marketplace

36
Future ofRetirement Plans

• Distribution Planning
• Current accumulation phase will shift to
  distribution phase as population ages (as baby
  boomers really move into retirement)
• Rollover IRA will become more important
• Distribution planning for retirees will become
  more important
• Fund sponsors must offer tools
• Fund sponsors must focus on appropriate
  investment products

37
Future ofRetirement Plans (cont.)

• Social Security Reform
• Aging population will stretch/break
  pay-as-you-go system
• Possible solutions being discussed include
• Reducing social security benefits for future
  retirees or raising retirement age
• Increasing payroll tax for current workers
• Diverting general tax revenues from other
  programs to pay for social security
• Allow some form of investmentpart of the trust
  fund or part of individuals accountsin the
  stock market
• Social Security debate raises questions about
  potential impact on the mutual fund industry