Designing Our Future

Chapter 7

 

Retirement Funding

 

 

 

  There was a time when many Americans could rely on a company pension when they retired. That simply is not true today for many reasons. A primary reason is the mobility of today’s society. We change jobs often. Another primary reason is the reducing likelihood that an employer will offer a pension plan. Many companies, in fierce competition with foreign companies, are reducing costs. One way of reducing costs is the elimination of pensions that are funded by the employer.

 

  Each of us will eventually retire. Some people will work far past the normal age of retirement, but that is not the usual course taken. In fact, the goal of many thirty-somethings is to retire earlier than normal. It is interesting that at the same time those in their thirties are saying they want to retire at a younger age, those in retirement are returning to work in record numbers.

 

  Back in 1986, some type of pension plan covered approximately 50 million people. That’s not to say they were adequately covered, but they did have a pension plan of some sort. Participants represented about 3.5 trillion dollars in trust assets at that time.

 

  Pension plan participants have specified legal rights. Many people worry that their employer can reclaim their pensions in some way, but any money contributed by the employees themselves should be secure. If it is a qualified pension plan there is even more security.

 

  The basic U.S. congressional legislation that protects an employee’s retirement plan is ERISA (Employee Retirement Income Security Act of 1974). ERISA requires that anyone associated with the pension plan, including those who direct pension investments and contributions, act with the same care, skill, prudence, and diligence as a “prudent man” would in the same circumstances. Under the prudent man rule, the individual must exercise the same thought and care that a person with similar training or experience would in similar circumstances.

 

  ERISA also requires that pension participants receive notification of a plan adoption, revision, or termination, a summary plan description of any new or amended plan document, and a summary annual report after the end of each plan year. This should describe the basic total financial activity in the plan. ERISA allows the employee the right to request additional information from the plan sponsor or trustee, which must be received within 30 days at a reasonable cost. A sponsor or trustee that does not respond to such a request can be fined.

 

 

  Two government agencies were given the responsibility of enforcing ERISA rules: The Internal Revenue Service and the Department of Labor. Either one of these agencies have the authority to ensure the pension plan is in compliance with the rules established by ERISA and any other applicable legislation.

 

 

Pension Plan Players

 

  Congress is the legal body of individuals that passes laws affecting pension plans. Many of these laws have been detrimental to companies that offer pension plans, which is one of the reasons we are seeing less and less of them being offered. That does not mean that these laws were not necessary because most of them were (although not everyone agrees with this statement).

 

  The IRS and the DOL (Department of Labor) have the job of enforcing our pension laws. Congress gave them this authority.  It is the IRS that most frequently seeks compliance with the pension laws, however. The Department of Labor is more likely to deal with the rights of the participants. Neither body is actually set up to offer individual help if the pension participant believes he or she is not receiving a fair deal from their employer. Their intent is more often that of pulling more money from the plan sponsors. As a result, the individual seeking personal help may only cause themselves more problems by involving either of these government agencies. This is unfortunate since it means individuals are often forced to hire attorneys instead.

 

  Plan sponsors are business entities that choose to offer a pension plan to their employees. They take advantage of any tax shelters available as a result of this offering. The plan sponsor might be a sole proprietor, a partnership, a regular corporation, or a Sub Chapter S corporation. It is the responsibility of the plan sponsor to adequately fund the pension plan, which may come from company funds, employee funds, or a combination of the two. The plan sponsor and plan administrator are often the same entity. The administrator is the person or company that has the responsibility of fulfilling all reporting and disclosure requirements of the IRS and DOL. The plan sponsor creates a trust to receive and hold plan assets and executes a plan document that is submitted in some way to the IRS for qualified tax status.

 

 

 

  The plan trust account is established with a financial institution and can be funded or nonfunded. If it is funded, it was established with a financial institution whereas a nonfunded account would be established with an insurance company. It is possible to have a trust that has both a funded and nonfunded portion. The trust is the legal vehicle designed to hold plan assets. The trust is tax exempt since it pays no income tax on its holdings. Only the trustee has control of the trust so even though the employer might be able to make deposits on the employee’s behalf, he or she does not have access to the trust funds.

 

  The plan document is the legal directions for the trustee. It outlines what the trustee may and may not do with the trust funds. The plan document will name the plan sponsor, administrator, and trustee. If the pension plan is tax qualified, the plan document will be submitted to the IRS. If the plan document is sent to the IRS prior to signing by the sponsor it is called a prototype plan, but if it is sent after the signature is acquired it is called a custom plan.

 

  Each participant will receive a copy of what is called the Summary Plan Description (SPD). This is required by the DOL (Department of Labor). The SPD is supposed to be printed in lay terms so that a person of normal ability can read and comprehend it. Pension participants also have the right to request a copy of the actual plan document for a reasonable cost. Many pension professionals feel each plan member should order a copy and keep it on file.

 

  The plan trustee or trustees (there can be more than one) is the person or persons who is legally responsible for safeguarding the trust assets on behalf of all who participate in it. A trustee (meaning someone who holds something in trust) is a fiduciary. The trustee is expected to act as a prudent man would in similar circumstances.  Even if the trustee is the employer, he or she is legally held to the same fiduciary level as a professional trustee would be. The summary plan description is required to state who the trustee of the pension plan is.

 

  Many pension plans have a person designated as an investment advisor. The trustee often chooses to delegate the responsibility of managing the trust funds to a person with higher investment qualifications than those possessed by the trustee. The investment advisor is not always a person; sometimes it is an institution such as a bank or insurance company. Of course, the institution assigns the account to an actual individual or group of individuals. When the investment advisor is a person, he or she is often a financial planner, security broker, or even an insurance agent. An investment advisor has the same fiduciary responsibility as the trustee, meaning he or she must follow the prudent man rule and is legally responsible for errors that might be made through carelessness, failing to properly diversify plan assets, using highly speculative investments, or unethical actions.  The employees participating in the pension have no input regarding the choice of the investment advisor unless the pension plan addresses this in some way.

 

 

  Some plans allow “segregated accounts,” meaning the same choices of financial investments must be offered to all participants. The sponsor of the tax-sheltered plan cannot put all the owner’s money in an account expected to earn one rate while other participants are put into a separate account expected to receive less, for example. Some types of plans, such as 401(k) Plans, may require the plan trustee to offer a certain range of investment choices to their members.

 

  Because managing a pension plan is complex, many employers do not wish to take on the task themselves. They often hire contract administrators. These are often outside firms that keep track of changing laws, IRS and DOL rules, and anything else that would affect the pension plan. They may be referred to as pension watchdogs. It is not unusual for contract administrators to even interact with the pension participants.

 

  Contract administrators often know more about the pension plan than the employer does since these firms and individuals deal with pensions on a daily basis. He or she is a paid professional whose job is to know and understand how pensions work, the laws affecting them, and the mistakes that can potentially be made. Most companies would be wise to hire a contract administrator but not all do, since it is an additional expense to do so.

 

  The pension plan participant is the employee or any other person who contributes or has money contributed on their behalf to the plan. The employer and employee are typically both participants, each having equal rights and privileges that were given by the plan document.  Qualified retirement plans are not savings plans; they are retirement plans. This is an important legal distinction. Congress has passed several laws restricting the use of pension plans for any use other than retirement. That does not mean that there are not “savings plan” options available in pension plans. Newer plans are less likely to offer these, but they may still exist. These include (but are not limited to) such things as participant loans, hardship withdrawals, after tax voluntary employee contributions, company stock options, and the purchase of limited amounts of life insurance.

 

  Congress has given the worker’s spouse legal rights regarding pension plans. One very important right is the legal right to continue receiving income following the worker’s death. Only if the spouse waives this right may the worker draw the full monthly amount of their pension. If the spouse does not waive his or her right, the pension received each month will be reduced by approximately 20 percent (depending upon factors such as the spouse’s age) so that he or she may continue to withdraw income following the worker’s death. The monthly amount is reduced because the pension is then based on two lives rather than one.

 

  The spouse has an equal say in most pension aspects, even regarding pension loans taken out prior to retirement. In most plans, the pension participant cannot make a loan or distribution without the written consent and agreement of his or her spouse. If another person is desired as a designated beneficiary, the spouse must also agree to that since the spouse would normally be considered the beneficiary. A single participant may make any changes without anyone else’s consent.

 

 

  Spousal rights always hinge on being legally married. During a divorce, pension benefits are often a legal issue. A pension plan is legally safe from any person or creditor except the spouse in a legal proceeding, or the IRS in a tax lien. In a divorce the participant’s pension balance is considered as part of the common property of the marriage and could be divided between the two parties. A legal order signed by a judge is called a Qualified Domestic Relations Order (QDRO). The Federal ERISA law covers this.

 

  When the IRS confiscates pension funds to satisfy a tax lien it is technically against ERISA law, but despite this the action has been upheld in tax courts. It is likely that the IRS will continue to be able to attach pension funds to settle a tax lien.

 

 

How Much Money Will You Need?

 

  It may sound good to tell your friends that you plan to retire at age 50. It is an entirely different matter to actually be able to do so.  Assuming that an individual lives until the age 80 (many live longer), retirement at age 50 means there must be enough assets to pay for thirty years of life. How much money will be needed each month? Will the retiree’s dollars at age 50 go as far as they would today if the individual is currently 30 or 40 years old?

 

  It is important for individuals to know what you are saving for, but it is equally important to know what the cost will be. For example, it would be very difficult to save for a new car if the buyer had no idea what the cost would be. Goals need an ending point (when there is sufficient cash to buy the car, for example) and this is just as true for retirement as it is for making a purchase. It is unfortunate that too few people have calculated how much their retirement will cost them. It is certainly more complicated than planning to buy a car, but the results can make the difference between living comfortably and living in poverty. Most people would agree that they would rather have too much money for retirement than too little.

 

  Too many Americans reach retirement only to discover they don’t have enough money to fund the cost of it. There are many reasons for this, but the fundamental reason is simple: they did not save enough.  Most people get sidetracked with the desire for a new car, new furniture, new anything. While we may believe that the day-to-day costs of living take everything we earn, how will we deal with retirement when there are not enough funds for even the basic needs of rent, utilities, medical care, and food?

 

  By calculating the cost of retirement, the time left until retirement, and the amount of savings currently in place for that goal, a person can determine how much should be saved on a monthly basis.

 

  Step 1: What will the basic costs of retirement be? It is true that we cannot say exactly what costs will be in the future, but we can use the starting point of what it currently costs each month to pay for rent or a mortgage, property tax, utilities, insurance for auto, home, and health, and food. Extras, like traveling, could be included but usually the starting point does not include non-essential items. One extra that probably should be included is the cost of long-term care.  That could be handled with an insurance policy to keep the cost lower. For our example we will use $4,000 per month, but each person should use a figure based on his or her current expenses with at least 6 percent inflation added in.

 

  Step 2: What is one’s current age? This determines the length of time that exists to save for the cost of retirement. 

 

  Step 3: How many years does the individual expect to live in retirement? That will depend upon the age at which he or she expects to retire. Family history of longevity must also be considered (the age the individual anticipates living to).

 

  Step 4: What is the current income and expenses? While it makes sense to save whatever is necessary for retirement it may not be possible if current spending levels are too high. This is probably why so many people fail to save adequately for retirement – they never want to face the possibility of having to spend less today.

 

  Let’s take this through the mathematics:

 

  $4,000 current monthly expenses X 12 = $48,000 yearly X 30 years = $1,440,000. This does not factor in what it will cost to live in the future. As we know, it costs more to live each year as our dollar has less spending power due to inflation and increased costs of living.

 

  The often heard “I will have Social Security income to help out” is just a way to avoid cutting back on spending to save more. Even factoring in the highest amount available from Social Security, it will not be adequate. Many professionals recommend using a factor of 3.3 percent per year until retirement to cover increases in costs of living above the increases given in Social Security. Health care costs will grow faster than Social Security income so any increases in Social Security will not be adequate. If a person only had Social Security to live on, there would be a retirement shortfall of approximately $1.3 million just to cover the basic-needs gap for thirty years of retirement.  Therefore, it is that $1.3 million that must be saved during one’s working years.

 

  Not everyone will live thirty years in retirement, but many will. The length of time will depend upon health factors, family longevity, and the age of retirement, but thirty retirement years is likely for many people. If a person has 28 years in which to save for retirement, he or she would need to save at least $1,000 per month, assuming an annual interest rate that is high enough to match inflation, which we know is often not the interest being earned. In recent years, investors have had a hard time finding 3% in a safe vehicle.

 

  Many people begin saving for retirement far later than they should so there is no way to save adequately for retirement. The longer one waits, the more he or she must save each month.

 

 

  Many professionals believe that anyone saving less than 10 percent of their income is not saving adequately. It does not matter what income level exists; 10 percent must be saved. If an individual is not saving at least 10 percent, he or she is spending too much and there will be inadequate funds for retirement.

 

  Where funds are held can also impact the bottom line. No-load funds should always be sought. Commissioned funds can rob the account of all earnings, especially in low interest rate markets.

 

 

Inflation

 

  Inflation is the largest thief of a retiree’s dollars. Inflation affects virtually every type of investment in one way or another.  There is no type of investment that escapes inflation. Inflation is also affected by other elements, such as political climates and programs, tax laws, and even investment fads.

 

  Once an individual retires, safety of accumulated assets becomes a big concern since there is no easy way to make up financial losses.  Therefore, the retiree is likely to seek out safer investment vehicles, which are likely to pay a lower rate of return. As a result, even if an individual is playing the stock market today (and possibly doing well) it is unlikely that he or she will want to do so in retirement. Risk takes on a different meaning when there is no longer any earned income to offset losses in stocks.

 

  Since inflation and interest have much in common (although one is negative while the other is positive) looking at how interest earnings work will help to understand the negative effects of inflation.

 

For Example:

  An investment of $10,000 earning an interest rate of 5 percent will accumulate an additional $500 now equaling $10,500. Along comes inflation. For this example, we are using an inflation rate of 4 percent. Therefore, the same $10,000 will experience an inflationary loss of $400. The end result? Instead of earning $500 the investment earns only $100.

 

  When inflation is higher than the interest being earned the investor experiences a loss. If inflation were 5 percent while the investment was only 4 percent, the end result would be a loss of $100 so that the investor ends up with $9,900 rather than the $10,000 he or she began with.

 

  It isn’t just inflation that robs an account; taxation also takes its cut.  If the investor had his or her $10,000 in a Certificate of Deposit, for example, at year’s end the investor must also pay taxes on any interest earned. The Internal Revenue Service does not consider the effects of inflation, so even if the investor lost money in real spending power, IRS would still tax any interest earnings. Therefore, not only did inflation remove the interest earned but also IRS then takes an additional bite. If the investor has his or her funds in an annuity or other tax-deferred account, taxation will be deferred until funds are withdrawn. The investor would try to withdraw funds at a time when taxes would be lowest.

 

  Obviously, it is not an easy task to determine how much one must set aside to cover thirty years of living. It is also obvious that it would be better to save too much than not enough since an individual cannot determine future rates of inflation.

 

 

  If an individual is currently living on $3,000 per month, it is conceivable that the same standard of living during retirement will require $5,000 per month. Thirty years at $3,000 per month equals $1,080,000. Thirty years at $5,000 per month equals $1,800,000.  That is one million, eight hundred thousand dollars! Few people realize the amount of money it takes to live on for thirty years, so it is little wonder that few Americans save adequately for retirement.

 

  When setting aside money for retirement, most people will combine a permanent portfolio with a variable portfolio. The permanent portfolio will include investments that are intended to be “permanent” or long-term. The variable portfolio will include those investments that are short-term (Certificates of Deposit are often the preferred short-term investments). These are usually flexible, allowing for changes as needed or desired by the investor.

 

 

Company Sponsored Pension Plans

 

  When a company-sponsored pension plan exists, it will be one of two types: defined benefit plan or a defined contribution plan. A pension plan defines either the benefits to be paid the employee at retirement or the annual contributions employers must pay to buy retirement benefits for the worker.

 

  Although many pension plans have floundered over the past years, the PBGC provides financial backing. The Pension Benefit Guaranty Corporation (PBGC) released 2018 numbers in 2019. The PBGC is in a better financial state than it was just five years ago when it showed a positive net position of 2.4 billion in late 2018. It came from a negative net or “deficit” of $10.9 billion at the end of 2017. Despite the improvement, financial figures show the possibility of insolvency by the end of fiscal year 2025. It was because of interest rates during the low period that took PBGC from a deficit to positive numbers since the low rates reduced the amount of debt held. As of September 2018, the program had liabilities of $56.2 billion and assets of $2.3 billion, so a deficit existed for $53.9 billion, down from the previous year’s $65.1 billion. The Pension Benefit Guaranty Corporation’s annual report is issued each year, usually at the end of the third quarter.

 

  PBGC protects the pension benefits for millions of Americans in private-sector pension plans. PBGC is heading towards insolvency despite improvements and eventual bankruptcy unless legislation prevents it. The Pension Benefit Guaranty Corporation receives no taxpayer dollars, instead funded by insurance premiums and investments. They also receive assets and recoveries from failed single-employer pension plans in some cases.

 

  The majority of the PBGC’s money comes from investment returns on corporate assets assumed from companies that turn over their pension liabilities to the government. The agency also collects premiums from employers whose plans it guarantees. When pension plans shut down without enough funds to meet their obligations, PBCG guarantees up to a set amount per retired employee per year. The exact amount varies based on several factors, including retirement age. 

 

  While it is comforting to know that our pensions have a guaranty fund there are caps placed on the maximum amount that is insured. Individuals expecting more income, based on what was in their retirement fund, will not be happy. The PBGC is subject to the limits imposed by Congress each year. The limit mostly affects higher salaried employees.

 

  When a pension plan bankrupts the people most affected are those near retirement or already in retirement. If those already in retirement receive more than the amount covered by the PBGC they will see a monthly reduction in their pension. Those nearing retirement may find themselves receiving much less each month than they had been promised. If their lifestyle cannot continue at the reduced amount the worker may have to work longer than planned to make up the shortages. Defined benefit plans use a formula reflecting years of work and final average pay. The longer one works the more he or she has at retirement. Therefore, someone on the verge of retirement has few options to make up what they will potentially lose by a pension crash.  The PBGC will determine the benefit based on salary and years of service as of the plan termination. If an employee has worked for a company 30 years when its pension plan is assumed by the PBGC, but retires five years later, his payout is based on 30 years rather than the 35 he worked. This is also true for the salary-figure used. The worker’s final and most lucrative earning years are ignored by the PBGC.

 

 

  Many analysists question whether the Pension Benefit Guaranty Corporation can keep up with the number of defined benefit pension plans that are likely to end. In the airline industry alone, they have taken over the pensions for Eastern, Pan Am, TWA, US Airways, United and American Airlines.

 

  Sometimes pensions continue with court protection from creditors under Chapter 11 of the bankruptcy law. Manufacturing industries are likely to see defined benefit pension assumptions by the PBGC.

 

  Workers who have defined benefit pension plans should save as though they do not have such a plan. Workers should utilize 401(k) plans if they are available as well as personal savings of at least 20% of gross income even if current lifestyles are affected, says one certified financial planner who saw many of her clients lose great portions of their retirement. Of course, we know that few Americans will save if it means a change in their current lifestyles. Americans are procrastinators when it comes to setting money aside for retirement.

 

 

Defined Benefit Plans 

 

A defined benefit plan promises the employee a fixed dollar benefit at retirement. The pension is related to the employee’s salary and length of employment. The more money paid in, and the more time allowed for accumulation, the larger the pension will be. These plans are often associated with large manufacturing, mining, and finance industries. They are also associated with the growth of the labor industry (labor unions).

 

  Defined benefit plans promise a lifelong string of payments, beginning at retirement. They are based on a pre-set formula that considers such things as gender, age, length of service, and other relevant factors. The employer assumes all the investment risk, promising to pay the retired worker a regular income even when investments perform poorly.  The accrued benefits cannot be reduced.

 

  Defined benefit plans account for around ten percent of traditional pensions, down from 60 percent in the 1980’s. This is not true for government workers where 90 percent continue to be covered with defined benefit plans. This could change, however, as the individual states face budget problems. Most financial experts feel defined benefit plans will cease to exist as current plans end in favor of less costly employer pension plans. Defined benefit plans are costly for employers because workers are living far longer today than when this type of plan was first conceived.[1] Employers compete globally today rather than nationally which also affects their ability to offer this type of pension plan.

 

  Where defined benefit plans are involved with unions, such as the auto manufacturing industry, it will be harder to dissolve defined benefit plans because they are part of collective bargaining.  Even though it may make the company unprofitable or in a difficult position to compete globally, it is likely that the unions will refuse to give up these lucrative benefits.

 

  It is not just the airlines and auto-manufacturing companies that have used defined benefit pension plans. Many states have as well.  State and local governments often provided their workers with defined benefit retirement plans. These are funded with tax dollars. Since they are so expensive to maintain some states have been looking at offering defined contribution plans instead. Lawmakers nationwide face problems of funding pension plans for current retired public workers, so obviously they cannot continue to offer these plans.

 

  We read about the financial problems Social Security funding is having, but we are less likely to hear about the same issues faced by defined benefit plans. Millions of retired teachers, judges, law enforcement, and other public employees now rely on public pensions with additional millions expecting benefits when they retire.  All of this requires tax dollar funding.

 

  Periods of poor investment returns, rising benefits, longer life, and states’ failures to properly fund their plans have created a gap between assets and benefits in many states.  In 2012 the Government Finance Officers Association (GFOA) recommended that every state and local government offering defined benefit pensions formally adopt a funding policy providing assurance of future funding.

 

  A sound funding policy means incorporating several principles and objectives. Governments must continue to obtain no less than biennially an actuarially determined contribution to serve as the basis for its contributions. The ADC should be calculated in a manner that fully funds the long-term costs of promised benefits while still balancing other obligations.

 

  Many states are acting now by proposing a variety of retirement restrictions and changing how they offer pension plans. Most states are trying to move to a defined contribution pension plan and away from defined benefit pension plans. Many of the changes will include later retirement requirements, working generally two years more than previously required. Some states have increased employer and employee contributions to stabilize financing. Many states will be selling bonds for state pension and social service programs.

 

 

  Defined benefit plans are changing, even at the government level, over to defined contribution plans. Nine out of ten state retirement plans currently provide a defined benefit retirement plan, but thanks to the popularity of the 401(k) plan that is changing. It will not be an easy changeover, but the change is necessary as funding defined benefit plans becomes increasingly difficult.

 

  There are disadvantages in defined benefit plans. These plans are very expensive for the employer, which has contributed to the decline in pension plan offerings. Administration is complicated and difficult for employees to understand. Defined benefit plans require an actuary to operate. Considering this, it is not surprising that defined benefit plans are disappearing. Some have actually gone bankrupt, placing a strain on the PBGC (Pension Benefit Guarantee Corporation).

 

  For those working employees who are currently part of a defined benefit plan he or she can probably assume:

1.     The company they work for is doing well financially, and

2.     The company has decided to keep this plan rather than change to a defined contribution plan as many companies have done.

 

  Defined benefit plans reward long periods of service with the same company or same group of companies. Older employees who have at least ten years of employment with the same company or group of companies before they retire are likely to be the most satisfied with their pension plan. Those with less than ten years of service will not benefit as greatly as those who have ten or more years.

 

  Once the worker retires and begins collecting from his or her defined benefit plan the sponsor may never take away the benefits that have accrued. This is true even if the plan sponsor is no longer doing well as a business or has been taken over by another firm. Even if the defined benefit plan becomes insolvent there is a measure of protection from the PBGC.

 

  Workers should realize that a company experiencing financial problems probably couldn’t afford to continue their defined benefit plan. In fact, if the firm does not change the plan, they might even be considering reducing the work force if they do not freeze the pension plan benefits at current levels. Many companies, even when not experiencing financial difficulties have changed their pension plans to Profit Sharing Plans or 401(k) Plans as a means of reducing the costs associated with defined benefit plans.

 

  Many professionals, such as doctors and lawyers, actually prefer defined benefit plans for personal use.  They can accrue large amounts later in their career, retire, and terminate the plan taking their pension with them. Professionals usually run the plan for ten to fifteen years in order to accumulate enough assets within the pension plan.

 

 

Defined Contribution Plans

 

  A defined contribution plan permits the employee, the employer, or both to invest a certain sum each year (before taxation) on behalf of the employee. The employee is entitled to the accumulated funds upon retirement. Company thrift and profit-sharing plans are defined contribution plans. Employers may choose to match funds deposited by their employees or set aside a percentage of profits. Employee contributions and all their earnings are tax deferred. Taxes will be assessed upon withdrawal. If the defined contribution plan performs poorly, the losses eventually come out of the employee’s pocket.

 

  Defined contribution plans became popular at the end of World War II and have grown as more companies move over to them. As Americans have become very job-mobile, these plans are more likely to work for those who change jobs often over the span of their working years. They offer a year-by-year benefit, which accumulates along with the growth of dollars previously contributed.

 

  Defined contribution plans may be based on a set formula, called a money purchase plan, or be based on yearly company profits, called a profit-sharing plan. Between the two, profit sharing plans are more widely used.

 

 

  The employee will assume the investment risk under a defined contribution plan. The amount received each month in retirement will be directly related to how well the investments performed during the pre-retirement years. A defined contribution plan is not insured by the PBGC or any other agency.

 

  The defined contribution plans are popular with small and medium sized companies since they are more flexible and certainly less costly to fund. They are also easier to administer so that companies with few extra dollars could do the task themselves.

 

  Despite the fact that the employee takes on the investment risk rather than the company, they have tended to perform well as long as the workers are young enough to weather investment losses and they work sufficient years to build up the account.

 

  Of course, not all pension plans are equal. Some are better managed than others; some receive more funding than others, and so forth. If the company (employer) becomes insolvent it will certainly affect the continuance of the pension plan. Although employees do have rights regarding their pension plan, few people actually pay attention to how it is performing. Most individuals are likely to assume their employer knows what they are doing – whether that is actually true or not.

 

  Even when a pension fund is well managed and adequately funded, the employee may expect more at retirement than he or she actually receives. The monthly payments could be much less than was expected from reading pension statements. The monthly payment is usually derived from a formula that takes into account how long the retiree is expected to live. Additionally, according to a company survey by Hewitt Associates, only three percent of companies give cost-of-living raises to pensioners.

 

  Many companies have a minimum employment period before the employee becomes “vested.”  Becoming vested means the individual is entitled to keep the benefits built up even if he or she leaves the company prior to retirement age. Of course, the longer the employee works for the company the more time there is to build up funds and accumulate interest earnings. Individuals who change jobs frequently cut their odds of lasting at any firm long enough to become vested.  Additionally, employees who work for small companies often get less generous pension plans that their counterparts at major corporations that have more dollars to work with.

 

  There is more to vesting than one might realize. If an employee does not see a vesting statement on their plan summary, he or she should ask their employer for specific facts regarding it. Vesting percentages and vesting balances should be in writing in the employee’s plan summary. Vesting should be at least at 20 percent after 3 years of creditable working history. No more than 1,000 work hours per year may be required for vesting, although it can be less. That means that those who work at least 20 hours per week would qualify for vesting.  By seven years, the employee should be 100 percent vested. Many companies vest earlier than that.

 

  Not all companies vest by percentages. Some use what is called “cliff vesting.” There is no vesting interest for a set number of years at which time the employee is instantly vested at 100 percent. Usually, the time period is between three to five years, depending upon the company size and company policy.

 

  When a new pension plan is begun the employee will not always receive credit for previous time with the company. The employee may have to begin the vesting period from the time the pension plan was born. Service with the company prior to the age of eighteen may also be excluded.

 

 

401(k) Plans

 

  401(k) Plans are now offered through many employers. 401(k) Plans are defined contribution plans. Created by Congress in 1978, IRS Code Section 401(k), these plans shift the burden of providing retirement benefits from the employer over to the employee. That simply means employees must take on the responsibility for funding their own retirement rather than counting on their employer to do it for them. Many employers are willing to cover the expensive administrative fees associated with this type of pension plan, which makes it that much more attractive for the employee. Many employers will also match all or a portion of what the employee contributes, up to specified limitations or percentages. When that is the case, the employee should contribute as much as allowed by the 401(k) Plan in order to receive full employer matching status.

 

 

  401(k) Plans may be offered by employers in addition to another type of pension plan or it may be the only type of pension plan available through the company. Some employers offer matching funds for 401(k) contributions. When this is the case, employees should always make the maximum contributions allowed. Some 401(k) Plans include a hardship withdrawal feature or the participant loan feature. Even if this is offered, however, funds should be considered retirement funds – not money available for other purposes.

 

  We know that Americans are not statistically good savers in general and this includes saving for retirement. 401(k) Plans place the entire responsibility for retirement saving directly on the employee. If he or she fails to contribute to the 401(k) Plan, there will be no funds for them at retirement. Employers may offer matching funds, but if the employee deposits nothing, the employer deposits nothing. If the worker is at least 21 years old and works at least 1,000 hours per year, within one year of employment the employer must give the worker the chance to participate in the company’s 401(k) Plan. In order to participate the employee must authorize the payroll department to have a certain percentage amount (usually up to 15 percent) deducted from their paycheck before state or local income taxes are deducted. The income taxes that were saved will be due when funds are withdrawn from the 401(k) Plan.  Social Security taxes will still be levied on the amount deposited into the 401(k) Plan.  Therefore, only state and federal taxes are saved on the 401(k) contribution – not social security payroll taxes.

 

  The employee makes investment decisions for his or her 401(k) Plan, but the plan sponsor will have narrowed the choices. The IRS only requires the sponsor to offer a specific number of diversified groups of investments (at least 3). Employees have the right to move their funds at least quarterly. Some companies may offer a “daily pricing” or “daily transfer” option.

 

  Upon retirement the tax deferred 401(k) funds may be rolled into the employee’s personal IRA, although there are IRA contribution limitations. It is often wise to seek professional tax advice prior to making such decisions. Employee contributions are always 100 percent vested, as legally required.

 

 

Collecting Pension Funds

 

  Employees should assume their pension would replace no more than 60 percent of their pre-retirement income. Seldom is a pension generous enough to equal their working income. The theory is that there will be fewer costs once retirement arrives. Unfortunately, that is seldom true unless the retiree plans to give up many activities previously enjoyed. While some expenses will be less, such as gas to commute back and forth to work or work-related clothing, there will be other expenses that take their place, such as health and long-term care insurance. At one time, many corporations continued health care coverage into retirement, but that is less likely to happen today. In the future it is likely that few companies will be able to afford the expense of providing health care for their retirees, even though they may do so during employment.

 

 

  If a worker meets their goal of an early retirement, pension income is likely to be reduced. Many employers cut benefits by a third or half for those who retire at age 55 or earlier.

 

  Marriage may also affect the amount of monthly retirement income. In most cases, the pension is reduced by 20 percent in order to provide income to the legally married spouse after the worker has died. Employers pay insurance companies more for an annuity for a couple than for a single person.  The cost is passed on to the employee in the form of a smaller pension.

 

  When an employee is vested, the law requires companies to give the spouse at least one-half of the pension benefits after the death of the worker, unless the spouse waived that right. Why would a spouse waive this right? Because he or she wanted to receive a higher monthly income while the worker was alive. There may be another choice: the pop-up option. If the spouse dies first, the pension reverts to the higher monthly income for the single worker.

 

  Companies may reduce their pension contribution if the worker will also receive Social Security. This is not illegal since the company must pay into Social Security on behalf of the employee. The pension summary that is provided to workers will note this. When this is the case, the employee will have their pension reduced by the amount of Social Security they are expected to receive, which could be more than expected on benefits accrued through the company plan’s fiscal year.  Subsequent benefits fall under a newer tax rule that guarantees the employee at least half of the company benefit.

 

 

  A pension plan is funded when assets are accumulated in advance to pay benefits at the time of retirement. A trustee or an insurer usually administers these assets. Pension assets are committed irrevocably to a pension annuity or other vehicle. A funded pension guarantees that participants will receive their full pension benefits only if the plan is fully funded. In order to be funded, a sufficient amount must have been paid in to cover the past service liability and sufficient contributions must be made each year to cover current service benefits as they accrue.

 

  Pension liabilities are divided into two parts:

1.     Accumulated past service, and

2.     Current service when earned. 

  Liability for accumulated past service includes not only liability for benefits earned prior to the plan being initiated, but also for any improved benefits for past service if the plan happens to be altered in some way.

 

  Discharging all past service liabilities in one payment would usually be prohibitive so the technical requirements for a fully funded plan are seldom met. A less stringent definition of a fully funded plan would allow past service liabilities to be covered by installments spread over the time until each employee retires.

 

  In a defined benefit plan the employer’s contributions must be determined actuarially. Actuaries must make reasonable assumptions about interest rates, mortality rates, employee turnover, retirement ages, salary scales, and administrative expenses. Although this is not an exact science, those who work with pension plans become very good at estimating. These assumptions and benefit levels determine estimated costs of the plan; the final cost will depend on how reality meets estimations.

 

  When judging the actuarial soundness of a pension fund, not only its liabilities must be viewed, but also its assets. Valuation of assets requires that realistic values be placed on the fund assets. Some types of assets are difficult to value, such as real estate holdings or unsecured notes.

 

  Defined benefit plans require some specific elements for adequate funding:

1.     Reasonable funding standards,

2.     Realistic actuarial assumptions for measuring liabilities, and

3.     Sound procedures for valuation of assets.

 

  Defined contribution plans do not need actuarial estimates since contributions determine what the worker will receive at retirement.  Contributions are determined by the plan agreement, usually being a percentage of the employee’s earnings. Even though there is no actuarially computed employer contribution that does not cause the plan to be unsound. As long as the employer makes the required contributions, the plan is fully funded, and the employee has the security the plan promises. Once the employee retires, the amount he or she receives from their pension plan will be determined by the amount that has accumulated in the account and the mortality, interest, and expense assumptions used to determine the benefit per $1,000 of accumulations.

 

  Under a defined contribution plan, contributions are segregated and used to finance the employees’ retirement benefits through immediate payment either to a life insurer or a trust (a trust is usually situated with a bank). If an insurer is used, funds are typically deposited in one of two ways: (a) in a series of single premium deferred annuities for each employee’s retirement or (b) they are invested in various ways until the employee retires. If an annuity was used, retiring employees will receive a pension amount equal to the sum of the single premium annuities purchased on his or her behalf during their employment. 

 

  If pension contributions were paid to a trustee, funds may accumulate with the trustee purchasing immediate lifetime annuities at the time of the employee’s retirement or the trustee can accumulate pension funds, bypass the insurer, and pay lifetime annuities from these funds directly to the retired employee. The amount paid by the annuity, whether through an insurer or privately held by the trustee, will depend upon the amount accumulated, current interest rates, mortality, and expense assumptions made by the trustee’s consulting actuary.

 

  Since the employer must meet certain requirements under ERISA, it is important that they use assumptions to determine retirement benefits rather than rely solely on predictions determined by employer contributions. Using statistic assumptions reduces the employer’s risk of failing to meet ERISA’s funding standards. Since ERISA, 80 percent of new plans have been defined contribution plans rather than defined benefit plans. Many existing defined benefit plans shifted to defined contribution plans as well.

 

  Why are companies shifting over to defined contribution plans? It would seem simple enough to meet minimum funding standards for defined benefit plans (which state in specific dollar terms how much will be received in retirement) but that is not necessarily the case.  Minimum funding calls for full funding of current service costs when incurred and full funding of any supplemental liability over a designated period, usually ten to thirty years. A pension is a long-term financial commitment, subject to changes in the law and outside influences beyond the company’s control. There may be mandated changes in the pension plan benefits, costing the employer more than anticipated. There may be actuarial experience that deviates from the original assumptions, which affect the pension. Revaluation might occur that affect the actuarial assumptions that were originally made.  Current changes could also affect future assumptions making the cost higher than anticipated or planned for. Because a pension is a long-term commitment, today’s costs affect the plan’s effectiveness for years.

 

 

  Techniques for spreading pension costs are called actuarial cost methods. While it is more complicated than we will go into, in simple terms they are the accrued benefit cost method and the projected benefit cost method. Pensions usually include two cost elements: normal costs and supplemental costs.

 

  Normal costs are the annual costs of funding current service benefits. Supplemental costs are those of discharging the accumulated liability for service performed in the past.

 

  There are several cost methods used. One of these is the accrued benefit cost method, which assumes that an employee earns a precise unit of benefit for each year of eligible service. Ineligible periods would not affect the equation. The current or normal service cost for each year is the benefit earned times the cost of that benefit. This does not necessarily produce a level annual pension charge because as employees age, the cost of providing employee service benefits typically increases. Only when employee turnover produces a constant age distribution, and the supplemental liability remains constant would the employer’s pension costs be a level annual charge. Both conditions are unlikely to exist.

 

  Under the accrued benefit cost method each benefit is fully funded as it accrues. When this method is used, a precisely determinable benefit must be allocated to each year of service. Usually, the basis for allocation is specified in the plan’s benefit formula.

 

  The accrued benefit cost method can be used even when the formula does not precisely allocate benefits to each year of eligible employment. In this case, the employer would make the allocation by dividing the projected benefit by the number of years of remaining service and a projected benefit. The employer’s allocation is not scientific, so a better approach is to use the projected benefit cost method. This method may be used either on an attained age or an entry age normal basis. “Normal” means the typical age standard used.

 

  When a projected benefit cost method is used, the pension is funded with equal annual contributions. Normal and supplemental costs are combined. The full cost is spread over the period elapsing from the employee’s age when first eligible (attained age) for the pension plan until retirement actually occurs. Contributions are level and calculated to be sufficient to fully fund the supplemental liability by the time the employee retires. Unless the plan is fully funded by insurance or annuity contracts, the attained age basis will not meet ERISA’s minimum funding standards because the plan is likely to include employees with more than thirty years of remaining service.  This extends the supplemental liability funding period beyond the maximum years allowed.

 

  Usually, supplemental costs and normal costs are handled separately using the entry age normal basis. In computing current service (normal) costs, this basis assumes that costs accrue before the plan is installed and that the employer has funded past service benefits for each employee from the point he or she first became eligible to participate in the pension plan. Of course, this begins the plan with an initial past service supplemental liability. The current service cost would be lower because it is computed at the employee’s lower entry age rather than the higher attained age. The initial supplemental liability offsets the lower current service cost. The employer’s annual pension cost is a level contribution sufficient to cover current or normal service cost and at least the amount required to fund the initial supplemental cost in equal payments over thirty years.

 

  So far, it has been assumed that the cost for each participant’s projected benefit has been separately calculated with the employer’s total cost being the sum of these calculations. This method is called the individual projected benefit cost basis. An aggregate projected benefit cost basis can be used to compute the employer’s annual pension cost without identifying particular employees. The aggregate level projected benefit cost basis requires fewer computations than the individual basis. Employees are divided into age groups that are usually banded by five-year increments. Computations are made from the midpoints of each group.

 

  When a bank or individual trustee is the funding agency, the plan is called a trust fund plan. When a life insurer is the funding agency, the plan is called an insured plan. When both agencies are used, the plan is called a split-funded plan.

 

  In trust fund plans, employers give the contributions to a trustee who invests them and pays the benefits according to the plan’s specifications. The plan is suitable for employers with sufficient employees to predict mortality within an acceptable range and who are financially able to handle losses that could occur if mortality experience goes beyond the anticipated range. The trust fund plan is popular with multi-employer and union pension plans.

 

 

  With an insured plan, employers transmit the contributions to an insurer who invests them and pays the scheduled benefits. Guarantees made by the insurer depend on the insurance contract selected. This contract is often called a funding instrument.

 

  When insurers are the pension funding agencies, two types of funding instruments are used:

1.     Allocated Funding Instruments, where cash value life insurance or deferred annuities are immediately purchased for each participating employee, and

2.     Unallocated Funding Instruments, where the funds accumulate and are used later to purchase immediate annuities for employees upon their retirement and pay any contractual benefits due to terminated employees.

 

  Allocated funding instruments have three forms: individual life or annuity contracts, group permanent life, and group deferred annuities.  Unallocated funding instruments include group deposit administration contracts, immediate participation guarantee plans, and guaranteed investment accounts. Unallocated funding instruments grew from the efforts of insurers to improve their competitive position among banks and other pension funding agencies.

 

 

At Retirement

 

  Even though today’s society typically has two working partners, it is not typical for both to have earned a pension. In many families, the wife does not have continuous employment because she worked between pregnancies, took time off to care for an ill parent, or left to follow her husband’s career as he moved around the country pursuing better pay or opportunities. Many women do not begin a vesting period until later in life when children are independent, and the husband has settled into a permanent job. Because she no longer has the time to invest in a long-term job, if she earns a pension, it will be small compared to her husband’s – if he is lucky enough to have one.

 

  Most professional financial planners no longer factor in a company-sponsored pension. It is simply wiser to save as though none will exist.  If a pension is present at retirement, it is always better to have more than expected rather than less.

 

  When a couple retires with a pension some decisions must be made.  The first will be whether to receive the pension for the life of both spouses (receiving a lesser monthly amount) or to waive the pension for the spouse following the worker’s death and receive a higher monthly income. The amount of the reduction for covering both lives will depend upon some elements involved – especially the age of the worker’s spouse. If the spouse is considerably younger than the worker, it can have a dramatic impact on the monthly income reduction. Usually, it is possible to expect a 20 percent monthly reduction in pension payment, but a much younger spouse will make the reduction greater.

 

  Insurance agents often suggest that the higher pension be taken, waiving the pension on the spouse. Then purchase a life insurance policy on the life of the worker paying the premiums from the extra monthly income received. When the worker dies, his or her spouse receives the insurance proceeds. If the spouse dies before the worker, he or she can surrender the policy, taking any cash value, and continue to receive the higher monthly income.

 

  While the insurance policy sounds like a sensible avenue the future cannot be predicted. The pension income is a sure thing while continuing the life insurance policy premiums may not be. If premium rates are not guaranteed to stay at a specified dollar amount, increasing age may cause the premium level to become unaffordable.  Inflation may cause even a level premium policy to become unaffordable.  As the value of the dollar declines, the worker may find that he or she is no longer able to pay the premium, even though they took the higher monthly pension income.  A lapsed premium means no protection for the non-pension spouse. If the choice comes down to purchasing food or healthcare or continuing the policy, the policy will lapse.

 

  When a life insurance policy is kept active, the surviving spouse will collect the proceeds once the insured dies. Many spouses, however, find that the proceeds are not adequate to last for her remaining lifetime. Additionally, receiving a lump sum, as is usually the case, may not be invested wisely providing a continuing monthly income.  Statistically, when a lump sum is received from any source (life insurance, court settlement, or lottery winnings) a great deal of the money is initially wasted. It may be a child that needs the down payment on a house; it may be a dream vacation that becomes very extravagant, or a luxury item that would not otherwise have been purchased. Whatever the reason, if the life insurance settlement is not invested into an annuity or other vehicle that will continue providing adequate monthly income, the spouse may find herself without the amount of income the pension would have provided.

 

  While many of today’s workers want to retire early, some companies are hoping workers will do so. They may even tempt higher paid employees with early retirement incentives. Companies have a financial reason for doing so. Even though they may give the employee a cash incentive, the cash will be far less than it would have cost the company to keep the employee, paying not only wages, but also health benefits, and various payroll taxes on their behalf. In most cases, these early retirement incentives are offered to employees between the ages of 50 and 60 but it will vary depending upon the situation and the company.

 

   Almost every company pension plan provides for early retirement.  Most of them cut early retirees’ pension income by less than the actuarial tables would mandate. Even so, the difference in payments can be substantial.

 

  What many workers also fail to realize is that their pensions would be higher had they continued working, continuing to build up their pension accruals. When the cut in benefits for early retirement is combined with the loss in pension accruals (which contribute to the final valuation of monthly pension income) the actual loss could be as high as 75 percent. In other words, the retiree receives only 25 percent of what they would have received had he or she had waited to retire until age 65.

 

 

  Money managers believe most people will need between 70 percent and 80 percent of their pre-retirement income to maintain a similar standard of living.  Inflation will certainly play a role. While it is not possible to know exactly where inflation will be, most managers use a rate of 4 to 6 percent when evaluating future needs. An individual who has not yet retired may not realize some future expenses, such as paying for health care over a long period of time. In fact, one of the most overlooked expenses is for long-term nursing home care. A healthy 50-year-old may not consider his health at age 70 or 75 when this type of care is often needed. The longer one expects to live, the more likely that some form of long-term nursing care will be needed.  Many people end up in the nursing home not due to illness, but due to frailty, resulting from simple old age.

 

  We often hear working individuals say their retirement is the home they will have acquired and paid for.  While there are programs geared towards providing income from home equity, all of us must live somewhere. Therefore, even if a home is sold, another must be purchased, or monthly rent must be paid. It is better not to consider one’s home when formulating retirement income. Again, if it turns out that the home does provide a bulk sum of money or monthly income, it will simply be additional to what already exists. More is always better than less.

 

  Any time the combination of company pensions added to Social Security falls below what will be needed to live in retirement, the difference must be made up. Without personal savings to make up this difference, retirees may find themselves returning to work. Some retirees discover they prefer working, but no individual wants to be forced back to work to have adequate income.

 

  Social Security penalizes those who retire early. At age 62, the earliest age that Social Security benefits may be received unless disabled, the monthly payment is about 20 percent less than benefits that begin at age 65. As more and more people approach retirement, we may see the “full” retirement age continue to be pushed farther back.

 

 

  Around 70 percent of pension plans allow the worker to take their retirement funds in a lump sum settlement. Some individuals believe they can do more with their money than the pension plan will.  Additionally, many people no longer have confidence that their pension will remain solvent and available. Even if the pension does remain strong and well managed, we can understand why Americans may feel this way. We have seen multiple examples of unethical company behavior.

 

  When a lump sum seems advisable, it is very important that the money be moved in its entirety into a vehicle that will provide continuous income. If even a portion is used for any other purpose, it may defeat the purpose of the pension – to provide retirement income.  It is also best to move directly into another vehicle to prevent taxation of the withdrawn income. Having the money moved to an Individual Retirement Account may be the best choice so that the funds never touch the worker’s hands.

 

 

End of Chapter 7