Module 1 - An Overview of Retirement Planning.docx

Consider an example company a desires to provide all

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Consider an example. Company A desires to provide all employees with $1,500 per month in retirement. Employee B is 45 years old and the company's normal retirement age is 66. The assumed life expectancy of all male employees is 83. An actuary has assumed an investment return rate of 7%. They will then use time value of money concepts to find an estimated account balance required at the time of retirement (age 66) to buy a 7% annuity that would provide $1,500 per month. The value needed at the time of retirement would be $178,643.60 (using the TVM keys on your calculator: N = 17 x 12 [83-66 = 17; 12 is to adjust to monthly terms]; PMT = -1,500; I/Y = 7/12 [12 is to adjust to monthly terms]; CPT PV = 178,643.60). The last step is to find the estimated monthly payment that would accomplish the goal of providing $178,643.60 at age 66. The monthly payment is $312.88 (using the TVM keys on your calculator: N = 21 x 12 [66-45 = 21; 12 is to adjust to monthly terms]; I/Y = 7/12 [12 is to adjust to monthly terms]; FV = 178,643.60; CPT PMT = -312.88). You will not need to conduct these calculations, but I wanted you to see the process. Company A will make a monthly, tax-deductible contribution into the account for Employee B of 312.88, but there is no guarantee that this participant will end up getting $1,500 per month during retirement. If the investments chosen earn more than 7% per year it could be a better scenario. If the investments earn less than 7% per year, then the monthly retirement check could be less than the target. The total annual deductible contribution is limited by the 415 (c) limit. As illustrated above, the attainment of the target benefit will be 100% reliant upon investment performance. There are no guarantees from the employer that the target will be reached. The sole purpose of the “target” is to give the actuary a starting point for determining the initial contribution level. The actuary will use both the employee’s age and their compensation in determining the employer’s contribution. Much like a DC plan, each participant has their own account in which contributions are made and the participant assumes all investment risk. Why would an employer choose a target-benefit plan? One reason is if the company has a high percentage of older employees at the time the target-benefit plan is established. Because the older employees have less time for their employer’s contributions to compound, the actuary will suggest a significantly higher employer contribution given a certain target benefit. Following the same logic, older owners will receive a higher allocation than younger rank-and-file should that scenario fit a company’s demographics. Target-benefit plans are rarely used in practice because other plans offer more flexibility for the employer’s contributions. How do target benefit plans deal with inflation? This is accounted for in the interest rate that is chosen for determining the monthly contribution. It does deserve noting that the benefit targeted is not explicitly adjusted for inflation. The plan sponsor might desire to target $1,500 per month in retirement, but $1,500 is very different in 5 years or in 25 years. The plan sponsor may need to consider this when picking the desired target for a given employee.
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1. Which type of plan has a required contribution with a flat percentage of compensation only?
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