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Chapter 18

Chapter 18

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Published by: Le Quang on Nov 01, 2012
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Answers to Chapter 18 Questions
1. Private pension funds are created by the private entities (e.g., manufacturing, mining, or transportation firms) and are administered by private corporations (financial institutions).
 
Public pension funds are those funds administered by a federal, state, or local government (e.g., SocialSecurity).2. Pension plans administered by life insurance companies (about 25 percent of the industry
=
sassets) are termed insured pension plans. The distinction is due not necessarily to the type of administrator, but to the classification of assets in which pension fund contributions are invested.Specifically, there is no separate pool of assets. Rather the funds are invested in the general assetaccounts of the insurance company. The portion of the insurance company
=
s assets devoted tothe pension fund are reported in the liability section under pension reserves. Noninsured pension plans (administered by mutual funds and other financial institutions) are managed by a trusteeappointed by the sponsoring business, participant, or union. Trustees invest the contributions and pay the retirement benefits in accordance with the terms of the pension plan.3. In a defined benefit pension plan, the employer (or plan sponsor) agrees to provide theemployee a specific cash benefit upon retirement, based on a formula that considers such factorsas years of employment and salary during employment. The formula is generally one of threetypes: flat-benefit, career-average, or final-pay formula.With a defined contribution pension plan
 
the employer (or plan sponsor) does not commit to provide a specified retirement income. Rather, the employer contributes a specified amount to the pension fund during the employee
=
s working years. The final retirement benefit is then based onthe total employer contributions, any additional employee contributions, and any investmentgains or losses.4. The three types of formulas used to determine pension benefits for defined benefit pensionfunds are flat-benefit formula, career-average formula, and final-pay formula. A flat benefitformula pays a flat amount for every year of employment. Two variations of career-averageformulas exist; both base retirement benefits on the average salary over the entire period of employment. Under one formula retirees earn benefits based on a percentage of their averagesalary during the entire period they belonged to the pension plan. Under the alternate formula, theretirement benefit is equal to a percentage of the average salary times the number of yearsemployed. A final-pay formula pays a retirement benefit based on a percentage of the averagesalary during a specified number of years at the end of the employee
=
s career times the number of years of service.5. Annual benefits will beYears worked Annual benefit25$2,500
Η 
25 = $62,50028$2,500
Η 
28 = $70,00030$2,500
Η 
30 = $75,000
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6. Annual benefits will beYears worked Annual benefit30$60,000
Η 
.05
Η 
30 = $90,00033$62,500
Η 
.05
Η 
33 = $103,12535$64,000
Η 
.05
Η 
35 = $112,0007. EXCEL Problem: Payment = $50,000Payment = $56,105Payment = $65,688Payment = $78,800Payment = $82,8478. EXCEL Problem: Payment = $40,000Payment = $44,884Payment = $52,551Payment = $60,640Payment = $66,2779. Annual benefits will beYears worked Annual benefit17$40,000
Η 
.03
Η 
17 = $20,40020$47,000
Η 
.03
Η 
20 = $28,20022$50,000
Η 
.03
Η 
22 = $33,00010. Defined contribution plans are increasingly dominating the private pension fund market.Indeed, many defined benefit funds are converting to defined contribution funds. Figure 18-1shows that as equity market values fell in 2001, pension fund asset values, particularly for definedcontribution funds, fell as well. As the economy recovered and equity market values increased in2003 and 2004, so did the value of pension funds assets. Figure 18-2 shows that from 1990through 2004, defined benefit funds actually experienced a reduction in assets held, while definedcontribution funds saw a continuous increase in new asset investments. One reason for this shift isthat defined contribution funds do not require the employer to guarantee retirement benefits andthus managers do not need to monitor the funds performance once the required contribution aremade. Thus, employees must bare more of the responsibility for monitoring fund performance.11. Figure 18-3 shows the growth in 401(k) plans in the 1990s: from $385 billion in 1990 to$1,867 billion in 2003. In 2003 there were over 300,000 401(k) plans and over 42 million participants.
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12. Your annual investment isEmployee
=
s contribution = $60,000 x.12 = $7,200Tax Savings = $7,200 x.31 = $2,232Employee
=
s cost $4,968Employer 
=
s match = $60,000 x .50 x .05 = $1,500Total 401(k) investment at year start $8,700Your one-year return is1-year earnings= $8,700 x .10 = $870Total 401(k) investment at year-end $9,570Employee
=
s 1-year return = ($9,570 - $4,968)/$4,968 = 92.63%13. Assuming the employee
=
s salary, tax rate, and 401(k) yield remains constant over a 25-year career, when the employee retires the 401(k) will be worth$8,700(FVIFA
10%,25
) = $855,61914. Individual retirement accounts are self-directed retirement accounts set up by employees whoare also covered by employer sponsored pension plans. Contributions to IRAs are made strictly by the employee. A Keogh account is retirement account available to self-employed individuals.Contributions by the individual may be deposited in tax deferred accounts administered by a lifeinsurance company, a bank, or other financial institution. Similar to 401(k) plans the participantin a Keogh account is given some discretion in how the funds are invested.15. Most state and local government pension funds are funded on a
A
 pay as you go
@
basis,meaning that contributions collected from current employee
=
s are the source of payments to thecurrent retirees. As result of the increasing number of retirees relative to workers, some of these pension funds (e.g., New York City) have experienced a situation in which contributions have not been high enough to cover the increases in required benefit payments (or the pension funds areunderfunded).16. Civil service funds cover all federal employees who are not members of the armed forces.This group is not covered by Social Security. Similar to private pension funds the federalgovernment is the main contributor to the fund, but participants may contribute as well. Inaddition to Social Security, career military personnel receive retirements benefits from a federalgovernment-sponsored military pension fund. Contributions to the fund are made by the federalgovernment and participants are eligible for benefits after 20 years of military service. Employeesof the nation
=
s railroad system are eligible to participate in federal railroad pension system.Originated in the 1930s, contributions are made by railroad employers, employees, and thefederal government. The largest federal government pension fund is Social Security. Also knownas the Old age and Survivors Insurance Fund, Social Security provides retirement benefits toalmost all employees in the U.S. Social Security was established in 1935 with the objective of  providing minimum retirement income security to all retirees.
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