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
The plans are examples of the two major types of plans. If make assumptions in last row of table
above, the plans will yield very similar benefits. The defined benefit plan has a larger present
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.
As above, the defined contribution plan has a larger present value and a greater risk. The option
to convert to a cash balance will give the plan portability, so that if the employee leaves the
3. Explain how you would use each of these plans in developing your own retirement
program.
The defined contribution gives the employee more control over their benefits along with more
risk. When you are 50 years old and have a balance of $500,000 in a retirement plan, if the
market drops 10%, it is likely that you will be concerned and have more stress in your life. With
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.
Most likely when employee reaches retirement age, the retirement funds will be converted to an
annuity funded by the balance in the defined contribution plan or by the employer for the defined
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?
Future Value of $1 at 5% for 8 years from Appendix A = 1.477; for $72,600 * 1.477 = $107,230
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?
$3,000 by Maria plus $3,000 by employer, $6,000 per year, 9%, 8 years, From Appendix B,
4. What would you advise Maria about her ability to retire in eight years, as she hopes to?
From sum of amounts in part 2 and 3, she will have a nest egg of $107,230 + $81,433 + 66,168 =
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
*Test Yourself*
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
*Test Yourself*
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
*Test Yourself*
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
*Test Yourself*
Summary
Financial Planning Exercises
Applying Personal Finance
Your Ideal Retirement Plan!
Critical Thinking Cases
14.1 Comparing Pension Plan Features
14.2 Evaluating Maria Sepulveda’s Retirement Prospects
Money Online!