Retirement Plans: Private Employment Based Plans

(Summary of Ch. 17, The Risk Management by Herrington)

One risk faced by every individual is that their human capital will decline. Productivity, especially physical productivity generally declines after some age, which is part explains why people choose to stop working and retire. The primary reason is that employers of retirement plans are to reduce taxed for employees and improve labor productivity.

Employer sponsored retirement plans can be divided into two general categories: Defined Benefit Plans and Defined Contribution Plans.

In a Defined Benefit Plans employer promises employees a monthly retirement benefit that is defined by a benefit formula. The employer (and sometimes the employees) contribute to a fund, and the define benefits are paid from the asset in the fund. If the assets have a lower than expected return then the employer has to make additional contributions to pay promised benefits. Consequently the employer bears most of the investment risk associated with pension asset.

With a Defined Contribution Plans the employer and often the employee makes a specific or scheduled contribution to a firm. The contributions are invested on behalf of the employee and the employees retirement benefit depends on the investment returns. Employee receives the accumulated value of all contribution and the associated investment earnings. Thus, employees bear most of the investment risks in define contribution plan.

During 1990s interesting hybrids of Defined Benefit and Defined Contribution Plans became more popular. The most common is known as a cash balance plan. These plans operate like defined plans from a sponsor perspective and are classified as defined benefits plan for regulatory purposes. But cash balance plans are similar to Defined Contribution Plans from an employee perspective.

Qualified Retirement Plans satisfied the regulations necessary to receive preferential tax treatment. In a qualified plan, contributions and earrings on the pension assets are tax deferred to the employee. The combination of tax deferral of contributions and tax deferral of investment earnings implies that employees essentially earn the before tax rate of return on money contributed to a qualified plan. The returns that can be earned by saving for retirement through a qualified plan can materially exceeds those that can be earned outside of a qualified plan.

Often the Benefit formula in a Defined Benefit Plan is structured so that benefits are strongly backend loaded. The backend loading of benefits imply those employees can suffer large losses in the value of their retirement benefits. If they leave the firm or the firm terminates the plan prior to retirement. Consequently, the backend loading discourages turnover, which provides greater incentives for employers to make investments. In training employees and provides employees with incentives to put forth greater effort.

There are some incentive effects of employers sponsor pension plans: 1) To increase employee productivity by inducing greater employee effort and by reducing turnover; 2) To promote retirement at an age when employee productivity often declines.

Types of defined contribution plans: Money Purchase and Profit Sharing Plans, Sanction 401(k) Plans, Employee stock Ownership Plans, Simplified Employee Pensions (SEP) and SIMPLE Plans, Growth in Defined Contribution Plans.

Money Purchase Plan is in which the employer makes contributions on behalf of the employee regardless of the firms profit when Profit Sharing Plans depends on the firms profit.

Sanction 401(k) Plans have grown dramatically in the past two decades these plans are defined contribution plan that allow employees to make discretionary tax deferred contributions subject to some limitations. Employers often match employee contributions.

ESOP (Employee Stock Ownership Plans) is a defined contribution plan that is required to hold at least 50 percent of its assets in the sponsoring firms stock. This is promoted because of improving employee productivity by tying employee compensation to the firms stock price and improving labor relations and having a disadvantage that it forces employees to hold poorly diversified portfolios.

Growth in Defined Contribution Plans is a good option for small corporations when having advantages of corporate finance perspective and labor contracting.

Self-employed individuals can establish retirement plans called Keogh Plans for themselves and full employees. These plans can be either defined benefit or defined contribution plans. From a regulatory and tax perspective, they are treated very similarly to corporate sponsored retirement plans.

Individual retirement accounts (IRAs) allow people who not participants in employee sponsored plans to save for

retirement and receives the same tax benefits as qualified plans. Participant in employer sponsored plans also can contribute IRAs under some circumstances. Annual contributions to IRAs, however, were limited to $3,000, in 2002. Roth IRAs were introduced in 1998. The tax treatment of Roth IRAs and traditional IRAs differs.

ERISA (Employee Retirement Income Security Income), which was introduced in 1974, regulates private pension plans. It imposes participation, vesting and non-decimation rules that plans must satisfy. It also mandates minimum finding of define benefits plans.

Define Benefits Plans can be over funded or under-funded (i.e. the value of pension assets can exceeds or fall short of the present value of promised benefits). ERISA established PBGC to ensure the promised benefits of employees who participate in under-funded plans that terminate.

Above all are the components of private employment based retirement plans. People who are going to retire or have a good retirement plan doing job in private can choose anyone that suits his policy.