Retirement Management Flashcards
1
Q
401(k) Plans
A
- AKA cash or deferred arrangement (CODA) plan, is a qualified profit-sharing or stock bonus plan that contains a salary deferral feature.
- All 401(k) plans are profit-sharing plans while not all profit-sharing plans have a 401(k) feature
- A loan is not required to be offered by an employer
2
Q
When would an employer choose 401k?
A
- When the employer is interested in supplementing an existing defined benefit or other qualified retirement plan to provide an additional employee savings vehicle.
- When the employer is interested in providing a qualified retirement plan for employees but cannot afford a significant investment beyond plan installation and administration costs. While employers may make contributions to a traditional 401(k) plan, the plan may be funded almost entirely from employee salary deferrals.
- When the employee group is relatively young, has the ability to accumulate several years of contributions, and is willing to accept a certain degree of investment risk on their accounts.
- When the employee group is interested in a certain degree of choice in the amounts that they wish to tax-defer for retirement savings.
3
Q
Profit Sharing Plans
A
- Qualified, defined contribution plan that allows an employer to contribute to the plan under either a discretionary or formula provision
- Profit-sharing plans are often designed to function more in the context of a tax shelter for business earnings than as an employee retirement plan. Profit-sharing plans are generally not structured to provide a pension benefit at retirement but rather to offer employee participation in company profits. Funding of the plan may vary greatly from year to year
- By meeting the tax law qualification requirements, the employer is able to take advantage of tax-favored benefits, including being able to deduct employer contributions to the plan when made. In addition, contributions and subsequent earnings are not taxable to the employee until distributed.
- Subject to ERISA
4
Q
When would an employer choose profit-sharing plan?
A
•When company profits tend to vary widely from year to year (e.g., in a cyclical business).
•When the employer would like to supplement an existing defined benefit plan to provide a more balanced employee retirement plan.
•When the employer wants to implement a qualified plan that includes an employee incentive to participate in the increase in company profits.
•When the employee group is relatively young, with the ability to accumulate several years of contributions, and is willing to accept a certain degree of investment risk on their individual accounts.
- Using an age-weighted profit-sharing plan, an older employee may receive an increased contribution amount. Older employees receive a higher percentage contribution relative to younger employees for a given level of compensation
5
Q
Defined Benefit Plans
A
- Plan that specifies the amount of benefit promised to the employee at retirement. As with any other defined benefit plan, the employer assumes the risk, funds are guaranteed by the employer
- DB plans do not have individual participant accounts, each participant has a percentage claim on the overall fund, typically distributed in the form of a lifetime annuity
- Enhanced deductibility of the plan contribution often leads cash-rich employers to adopt this type of plan
- Subject to both ERISA requirements and IRS regulation
- Mandatory insurance coverage by the government-sponsored Pension Benefit Guaranty Corporation (PBGC).
6
Q
When would an employer choose DB plan?
A
- When the employer is interested in, and capable of, guaranteeing a specific benefit amount to employees at retirement.
- When the business owner is an older participant who needs to defer a large amount of taxable income. Defined benefit pension plans provide the maximum tax shelter potential available under any qualified plan.
- When the employer is interested in providing an attractive retirement benefit for highly compensated or older participants, regardless of length of service.
7
Q
Cash Balance Pension Plans
A
- Qualified pension plan in the DB category that provides a specified employee benefit, which is funded by annual employer contributions to hypothetical individual employee accounts (commingled in a large trust account)
- Investment returns on contributions are also hypothetical and are based on a fixed rate specified in the plan or on a floating rate based on an external index.
- A “smoke and mirrors” type of defined benefit plan that is designed to look and function like an employee-defined contribution plan
- Allocations and investments are controlled solely by the employer
- All employees receive the same contribution regardless of age for a given level of compensation
- An employee may not withdraw the account balance unless the employer gives the employee a lump-sum distribution option.
8
Q
When would an employer choose Cash Balance plan?
A
- When the employer is a mid-size or larger corporation who is interested in a less costly alternative to a traditional defined benefit plan.
- When the employer is interested in providing a defined benefit plan that is simpler to explain to its employees. In a cash balance pension plan, employees receive an annual statement showing their allocated account balance.
- When the employee group is relatively young, with the ability to accumulate several years of contributions and prefer a guaranteed rate of return on their accounts.
9
Q
Hybrid Plans
A
- Treated as a defined contribution plan to the extent that benefits are based on the separate account of a participant, and as a defined benefit plan with respect to the remaining portion of the plan’s benefits
- Differs from a target benefit plan in that a hybrid plan includes a definitely determinable employee retirement benefit when the employee retires, while a target benefit plan does not.
10
Q
Non-qualified Deferred Compensation Plans
A
- Secular Trust: FUNDED trust where specific funds are set aside for the employee. These funds are insulated from the claims of the employer’s general creditors. However, all assets placed in the trust are taxable to the employee. Secular trusts are generally used as a conversion vehicle for rabbi trusts in instances where the employee participant may have concerns about the employer’s ability to avoid creditor claims and prefers a greater level of asset security.
- Rabbi Trust: UNFUNDED nonqualified plan that is subject to the claims of the employer’s general creditors. However, in a rabbi trust, unlike a traditional unfunded plan, the employer is barred from accessing participant funds. In this way, the participant in a rabbi trust receives more protection from the potentially unscrupulous actions of an employer. The employer likewise is not tempted by the easy access and availability of employee retirement plan funds.
11
Q
Inflation-adjusted Interest Rate
A
- The inflation premium is an adjustment to the real risk-free rate to compensate investors for expected inflation and tightening or easing of monetary policy due to inflationary expectations.
12
Q
Serial Payments
A
A serial payment is a payment that increases at some constant rate on an annual basis, usually the inflation rate. The last serial payment will have the same purchasing power as the initial serial payment.
13
Q
Mortgage & Mortgage Payments
A
- More than $548,250 as “jumbo mortgages”
• Typically carry a higher interest rate compared to conventional mortgages.
• Typically enforce stricter qualification standards and/or rules.
• Typically require higher down payments (e.g., 20% minimum).
14
Q
Return Sequencing
A
- In situations where an individual is making contributions to his/her account, it would be preferable to experience market losses early in the period (as opposed to later) so that the individual could purchase more shares at lower prices.
- In situations where an individual is withdrawing from his/her account, it is generally less harmful to experience heavy market declines in the later years of withdrawals as there is less value to be negatively impacted.
- If there are no cash in-flows or out-flows, the order of returns does not typically matter.
15
Q
Monte Carlo Simulation
A
- Will not give an exact value of a portfolio at any specific time, but it will indicate the possible range of these values and the probability of that range.
- Advisor is looking to draw from the various possible random ordering of returns over a period of time and model those possible outcomes with a log normal distribution
- Some assumptions have to be made: expected return of the portfolio and the standard deviation of the portfolio, assuming a normal bell-shaped curve
- Assumption of a higher standard deviation will provide a wider range of possible outcomes
- Helps evaluate the tradeoffs between risk and return without the limitations inherent to a linear forecasting model
