 Personal Finance PowerPoint presentation. Employer pension plans. Prepare to get financially fit by practicing personal finance. Support accounting instruction by clicking the link below giving you a free month membership to all of the content on our website broken out by category further broken out by course. Each course then organized in a logical reasonable fashion making it much more easy to find what you need than can be done on a YouTube page. We also include added resources such as Excel practice problems PDF files and more like QuickBooks backup files when applicable. So once again click the link below for a free month membership to our website and all the content on it. In prior presentations we've been focusing in on retirement planning. In prior sections we talked about investment in general different investment strategies and tools. Now we want to focus specifically on retirement planning. First listing out the major sources of income what we're typically going to be living on in retirement. So we might have sources of income that could include employer pension plans. We could have a public pension plans by the way we're going to focus in on the employer pension plans here. The public pension plans we can in essence think of as kind of equivalent to the employer pension plans but if working in the public area I'm also going to include in here the benefit programs that we might have including the social security and then possibly you can think of Medicare and Medicaid as kind of like a source of income as well. I'm skeptical of including those in our retirement planning as though we're going to be dependent upon them however because there could of course be changes in the laws going forward related to them. So how big of a component they will be in our retirement planning will be dependent upon our particular circumstances. We'll talk more about that later. Personal retirement plans so we might have our personal savings which could include things like an IRA and you could include like a 401k. You might think of it basically here or you can basically think of it you know as as something similar to the employer pension plan or a 403b or you might have other savings that are going to be that you set aside for retirement. We'll talk more about some of those plans in a future presentation and then we have annuities which is another vehicle often used which we've talked about in prior presentations but we might look at more specifically here geared towards retirement. So most of this information comes from Investopedia. Our pension plan we're focusing in on the pension plan component at this point in time. You could check them out online and this is by the Investopedia team updated August 30th 2021. So we're focusing in on what is a pension plan. So a pension plan is an employee benefit that commits the employer to make regular contributions to a pool of money that is set aside in order to fund payments made to eligible employees after they retire. So note that oftentimes our retirement planning is kind of tied in with our employer which has pros and cons. It's kind of similar to the health insurance. Part of the reason that happened is because there's tax benefits to it and part of the reason is because that pooling component can be advantageous at times. This has become more and more problematic going forward because some of the strategies for retirement calculations and planning have proved difficult going forward. Meaning if they make bad investments for example or the company goes bankrupt or something like that it's going to cause a problem on the public sector side. That's less of an issue because they can always raise taxes but you have these deals that could come up to be possibly not as favorable to the taxpayers and also people in these days might not be at the same job as much as they were before. So having things like your health insurance and your retirement planning tied to the job can be kind of a little bit more problematic if you're moving around. These kind of benefits are also a way that employers can kind of lock people into a job because if these things are tied to your job then of course you're going to be more committed to the job possibly. So in any case traditional pension plans have become increasingly rare in the U.S. private so they have been largely replaced by retirement benefits that are less costly to employers such as the 401k retirement savings plan. So a 401k plan that's why we can think of it kind of like a personal savings plan but it's still kind of connected to the work which gives you generally certain tax benefits as well. So it's still kind of linked but it's format how it's going to be executed is a little bit different than a traditional kind of pension plan which we'll get into in a little bit more here. Still about 83 percent of the public employees and roughly 15 percent of private employees in the U.S. are covered by a defined benefit plan today according to the Bureau of Labor Statistics. So notice it's a lot bigger on the public employee side of things and oftentimes it's a it's kind of a better or more guaranteed kind of benefit program so oftentimes in the public side it used to be on the public side you had kind of better benefits but usually were paid less but then as public unions have kind of it seems like they get paid as much and they got the better benefits seems like a little bit are going here because again when when these kind of negotiations happen with relation to pension plans the taxpayers the one that pays for that so it's kind of so politically it's kind of a skewed situation whereas on the private sector side of things obviously if it if it bankrupts the company they can't go to tax revenue to try to try to fix it so they have to make sure that they have a negotiation that's viable years into the future whereas on a political side they really only need to the politician making the deal only needs to make it viable for the short term right because then it's the next guy's problem after a while so that's kind of an issue there but in any case understanding pension plans a pension plan requires contributions by the employer and may allow additional contributions by the employee the employee contributions are deducted from wages so they're going to take it out of the wages as a withholding the employer may also match a portion of the workers annual contribution up to a specific percentage or dollar amounts you could have that matching component where the employer matches which could be a huge benefit program so there are two main types of pension plans the defined benefit and the defined contributions plans so these two are accounted for a little bit differently and can be a little bit work you know can have more complexity or less complexity the defined benefit plan and a defined benefit plan the employer guarantees that the employee will receive a specifically monthly payment after retiring for life regardless of the performance of the underlying investment pool now this is a guarantee which you can see is a is a can be problematic right because if the investment pool invests poorly they still have the guarantee for life and also it takes into consideration a lot of unknowns such as how long is the person going to live so if if in a negotiation you make a poor calculation in terms of how long people are going to live and you make poor investments you can find you can find companies that could end up in trouble with that kind of plan that's why that's why it takes on a bit of risk there so the employer is thus liable for a specific flow of pension payments to the retiree in a dollar amount that is typically determined by a formula based on earnings and years of service so you got this standard calculation you've been there longer you've got years of service and your top income so when you think about people in retirement you're often thinking what if i'm related to a defined benefit plan where am i standing what's my biggest in what's my top income how long have i been here what's going to be the amount of money i'm going to get based on that kind of calculation if the assets in the pension plan account are not sufficient to pay all the benefits that are due the company is liable for the remainder of the payment so that could be a problem clearly so defined pension employer sponsored pension plans date from the 1870s the american express company established the first pension plan in 1875 at their height in the 1980s they covered 38 percent of all private sector workers so that's could be a high benefit plan so the defined contribution plan in a defined contribution plan the employer commits to making a specific contribution for each worker who is covered by the plan this may be matched by contributions made by the employee the final benefit received by the employee depends on the plan's investment performance so now you can see this is a little bit more risk off of a situation because now you're saying hey look it's going to be dependent in part on the performance in terms of how much how much you're going to get rather than us just committing upfront no matter what happens kind of in the future right so the company liability ends when the total contributions are expended so the 401k plan is in fact a type of defined contribution pension plan although the term pension plan is commonly used to refer to the traditional defined benefit plan so this is where the terminology gets a little bit confusing so when you say pension plan you could be referring to like a 401k which in the private sector is is the more common type of plan but you might have people that are saying pension plan and they're thinking you know a traditional kind of pension plan in their mind so you gotta you gotta kind of make sure that you're getting an understanding what with what is meant by the terminology both of them like we say is kind of going through or connected in some way to the employer the 401k plan you can think of as as kind of similar or the employer equivalent or similar has similar characteristics as like an individual type of IRA although you could have more benefits to the 401k such as being able to put more money in it and you might have the matching contributions so if you have access to these benefit plans in your employer through your employer they're often great to be able to take advantage of although it does require cash flow to do so so the defined contribution plan is much less expensive for a company to sponsor and the long-term costs are difficult to estimate accurately they also put the company on the hook for making up any shortfalls in the fund that's why a growing number of private companies are moving to the defined contribution plan so the best known defined contribution plans are the 401k and it's equivalent for not-for-profit employees the 403b so oftentimes if you're if you're looking at people that are working for the government they might be switching over into a similar plan as the 401k plan a defined contribution plan which would typically be a 403b so if you hear someone has a 403b that's kind of like a 401k but they probably work for the government in some way variations some companies offer both types of plans they even allow participants to roll over 401k balances into defined benefit plans so there is another variation the pay-as-you-go pension plan set up by the employer these may be wholly funded by the employee who can opt for salary deductions or lump sum contributions which are generally not permitted on 401k plans otherwise they are similar to 401k plans except that they rarely offer a company match a pay-as-you-go pension plan is different from a pay-as-you-go funding formula and the latter current workers contributions are used to fund current benefits social security is an example of a pay-as-you-go program so social security we'll talk possibly more about social security in the future but one of the issues with social security is that it's not like you're paying into the system at this point in time in order to have that money grow and then you take that money out in the future no it's set up so that the money that's going into the system now is paying for the current beneficiaries that are receiving the money at this point in time so one of the issues that happens with that or one of the problems is going to be well if there's fluctuations in like the amount of income or the workflow or the population then you're going to have these fluctuations in terms of of how you're going to be able to fund the plans and that's one of the issues with the baby boomers going through going through because that they now the people that are funding it might have less of a population than the people that are in retirement that causes kind of the problems so there's a lot of kind of issues with the social security in terms of how they're going to make that work in the future which again is one of the reasons that you would like to be able to make a plan not dependent upon it and hope that you still get it and if you do great if you don't you know it's not it's not the end of the world hopefully but in any case pension plans factory in ERISA the Employee Retirement Income Security Act of 1974 ERISA is a federal law that was designed to protect the retirement assets of investors the law establishes guidelines that retirement plan fiduciaries must follow to protect assets of private sector employees so note one of the issues with these kind of pension plans would be like if for example they the pool of investments were all invested in the company itself that becomes an issue because if the company goes bankrupt then then the benefits are all worthless at that point in time and you could see why they would want to do that like a company is going to say hey look this is our company A we're going to we're going to give you a a retirement plan which we're going to invest in our company which means that the people working in the company have a very big interest in making sure that the company does well which might make them work harder right but the problem is then you're not diversified in your portfolio and if the company goes under it not only devastates the employees in terms of their current salary it also just ruins their retirement plan because now now the retirement plan was all funded by the same company that they're currently working in that's a high level of of non-diversification so so there became issues with that and so then there became regulations related to it and so on and the here we go round and round we go so companies that provide retirement plans are referred to as plan sponsors fiduciaries and e r i s a requires each company to provide a specific level of information to employees who are eligible plan sponsors provide details on investment options and the dollar amount of any work or contributions that are matched by the company so it's got to be specific the other kind of issue you have of course is that is that you you you can't be like discriminatory in some ways in the nature meaning not like typically like racial discrimination or anything like that but generally if you only give if you say you have a 401k plan there's going to be rules in terms of who has access to the 401k plan you can't just pick uh in general usually you can't just pick you know the high income uh individuals there's got to be some kind of consistent rules on who qualifies for the pension plan and who doesn't qualify for the pension plan that everybody can look at be clear about and see what the benefits are uh with them employees also need to understand vesting which refers to the amount of time that it takes for them to begin to accumulate and earn the right to pension assets so vesting is based on the number of years of service or other factors so there might be a period in time that you're going to be in place before you're able to participate so pension plans vesting enrollment in a benefit in a defined benefit plan is usually automatic within one year of employment although vesting can be immediate or spread out over as many as seven years leaving a company before retirement may result in losing some or all pension benefits now you can see how this then can be used as a tool by the company to try to lock in good employees right they're going to say now you know if you're if you're losing your pension plan that's going to be a lot more difficult to leave to leave an uh employer so again there's pros and cons to that kind of system whereas if they hire just contractors or something the contractors are going to be there as long as the money's there and then they're then they're take it off so with the fine contribution plans and individual contributions are 100 invested as soon as they are paid in but if your employer matches those contributions or gives you company stock as part of a benefit package it may set up a schedule under which a certain percentage is handed over to you each year until you are fully vested so just because retirement contributions are fully vested doesn't mean you're allowed to make withdrawals however so so they're putting money into the retirement plan it's under the retirement plan which has certain restrictions to you taking the money out that's the point because you're typically getting tax benefits from that that kind of contribution as well so you can't just take the money out without having a problem so our pension plans taxable most employer sponsored pension plans are qualified meaning they meet internal revenue code 401a and employee retirement security act of 1974 requirements that gives them their tax advantaged status for both employers and employees this is often why the retirement plan is tied to work because you got these tax benefits related to it so and you could have other plans that have tax benefits like an IRA but there's limitations like matching contributions and like like the limit in terms of how much you could put in so contributions employees make to the plan come off the top of their paychecks that is are taken out of the employee's gross income so you got your gross income if you're putting money in from your income they're going to take it out and then your net pay will be after the amount that they put into the plan that effectively reduces the employee's taxable income and the amount they owe the IRS come pay tax day so you get to defer the tax generally meaning when you pay into the plan it's generally not included in income that will be reflected in your w2 where you have box one you got box three you got box i believe five which are all income boxes but box one is income subject to federal income tax which will be lower than say box five which is the Medicare box i believe and that's the in part of that will be if you have put money into a 401k plan the money you put into the 401k plan so in essence it's already been deducted out of the box on the w2 which is going to be used to calculate your your taxes although it still could be subject to other taxes possibly like social security medicare but maybe so funds placed in a retirement account then grow at a tax defined deferred rate meaning no taxes due on the funds as long as they remain in the account so meaning now you've got your funds in essence generally like you can think of in a mutual fund that is under the umbrella of like a 401k plan for example it's going to grow meaning you might have income due to dividends you might have interest income you might have then just a growth in terms of the value of the stocks that invested which you haven't sold so they haven't been realized but the fund may buy and sell them which means there could be capital gains which would be realized for taxes if not under the umbrella of the 401k plan all that income then deferred until the point that you take the money out hopefully in retirement if done well then you get that huge deferral and then your tax when you take the money out so both types of plans allow the worker to defer tax on the retirement plans earnings until withdrawal begin this tax treatment allows the employee to reinvest dividend income interest income and capital gains all of which generate a much higher rate of return over the years before retirement so upon retirement when the account holder starts withdrawing funds from a required pension plan the federal income taxes are due some states will tax the money too so if you contributed money in after tax dollars your pension or annuity withdrawals will be only partially taxable partially taxable qualified pensions are taxed under the simplified method so can companies change plans yes they can change plans some companies are keeping their traditional defined benefit plans but are freezing their benefits meaning that after a certain point workers will no longer accrue greater payments no matter how long they work for the company or how large their salary grows so if they're in the older like traditional plans which are more risky to the company the company might be saying hey we have an obligation to the people up until this point we're going to try to transition and if they do that then you would think they're going to say hey we're cutting the line right here nothing's going to happen beyond that point and then we're kind of convert into the new plan which could be a tedious process but one that might be worth doing for companies it's harder to do on the public side of things because on the public sector uh then then people are going to perceive that you're not giving them as big a benefit right and that's not good politically and so as long as the politician keeps the current cohort happy then it's the future guy's problem that has to try to cut back the benefits which is almost impossible which means they they grow infinitely but in any case when a pension plan provider decides to implement or modify the plan the covered employees almost always receive credit for any qualified work performed prior to the change the extent to which past work is covered varies from plan to plan when applied in this way the plan provider must cover this cost retroactively for each employee in a fair and equal way over the course of his or her remaining service years pension plan versus pension funds when a defined benefit plan is made up of pooled contributions from employees unions or other organizations it is commonly referred to as a pension fund managed by professional fund managers on behalf of a company and its employees pension funds can control vast amounts of capital and are among the largest institutional investors in many nations their actions can dominate the stock market 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 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 may be allowed as well since benefits do not depend on asset returns benefits remain stable in a changing economic climate businesses can contribute contribute more money to a pension fund and deduct from their taxes when they when with a defined contribution plan a pension fund helps subsidize early retirement for promoting specific business strategies however a pension plan is more complex and costly to establish and maintain than other retirement plans employees have no control over the investment decisions in addition an excise tax applies if the minimum contribution requirement is not satisfied or if excess contributions are made to the plan and employees payout depends on the final salary and length of employment with the company no loans or early withdrawals are available from a pension fund and service distributions are not allowed to a particular before age 59 and a half taking early retirement generally results in a smaller monthly payout monthly annuity or lump sum with a divine benefit plan you usually have two choices when it comes to distributions periodic usually on a monthly basis payments for the rest of your life or lump sum distribution get it all in a lump sum some plans allow participants to do both that is they can take some of the money in a lump sum and use the rest to generate periodic payments obviously there's typically a time kind of difference in a time value of money right so if you take the lump sum up front you get the lump sum if you get the money over an extended period of time it's going to be it's going to take into consideration the time value of money and then of course you often you also have the component in terms of when does the payment in possibly upon death which means you're also thinking about what the life expectancy will be in terms of which would be better in terms of a lump sum payment up front or a series of payments over the life on a monthly basis so in any case there will likely be a deadline for deciding and the decision will be final there are several things to consider when choosing between a monthly annuity and a lump sum on the annuity side of things remember an annuity is like a series of payments possibly until some future point in time or until death if you're talking about this type of annuity monthly annuity payments are typically offered as a choice of a single life annuity for the retiree only for life or as a joint and survivor annuity for the retiree and spouse so you want to take into consideration life expectancy how does it tie together with the retiree and with their spouse the latter pays a lesser amount each month typically 10% less but the payouts continue until their surviving spouse passes away some people decide to take the single life annuity when the employee dies the pension payouts stop but a large tax-free death benefit is paid out to the surviving spouse which can be invested so can your pension fund ever run out of money theoretically yes but if your pension fund doesn't have enough money to pay you what it owes the pension benefit guarantee corporation the PBGC could pay a portion of your monthly annuity up to a legally defined limit for 2019 the annual maximum PBGC benefit for a 65 year old retiree is $67,295 of course PBGC payments may not be as much as you would have received for your original pension plan so you got possibly some coverage there in the event that they basically go bankrupt so annuities usually pay at a fixed rate they may or may not include inflation protection if not the amount you get is set from retirement on this can reduce the real value of your retirements each year depending on the rate of inflation at the time on the lump sum side of things what if i take it up front a lump sum if you take a lump sum you avoid the potential if unlikely danger of your pension plan going broke so that's one thing to consider it's not likely the pension plan is going to go broke but at least you got you got that covered because you got the money right now plus you can invest the money so clearly if you get the money up front then you can put it somewhere hopefully get a return on it keeping it working for you and possibly earning a better interest rate too so if there is money left when you die you can pass it along as part of your estate so if you get the lump sum and you die then then you have the money whereas if you get the monthly payments and you die then the annuity stops at the point of death so on the downside there's no guaranteed life income it's up to you to make make the money last so clearly if you have a monthly kind of situation then you might live to what if you live to be 150 right if you took the lump sum out like you know 50 years ago then it might not be lasting that whole time so if you expect to live forever if you expect to live a longer time frame then it might be beneficial to take the monthly payments because then they're gonna have to pay that you're gonna pay that thing out until i keel over i'm still hanging on i'm still hanging on so and unless you unless you roll the lump sum into an IRA or other tax shelter accounts the whole amount will be immediately taxed and could push you into a higher tax bracket that's also going to be an issue because we have a a tax bracket that's a progressive tax bracket so if you have to record all of the income at one time in one tax year you're going to be subject possibly to a higher tax bracket than if you got it gradually over multiple years and typically from a tax planning strategy that's one of the things that we're trying to do we're trying to say is there a way that i can live off money that only has part of it taxable possibly because it's not under the umbrella of an IRA or possibly it's in a it's in a Roth IRA or something like that so i have lower income on a year by year basis even though i have a good standard of living in terms of what i'm living on so if your benefit if your defined benefit plan is with a public sector employer your lump sum distribution may only be equal to your contributions with a private sector employer the lump sum is usually the present value of the annuity or more precisely the total of your expected lifetime annuity payments discounted to today's dollars of course you can always use a lump sum distribution to purchase an immediate annuity on your own which could provide a monthly income stream including inflation protection as an individual purchaser however your income stream will probably not be as large as it would with an annuity from your original defined benefit pension fund so which yields more money then that's the big question the lump sum or annuity if i have the choice with just a few assumptions and a small math exercise you can determine which choice yields the largest cash payout you know the present value of lump sum payments of course but in order to figure out which makes better financial sense you need to estimate the present value of annuity payments meaning you have a stream of payments in the future if you can try to take that stream of payments and discounted present value it then you can compare that to the lump sum payment to figure out the discount of future expected interest rate for the annuity payments think about how you might invest the lump sum payments and then use that interest rate to discount back the annuity payments so you might think about how you're going to invest what's going to be the rate of return using that as the discount rate on the annuity payments so a reasonable approach to selecting the discount rate would be to assume that the lump sum receipt invests the payment in a dividend investment portfolio of 60 percent stock and 40 percent bonds so using historical averages nine percent for stocks five percent for bonds the discount rate would be 7.4 percent imagine that sarah was offered $80,000 today or $10,000 per year for the next 10 years on the surface the choice appears 80,000 versus 100,000 which is the 10,000 times the 10 years take the annuity but of course the 10,000 is going to be given over the 10 year life this is often also a bit simplified because we we don't know if it's going to be 10 years also because you might have it for life meaning you could live 10 years or you could live you know 100 whatever more years they might come up they're coming up with a new thing to make you live forever won't that kill the insurance companies in any case 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 the 7.4 percent which is took a look at 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 the $68,995.33 sarah would take the lump sum payment so this implied example does not factor in adjust adjustments for inflation or taxes and historical averages did not generate future returns so obviously when you think about a calculation like this one they kind of they assume 10 years into the future which which might be you might have to make an assumption in terms of life expectancy they also made an assumption about the discount rate that they're going to be using based on prior prior year returns and then you also have the tax implications that could be a factor well as well that could be significant because again if you took the $80,000 in year one that's going to be that might push you into higher tax brackets if you had to be taxed on all of that then if you took the $10,000 per year over the 10 years all could be relevant factors but in any case other deciding factors there are other basic factors that must almost always be taken into consideration and any pension maximization analysis these variables include your age your current health and projected longevity how long you're going to live your current financial situation what do you have to live on at this point the projected return for a lump sum investment your risk tolerance inflation protection a state planning consideration so when you die you're going to have you're going to have what's going to happen to your state you have a state taxes that you're going to deal with as well defined benefit versus defined contribution what is the difference a defined benefit pension plan guarantees an employee a specific monthly payment for life after retiring the employee usually may opt instead for a lump sum payment in a specific amount a defined contribution pension plan is a 401k or similar retirement plan the employee and the employer may make a regular contributions to the account over the years the employee takes control of the account after retiring and the employer has no further responsibility both plans have distinct tax advantages for both employees and employers most public sector employees still have defined benefit pension plans but private employers increasingly don't offer them some lucky people work for employers who offer both how long does it take to get vested under a pension plan vesting can be immediate but it may kick in partially from year to year for up to seven years of employment if you contribute money to the plan it's yours if you leave if your employer kicks in money it's not all yours until you are fully vested leaving a job earlier than retirement can affect your eligibility for a defined benefit pension