Retirement Benefits

MGMT 4030 - Managing Employee Reward Systems

Purpose of Retirement Benefits Income Replacement at Retirement Maintain Standard of Living after Retirement Need About 80 Percent of Pre-Retirement

Income from All Sources Retired Individuals get Special Tax Treatment,

Have Less Expenses Employer Receives Special Tax Treatment by

IRS When Benefits Are “Qualified” Use as asset to create wealth, borrow, or

estate to leave to your heirs (children, relatives or charity)

Sources of Retirement Income

When you Decide to Retire... Retirement Benefits (50 Percent) - Most

Significant Source– pensions, employer sponsored savings plans

Social Security (15 - 20 Percent) Personal Savings (25-30 Percent)

– home equity (most significant personal source),other investments

Employee Income Security Act (ERISA) - 1974 Protects Benefits from Mismanagement Eligibility for Benefits

– Employees Must Participate After One Year of Service or 1000 Hours in 12 Months

Employee Vesting Schedules - Employer selects– Vesting - right to take employer’s contribution to

plan

– Cliff Vesting - 5 Years of Service (all or nothing)

– Partial Vesting - 7 Years of Service

ERISA (Continued) Retirement Fund Administrators

Obligated to Act with Prudence When Making Investments– Only investments with reasonable risks are

acceptable (such as blue chip stocks, not Internet stocks, commodities or options).

Employers Required to Pay for Plan Termination Insurance - ensures availability of funds for retirees– Pension Benefit Guaranty Corporation -

Govt. Agency

Defined Benefit Plans

Benefit is Defined/Known in Advance Traditional Pension Plan - Large Firms

Use It Benefit is Based on a Formula

– Average of Last 5 years of Salary– Number of Years of Service

Employer Assumes All Financial Risk

Pension Fund Formula - DB Calculation

Retirement = (5 yr. ave. income) X (yrs. of service)

(Percentage factor)Example: 5 year ave. income = $50K Years of service = 30 years Percentage factor = 1.5%Retirement Income = ($50K)X(30)X(1.5%)Retirement Income = $22,500/year which is 45% of pre-retirement income

Defined Contribution Plans

Employer Contributions to Plan Are Known Benefits at Retirement are Unknown

– Depends on Success of Plan’s Investments

Employee Shares Risk With Employer– Takes Active Role in Managing

Investments Examples: 401(k) Plan, IRA, SEP, profit

sharing plan

401(k) Plans

Fastest Growing Retirement Plan Employee Contributions and Retirement

Earnings not Taxed Limit: 15% of Salary up to $10,000/year Employee in for-Profit Business Employer Matches 25 to 100 percent of

Employee Contributions May make self loans up to $50K

401(k) Plan Tips Start your 401(k) immediately, take advantage

of “miracle” of compound interest If 20 or more years from retirement, invest

aggressively in stocks When changing jobs roll over money into new

employers’ 401(k) if greater than $5K, if less than $5K roll into an IRA - there are large tax penalties for cashing out early (before age 59 1/2).

If paid in company stock, sell some of company stock when vested so there is diversification of assets and reduced exposure to risk.

Mutual Fund Investments and 401(k) PlansMutual Funds Definition: A pooled investment with

stated goals and with a professional manager.Advantages of Mutual Funds1. Diversification - risk is pooled over many

investments and accessible to middle class people.2. Professional management - full time investment

monitoring, with superior access to information.3. Flexibility - possible to move money into diverse

funds with different goals and levels of risk.

Mutual Fund Investments and 401(k) PlansTypes of Mutual Funds Low Risk

– Money Market funds– Bond Funds

Medium Risk– Stock Funds (Growth and Value funds)– Stock Index Funds (S&P 500 Index, Dow Jones

Index) High Risk

– International Funds– Small Cap Funds (small and mid-sized firms)