978-0357033616 Chapter 14 Part 2

Test Yourself

14-1 Discuss the relationship of retirement planning to financial planning. Do investment

and tax planning have a role in retirement planning?

The financial planning process would be incomplete without retirement planning. Certainly no

14-2 Identify and briefly discuss the three biggest mistakes people tend to make when

setting up retirement programs.

When it comes to retirement planning, people tend to make three big mistakes:

• Starting too late.

14-3 How do income needs fit into the retirement planning process?

or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a

password-protected website or school-approved learning management system for classroom use.

receive in retirement, along with the amount of funds you must amass to achieve that desired

standard of living. Then develop a plan to build savings to provide that amount.

14-4 What are the most important sources of retirement income?

14-5 What benefits are provided under the Social Security Act, and who is covered?

There are three basic benefits:

14-6 What is the earnings test, and how does it affect Social Security retirement benefits?

14-7 Does Social Security coverage relieve you of the need to do some retirement planning

on your own?

14-8 Which basic features of employer-sponsored pension plans should you be familiar

with?

An employee should be familiar with the following features of an employer-sponsored pension

plan:

or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a

password-protected website or school-approved learning management system for classroom use.

b. Contributory obligations specify who pays into the plan. In a noncontributory pension

plan, the employer pays the total cost of the benefits. Under a contributory pension plan, the

employee must bear a portion of this cost. Most pensions established by corporations used to be

noncontributory, but today the trend is toward contributory plans.

c. The vesting rights of the pension are the criteria the employee must meet before

he or she can obtain a nonforfeitable right to pension assets accumulated in his or her name.

Once these nonforfeitable rights are secured by the employee, they are said to be vested in the

plan. The law sets down the rules for vesting and partial vesting.

d. Retirement age is also an important feature of the plan. Most pensions specify a

retirement age, but there may provision for early retirement. Also, find out if the pension benefits

are portable—can you take them with you if you change jobs?

e. The method of computing benefits is spelled out in every retirement plan. A

defined benefit plan provides a formula for computing benefits that is stipulated in the plan

provisions. This type of plan allows employees to determine before retirement how much their

monthly retirement income will be. The formula is frequently based on number of years of

service and average annual salary, although other formulas are possible. In contrast, a defined

contribution plan specifies, how much the employer and/or employees are to contribute to the

plan, but says nothing about what the plan benefits will be. That depends on how much the

pension plan administrators are able to earn on the plan’s investments.

f. Finally, you should get a full run-down on what, if any, voluntary supplemental

programs the company offers, such as a 401(k) salary reduction plan.

14-9 Under which procedure will you become fully vested most quickly—cliff or graded

vesting?

14-10 What is the difference between a profit-sharing plan and a salary reduction, or

401(k), plan?

A profit-sharing plan may be qualified under the IRS and become eligible for essentially the

same tax treatment as other types of pension plans. An argument supporting the use of profit-

or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a

password-protected website or school-approved learning management system for classroom use.

contribution. The employee selects the amount to contribute up to a maximum of $18,000 in

2015 [the maximum changes with the Consumer Price Index. Depending upon the plan, the

funds may be investment in the company’s stock or a family of mutual funds, which is the more

common plan.

Under both plans the contributions are tax deferred [not taxed when contributed; taxed when

distributed] and they are generally invested in mutual funds. The employer may provide both

plans and the employee may decide to contribute to the 401(k) plan or not. With a profit sharing

plan, all the funds contributed are the employer’s; the employee does not contribute. With a

401(k) plan, the employee contributes their money to the plan.

14-11 Why is it important to evaluate and become familiar with the pension plans and

retirement benefits offered by your employer?

When participating in a company-sponsored pension plan, you’re entitled to certain benefits in

14-12 Briefly describe the tax provisions of 401(k) plans and Keogh plans.

The tax law generally treats qualified plans the same. The basic feature is the contributions to

14-13 Describe and differentiate between Keogh plans and individual retirement

arrangements. What’s the difference between a nondeductible IRA and a Roth IRA?

Keogh and IRAs are very similar. The major difference is the limit on the amount that may be

contributed to the plan. Keoghs are limited to $53,000 or 25% of income in 2015 [limit changes

14-14 Under what circumstances would it make sense to convert your traditional IRA to a

Roth IRA?

14-15 What is an annuity? Briefly explain how an annuity works and how it differs from a

life insurance policy.

An annuity is the systematic liquidation of an estate in such a way that it provides protection

14-16 Which one of the annuity distribution procedures will result in the highest monthly

benefit payment?

14-17 What is a fixed-rate annuity, and how does it differ from a variable annuity?

Does the type of contract (fixed or variable) have any bearing on the amount of money

you’ll receive at the time of distribution?

or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a

password-protected website or school-approved learning management system for classroom use.

Not so with a variable annuity. With a variable rate annuity, the amount that is ultimately paid

out each month varies with the investment results of the insurance company. Nothing is

guaranteed.

14-18 Which type of contract (fixed or variable) might be most suitable for someone who

wants a minimum amount of risk exposure?

14-19 How do variable annuity returns generally compare to mutual fund returns? Can

you explain why there would be any difference in returns?

The average returns on variable annuities are usually lower than the average returns on mutual

Criterial Thinking Cases

14.1 Comparing Pension Plan Features

Linda Calloway and Meredith Perdue are neighbors in Charleston. Linda works as a

software engineer for Progressive Apps Corporation, while Sherry works as an executive

for Industrial Container Company. Both are married, have two children, and are well paid.

Linda and Meredith are interested in better understanding their pension and retirement

plans.

Progressive Apps Corporation, the company where Linda works, has a contributory plan

in which 5 percent of the employees’ annual wages is deducted to meet the cost of the

benefits. The firm contributes an amount equal to the employee contribution. The plan uses

a five-year graded vesting procedure; it has a normal retirement age of 60 for all

employees, and the benefits at retirement are paid according to a defined contribution

plan.

Industrial container, where Sherry works, has a minimum retirement age of 60.

Employees (fulltime, hourly, or salaried) must meet participation requirements. Further, in

contrast to the Progressive Apps plan, the Industrial Container program has a

noncontributory feature. Annual retirement benefits are computed according to the

following formula: 2 percent of the employee’s final annual salary for each year of service

with the company is paid upon retirement. The plan vests immediately.

Critical Thinking Questions

1. Discuss and contrast the features of the retirement plans offered by Progressive Apps

and Industrial Container.

Plan feature

Progressive Apps – Linda

Industrial Container – Sherry

Type of Plan

Defined Contribution

Define Benefit

Contribution by employer

5%

Fully funded by employer

Contribution by employee

5%

none

Vesting

5-year graded

Immediate vesting

Benefits

Depends upon market results

2% of final salary for each

year of service to company

Assumed salary $100,000,

Years in service 30

Market return 6%

$10,000 per year contributed

Amount to 79.085 * 10,000

=$790,850

2% * 30 = 60% of salary

Amount to $60,000 per year

PV if live 20 years, earn 6%,

11.470 * 60,000 = $688,200.

2. Which plan do you think is more desirable? Consider the features, retirement age, and

benefit computations just described. Which plan do you think could be subject to a

conversion to a cash balance plan sometime in the future? Explain. Include in your answer

the implications for the employee’s future retirement benefits.

3. Explain how you would use each of these plans in developing your own retirement

program.

4. What role, if any, could annuities play in these retirement programs? Discuss the pros

and cons of using annuities as a part of retirement planning.

14.2 Evaluating Maria Sepulveda’s Retirement Prospects

Maria Sepulveda is 57 years old and has been widowed for 13 years. Never remarried, she

has worked full-time since her husband died 13 years ago—in addition to raising her two

children, the youngest of whom is now finishing college. After being forced to go back to

work in her 40s, Maria’s first job was in a fast-food restaurant. Eventually, she upgraded

her skills sufficiently to obtain a supervisory position in the personnel department of a

major corporation, where she’s now earning $58,000 a year.

Although her financial focus for the past 13 years has, of necessity, been on meeting living

expenses and getting her kids through college, she feels that now she can turn her attention

to her retirement needs. Actually, Maria hasn’t done too badly in that area, either. By

carefully investing the proceeds from her husband’s life insurance policy, Maria has

accumulated the following investment assets:

Money market securities, stocks, and bonds $72,600

IRA and 401(k) plans $47,400

Other than the mortgage on her condo, the only other debt she has is $7,000 in college

loans. Maria would like to retire in eight years, and she recently hired a financial planner

to help her come up with an effective retirement program. She has estimated that, for her

to live comfortably in retirement, she’ll need about $37,500 a year (in today’s dollars) in

retirement income.

Critical Thinking Questions

1. After taking into account the income that Maria will receive from Social Security and

her company-sponsored pension plan, the financial planner has estimated that her

investment assets will need to provide her with about $15,000 a year to meet the balance of

her retirement income needs. Assuming a 6 percent after-tax return on her investments,

how big a nest egg will Maria need to earn that kind of income?

2. Suppose she can invest the money market securities, stocks, and bonds (the $72,600) at 5

percent after taxes and can invest the $47,400 accumulated in her tax-sheltered IRA and

401(k) at 7 percent. How much will Maria’s investment assets be worth in eight years,

when she retires?

3. Maria’s employer matches her 401(k) contributions dollar for dollar, up to a maximum

of $3,000 a year. If she continues to put $3,000 a year into that program, how much more

will she have in eight years, given a 9 percent rate of return?

4. What would you advise Maria about her ability to retire in eight years, as she hopes to?

Terms Found in the Chapter

accumulation

period

The period during which premiums are paid for the purchase of an

annuity.

annuity

An investment product created by life insurance companies that

provides a series of payments over time.

annuity certain

An annuity that provides a specified monthly income for a stated

number of years without consideration of any life contingency.

cash-balance plan

An employer-sponsored retirement program that combines features of

defined contribution and defined benefit plans and is well suited for a

mobile workforce.

contributory

pension plan

A pension plan in which the employee bears part of the cost of the

benefits

deferred annuity

An annuity in which benefit payments are deferred for a certain

number of years.

defined benefit

plan

A pension plan in which the formula for computing benefits is

stipulated in its provisions.

distribution period

The period during which annuity payments are made to an annuitant.

Employee

Retirement Income

Security Act

(ERISA)

A law passed in 1974 to ensure that workers eligible for pensions

actually receive such benefits; also permits uncovered workers to

establish individual tax sheltered retirement plans.

fixed-rate annuity

.

An annuity in which the insurance company agrees to pay a guaranteed

rate of interest on your money.

Guaranteed-

minimum

annuity

(life annuity with

refund)

An annuity that provides a guaranteed minimum distribution of

benefits.

immediate annuity

An annuity in which the annuitant begins receiving monthly benefits

immediately.

individual

retirement

account (IRA)

A retirement plan, open to any working American, to which a person

may contribute a specified amount each year.

installment

premium annuity

contract

An annuity contract purchased through periodic payments made over

time.

Keogh plan

An account to which self-employed persons may make specified

payments that may be deducted from taxable income; earnings also

accrue on a tax-deferred basis.

life annuity, period

certain

A type of guaranteed-minimum annuity that guarantees the annuitant a

stated amount of monthly income for life; the insurer agrees to pay for

a minimum number of years.

life annuity with no

refund (pure life)

An option under which an annuitant receives a specified amount of

income for life, regardless of the length of the distribution period.

noncontributory

pension plan

A pension plan in which the employer pays the total cost of the

benefits.

Pension

Protection Act

A federal law passed in 2006 intended to shore up the financial

integrity of private traditional (defined benefit) plans and, at the same

time, to encourage employees to make greater use of salary reduction

(defined contribution) plans.

profit-sharing plan

An arrangement in which the employees of a firm participate in the

company’s earnings.

qualified

pension plan

A pension plan that meets specified criteria established by the Internal

Revenue Code.

refund annuity

A guaranteed-minimum annuity that, on the annuitant’s death, makes

monthly payments to the beneficiary until the total price of the annuity

is refunded.

salary reduction,

or 401(k), plan

An agreement by which part of a covered employee’s pay is withheld

and invested in some form

of investment; taxes on the contributions and the account earnings are

deferred until the funds are withdrawn.

single premium

annuity contract

An annuity contract purchased with a lump sum payment

survivorship

benefit

On an annuity, the portion of premiums and interest that has not been

returned to the annuitant before his or her death.

thrift and

savings plan

A plan to supplement pension and other fringe benefits; the firm

contributes an amount equal to a set proportion of the employee’s

contribution.

variable annuity

An annuity in which the monthly income provided by the policy varies

as a function of the insurer’s actual investment experience.

vested rights

Employees’ non-forfeitable rights to receive benefits in a pension plan

based on their own and their employer’s contributions.

Planning for Retirement

Chapter Outline

Learning Goals

I. An Overview of Retirement Planning

A. Role of Retirement Planning in Personal Financial Planning

B. The Three Biggest Pitfalls to Sound Retirement Planning

1. Compounding the Errors

C. Estimating Income Needs

1. Determining Future Retirement Needs

2. Estimating Retirement Income

3. Funding a Projected Shortfall

D. Online Retirement Planning

E. Sources of Retirement Income

II. Social Security

A. Coverage

B. Social Security Payroll Taxes

C. Social Security Retirement Benefits

1. Old-Age Benefits

2. Survivor’s Benefits

D. How Much Are Monthly Social Security Benefits?

1. Range of Benefits

2. Taxes on Benefits

III. Pension Plans and Retirement Programs

A. Employer-Sponsored Programs: Basic Plans

1. Participation Requirements

2. What’s Your Contribution?

3. Defined Contributions or Defined Benefits

4. Cash-Balance Plans

5. Qualified Pension Plans

B. Employer-Sponsored Programs: Supplemental Plans

1. Profit-Sharing Plans

2. Thrift and Savings Plans

3. Salary Reduction Plans

C. Evaluating Employer-Sponsored Pension Plans

D. Self-Directed Retirement Programs

1. Keogh and SEP Plans

2. Individual Retirement Account (IRAs)

3. Self-Directed Accounts and Their Investment Vehicles

IV. Annuities

A. Classification of Annuities

1. Single Premium or Installments

2. Disposition of Proceeds

3. Fixed versus Variable Annuity

B. Sources and Costs of Annuities

C. Investment and Income Properties of Annuities