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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?
© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole
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:
© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole
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-
© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole
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?
© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole
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
