Exam 1 Review Sheet - Retirement Planning | AAEC 4104, Study notes of Agricultural engineering

Download Exam 1 Review Sheet - Retirement Planning | AAEC 4104 and more Study notes Agricultural engineering in PDF only on Docsity! AAEC 4104: Retirement Planning Exam 1 Review Guide Dr. Hyrum Smith While this list may not be entirely complete, this is a very comprehensive list of concepts that will likely be tested on the Exam 1. Format: 35 Questions, 25 MC, 10 T/F, Plenty of Calculation/ Short Answers Know TVM, Coverage Tests, ADP and ACP Tests I. Chapter 2: Retirement Accumulations and Distributions a. Factors Affecting Retirement Planning—generally know what each is and be able to identify how each influences amount need to save for retirement, and be able to identify mitigating factors (Exhibit 2.21) i. Retirement Income Sources 1. Earnings (25%) 2. Pensions and annuities (20%) 3. Income and Assets (13%) 4. Social Security (40%) 5. Other (2%) ii. Work Life Expectancy (WLE) 1. Defined: The period of time a person is expected to be in the work force, generally 30-40 years iii. Remaining Work Life Expectancy (RWLE) 1. Defined: The work period that remains at a given point in time iv. Retirement Life Expectancy (RLE) 1. Defined: The time period beginning at retirement and extending until death; the RLE is the period of retirement that must be funded v. Savings 1. Defined: The Savings Rate identifies the average savings amount in the US based off consumption. Fell below 0 in 2005. The earlier one saves the less they need to save over their life (compounded periods). vi. Investment Returns 1. Defined: Risk versus return. vii. Inflation 1. Defined: Causes a loss in purchasing power. How the value of a dollar decreases over time. viii. Wage Replacement Ratio (WRR) 1. Defined: An estimate of the percent of income needed at retirement compared to earnings prior to retirement See table below: 1 AAEC 4104: Retirement Planning Exam 1 Review Guide Dr. Hyrum Smith Factor Risk Mitigator Work Life Expectancy (WLE) Shortened due to untimely death, disability, health, or unemployment Life insurance, disability insurance, health insurance, education, training, experience Retirement Life Expectancy Lengthened Adequate capital accumulation Savings rate, amount, and timing Too low and too late Save enough; start early Inflation Greater than expected Conservative estimate inflation and needs Retirement Needs Underestimated Use wage replacement estimators Investment Returns Inadequate to create necessary retirement capital Knowledge of and investments in broad portfolio of diversified investments and proper asset allocation Sources of retirement income Overestimation of social security benefits, private pension plans, or personal income (or adverse changes in taxation of such income) Conservatively estimate and plan for such income, as well as, monitor income projections and tax policy 2. How to calculate WRR a. It is a calculation of the pre-retirement lifestyle; minus some bills (usually you pay less in retirement). For instance, if someone who made $100,000 requires $80,000 to live, they have a 80% WRR. 3. Two Approaches to Calculate: Top-Down and Bottom-Up a. Top Down: Used with younger clients. Uses common sense and percentages. Example of Top Down: Tim makes $50,000/yr and pays 7.65% in Social Security and 10% of his gross income. We assume here that Tim’s work-related savings will be offset by new needs during retirement. 2 AAEC 4104: Retirement Planning Exam 1 Review Guide Dr. Hyrum Smith Step 2: $70,000 * .8 = $56,000, which is total needs in today’s dollars Step 3: Less: $15,000 from Social Security Equal: $41,000 annual amount needed in today’s dollars Step 4: N =20 (WLE) i = 3%(Inflation) PV =$41,000 (taken from Step 3, Retirement needs in today’s dollars PMT =0 FV = COMPUTE (in this case, it equals $74,050.56), which is the amount needed in the first year or retirement at age 62. Step 5: N =28 (Retirement Life Expectancy) i = 6.3107 (IARR) 1.095/1.03 -1 x 100) PV =COMPUTE (Amount needed at age 62, $1,022,625.84) PMT =$74,050.56 (this is also an annuity due, so BGN pmt) FV = 0 (Annuity method, die broke) 2. Capital Preservation: a. Defined: Retiree meets assumptions and dies with NOMINAL balance at retirement Steps to Compute (this is assuming it is the same employee for the next method: Step 6: You have the PV needed at age 62. Then, you do the following step: N =28 (Retirement Life Expectancy) i = 9.5 PV =COMPUTE (Additional needed, which is $80,560.37 PMT =$0 FV = $1,022,625.85 $80,560.37 + $1,022,625.85 = $1,103,186.21 3. Purchasing Power Preservation: a. Defined: Retiree meets assumptions and dies with REAL (inflation adjusted) balance at retirement 5 AAEC 4104: Retirement Planning Exam 1 Review Guide Dr. Hyrum Smith Step 7: You still want to use the FV of the Annuity method; however, your payment is different than the Captial Preservation, as well, as your i. N =28 (Retirement Life Expectancy) i = 6.3107 (IARR) PV =COMPUTE (Total needed, which is $1,022,625.84 PMT =$74,050.56 FV = $1,022,625.85 Additional amount needed is $184,313.40 more than the annuity approach AT RETIREMENT (age 62) II. Chapter 3: Qualified Plan Overview a. Differences between pensions and profit sharing (table) Characteristic Pension Plan Profit-Sharing Plan Legal promise of a plan Paying a pension at retirement Deferral of compensation and taxes Are in-service withdrawals permitted? No Yes (after two years) if plan documents permit Is the plan subject to mandatory funding standards Yes No Percent of plan assets available to be invested in employer securities 10% Up to 100% Must the plan provide qualified joint and survivor annuity and a qualified pre- survivor annuity? Yes No Pension Plans (2 Categories, 4 Total Types) 1. Defined Benefit Pension Plans a. Defined Benefit Pension 6 AAEC 4104: Retirement Planning Exam 1 Review Guide Dr. Hyrum Smith b. Cash Balance 2. Defined Contribution Pension Plans a. Money Purchase Pension Plans b. Target Benefit Pension Plans Profit Sharing Plans (7 Total Types) 1. Profit Sharing Plans 2. Stock Bonus Plans 3. Employee Stock Ownership Plans 4. 401(k) Plans 5. Thrift Plans 6. New Comparability Plans 7. Age-Based Profit Sharing Plans b. Be able to identify general differences/characteristics b/w Defined Benefit (DB) and Defined Contribution (DC) Plans (Exhibit 3.3) i. So, there are two types of Pension Plans, (1) Defined Benefit and (2) Defined Contribution. Here is a table that talks about the differences/characteristics of each: Characteristics Defined Benefit Defined Contribution What is the Annual Contribution Limit? The greater of (1) the sum of the plan’s funding target normal cost, and a cushion amount, OR (2) The minimum required contribution for the plan year 25% of covered compensation Who assumes the investment risk? Employer Employee How are forfeitures allocated? Reduce plan costs Reduce plan costs OR allocate to other plan participants Is the plan subject to Pension Benefit Guaranty Corporation (PBGC) coverage? Yes (except Professional Firms with less than 25 employees) No Does the plan have separate investment No, they are commingled Yes, they are usually separate 7 AAEC 4104: Retirement Planning Exam 1 Review Guide Dr. Hyrum Smith a. Nondiscrimination—reasonable (i.e. hourly/salaried, geographic) b. An employee is covered when he/she receives benefits from the plan. For instance, an employee is covered if he receives a contribution to the profit sharing plan at the end of the year. 2. Highly compensated employee Defined: 5% owner earns more than $110,000. Also defined as top 20% of employees ranked by compensation a. 5% means they own 5% of the company stock or capital. b. 20% can be manipulated for smaller companies; make it easier to pass tests 3. Three Coverage Tests (must meet one of three tests) a. General Safe Harbor i. Considers the number of non-highly compensated employees covered. Plan has to benefit 70% or more of the non-excludable, non-highly compensated employees. Nonexcludabl e Employees Covered Employees % Covered Employees NHC 75 55 73.3% HC 25 21 N/A Total 100 76 Passes test because > 70% b. Ratio Percentage Defined: Compares percentage of covered non-highly compensated employees to the percentage of covered highly compensated employees. i. > 70% ratio of NHC to HC Nonexcludabl e Employees Covered Employees (%) Covered Employees NHC 100 60 60 HC 50 40 80 Total 150 100 Ratio % Test: % of NHC Covered 60% % of HC Covered = 80% = 75%> 70%, PASS c. Average Benefits Defined: Determines whether the plan adequately benefits the NHC compared the benefits of the HC. 10 AAEC 4104: Retirement Planning Exam 1 Review Guide Dr. Hyrum Smith Average benefit % ratio of NHC must be >70% Employ ee Statu s Salar y Bene fit $ Bene fit % Avg. Benefit % A HC $150,0 00 $15,000 10% 10% B HC $110,0 00 $11,000 10% C NHC $50,00 0 $3,000 6% 5.33% D NHC $50,00 0 $5,000 10% E NHC $50,00 0 $0 0% NOTE: A benefit percentage is also determined for each non-excludable employee who does not benefit from the plan (thus, a benefit % of 0) Defined Benefit Plan must also satisfy the 50/40 Test a. 50 Employees/40% eligible test i. Plan must cover the lesser of 50 employees or 40% of employees. Number of Non-excludable employees How many must be covered? 1 1 Employee 2-4 2 Employees < 125 40% of Employees >125 50 Employees iii. Vestin iii. Vesting 1. Employee Contributions—100% vested 2. Employer Contributions - Depends a. Graduated vs. Cliff Vesting i. Graduated –Provides an employee full rights to a certain percentage benefit (less than 100%) after completing a certain number of years of service and provides the employee with an additional percentage for additional years of service. 11 AAEC 4104: Retirement Planning Exam 1 Review Guide Dr. Hyrum Smith ii. Cliff – Provides an employee full rights to the plan’s assets immediately upon the passage of a certain number of years of service, usually three b. DC plans—2 to 6 yr graded, or 3 yr cliff; unless 2-yr, 100% election c. DB plans—3 to 7 yr graded, or 5 yr cliff; unless 2-yr, 100% election 3. Earnings must be prorated b/w employee and employer contributions iv. Top-Heavy Plans (>60% accrued benefits or >60% balances in DC to key employees) 1. Be able to identify key employees: >5% owner, >1% owner AND >$150k, or officer and >$160k a. Officer means an administrative executive who is in regular and continued service 2. How does being top heavy influence vesting and funding of non-key employees? Top-Heavy Plan Summary DEFINITION FUNDING VESTING Defined Benefit Plan Defined Contribution Plan More than 60% of the total accrued benefits of the defined benefit plan are for the benefit of key employees More than 60% of the total account balances of the defined contribution plan are for the benefits of key employees Must be at least 2% x years of service x compensation factor (up to 20%) 3% minimum to all eligible non-key employees or les if less provided to the key employees The plan participant’s benefits must vest at least as rapidly as a 2 to 6 year graduated vesting schedule or a 3-year cliff vesting schedule. e. Plan Limitations on Benefits and Contributions i. Covered Compensation Limit 1. $245k in 2010--max. salary that can be used in plan funding formulas in qualified plans (both DB and DC plans) a. If you make more than $245,000, you can only contribute up to $245,000. ii. DB Plans—max. annual benefit at retirement up to 100% avg. 3 highest yrs salary (but not more than $195k) 12 AAEC 4104: Retirement Planning Exam 1 Review Guide Dr. Hyrum Smith times the monthly accrued retirement benefit provided under the same qualified plan's defined benefit formula. 3. Know in general what a 412(i) plan is: a. a specific type of defined benefit pension plan that is funded entirely by a life insurance contract or annuity. The employer claims tax deductions for contributions used by the plan to pay premiums on an insurance contract covering an employee v. Differences b/w DB Pension and DC Pension Plans related to: 1. Actuaries- DB/Cash Balance – actuary needed annually. Target benefit – needed at inception only and Money Purchase – not used at all. For assumptions/relationships to plan costs see exhibit 4.4. As wages, inflation, and life expectancy increase, costs increase but expected investment returns, expected mortality and expected turnover all decrease. 2. Investment risk: for DB or Cash Balance, risk burden is on employer. For Target Benefit or Money Purchase its on employee. 3. Plan Forfeitures—what are they; how can they be used? Benefits allocated to the employee that are not vested. For a DB plan, they can only be used to reduce future plan funding costs for the employer. Cannot increase the benefit of any other plan participant, nor may the forfeited funds be allocated for any other purpose. But for a DC plan, you can use these in one of two ways. To reduce future plan funding costs or they can be allocated to toher remaining participants in a nondiscriminatory manner. 4. PBGC—general purpose; $54k max PBGC guarantee; not used in DC plans- guarantees pension benefits. Its a fed corp that acts as an insurance provider to maintain the benefits promised to employees by their DB pension plans 5. Accrued Benefit (DB) vs. Account Balance (DC) accrued benefit is a benefit payable from the plan equal to the retirement benefit earned to date (usually for someone who terminates their plan earlier than retirement). Account balance is simply the participants account balance reduced by any non-vested amounts. So, it is basically the sum of the employer contributions to the plan and the employee contributions to the plan minus any investment earnings/losses. 6. Credit for prior service—what is this; used for both DB and DC plans? Used for DB and Cash Balance but not TB or MP. It 15 AAEC 4104: Retirement Planning Exam 1 Review Guide Dr. Hyrum Smith gives employees credit for years of service prior to the establishment of the qualified plan 7. Social Security Integration a. What is this basically? Method of allocating plan contributions or benefits to employees that provide higher contributions to those employees whose compensation is in excess of the social security wage base for the plan year. b. Know how to calculate examples of Excess and Offset Method (percentages will be given) i. Excess: limit for 2010 is 59,286...to calculate take the lesser of 0.75 percent per year of service or the benefit percentage for earnings below the covered compensation limit per year of service (up to 35) and multiply it by the years the benefit applies. Tbenefit/MP use excess only, while DB/CB can use either. ii. Offset: lesser of 0.75 per year of service up to 35 years, or 50 percent of the overall benefit funding % per year of service by the number of years. 8. Commingled (DB) vs. Separate Accounts (DC) d. Defined Benefit Pension Plans (DB plan) i. Know flat amount (each participant gets an equal dollar amount benefit at retirement) ii. flat percentage (provides all participants with a benefit equal to a specific % of the participants salary, usually the final salary or an avg of the participant's highest salaries iii. Unit credit formula; how do incentives for employees to stay at employer and increase salary change b/w these 3 methods? iv. DBPP tend to favor older or younger participants? e. Cash Balance Pension Plans (DB plan) i. Guarantees 2 things—what are they? ii. Favors younger/older plan entrants? f. Money Purchase Pension Plans (DC plan) i. Guarantees contribution (% of compensation each year) but not earnings ii. Favors younger/older plan entrants? g. Target Benefit Pension Plans (DC plan) i. Guarantees contribution based on funding schedule determined by actuary hired at beginning when plan established ii. Earnings are not guaranteed similar to Money Purchase Pension Plans iii. Favors younger/older plan entrants? I. Chapter 5: Profit Sharing Plans a. Be able to generally identify profit sharing plan characteristics 16 AAEC 4104: Retirement Planning Exam 1 Review Guide Dr. Hyrum Smith 1. i.e. DC plan, predetermined formula, noncontributory vs. contributory plans b. Contributions and Deductions 1. When must contributions be made? Plan must be established by Dec 31 but contributions aren’t due til date of company’s income tax return  Are they mandatory? No, but plan risks disqualification if contributions aren’t made for an extended period of time 2. What are the total contributions that can be made to each employee from employer, employee, forfeitures in 2010?  $49k total or $54,500 for employees over 50 yrs old 3. Employer Deduction limited up to what % of total employer covered compensation? 25% c. Different methods of allocations in standard profit sharing plan - know how to calculate and major differences b/w each method 1. Standard Allocation - % of employee’s compensation; benefits the HC 2. Social Security Integration ("Excess" method only for profit sharing plans)  Excess rate is limited to the lesser of twice the base rate or 5.7% 1. Ex: $200k salary, 10% base rate, 15.7% excess rate. Results in a contribution of $25,312 [(10% x $106,800) + (15.7% x ($200k-$106,800))] 3. Age-Based – uses a combination of age and compensation for contribution allocation. Used when owners and key employees are older than most or all other employees and the company wants to tilt the contribution towards those older employees.  Steps to Calc: 1. PV of $1 @retirement 2. Allocation Factor = Employee compensation x PV of $1 3. % of total Contribution = Allocation factor/Total Allocation 4. Dollar Contribution = % of total contribution x $52,250 d. New Comparability Plans – profit sharing plan in which contributions are made to an employee’s account based on their respective classification in the company 1. why are these far less common? Expensive, scrutinizes by IRS (borderline discriminatory) 17