Chapter 18

Chapter 18 Pension Funds True/False Questions 1. Of the different types of defined benefit plans, plans using the final pay method will usually produce the biggest retirement benefit to employees. Answer: True Page: 514-515 Level: Easy 2. A Keogh plan is designed for self-employed individuals. Answer: True Page: 522 Level: Easy 3. Pension plans administered by the federal government are called insured pension plans. Answer: False Page: 512,528 Level: Easy 4. Insured pension plans are backed by a percentage of the sponsor's assets but do not have separate asset backing. Answer: True Page: 512 Level: Medium 5. The largest amount of private pension fund assets are held by uninsured private pension funds. Answer: True Page: 512 Level: Medium 6. Noninsured pension plans generally invest in riskier assets than insured pension plans. Answer: True Page: 513 Level: Medium 7. If you believe that taxes and are going to go up and you will likely have to pay a high tax rate when you retire, you will probably be better off with a Roth IRA than with a traditional IRA. Answer: True Page: 520-522 Level: Medium 8. If you are terminated before you are fully vested in an employer sponsored plan you may not get to keep previous contributions to your pension made by your employer. Answer: True Page: 527 Level: Easy

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9. In a defined benefit plan the retirement benefit will vary according to rates of return on pension fund reserves. Answer: False Page: 514 Level: Medium 10. In terms of assets managed and numbers of plans, defined contribution plans are becoming more predominant and defined benefit plans are declining. Answer: True Page: 515-516 Level: Easy Multiple Choice Questions 11. A pension plan has promised to payout $15 million per year over the next 10 years to its employees. Actuaries estimate the rate of return on the fund's assets will be 5%. What amount of pension fund reserves (to the nearest dollar) are needed for the plan to be fully funded? A) $115,826,024 B) $150,000,000 C) $125,657,890 D) $111,458,231 E) None of the above Answer: A Page: 515 Level: Medium Rationale: Actual calculations may be more complicated than this but this is a good time value example. Not in the text. 12. Private pension funds are funds administered by A) The Federal government B) State and local governments C) Insurance companies D) Banks and mutual funds E) Both C and D Answer: E Page: 512 Level: Medium

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13. In general terms, which one of the following plan types is the riskiest for an employee? A) Defined contribution plan invested in fixed income securities B) Defined contribution plan invested in equities C) Final pay defined benefit plan D) Career average defined benefit plan E) Overfunded defined benefit plan Answer: B Page: 515 Level: Medium 14. Over the last 10 years defined contribution plans have grown faster than defined benefit plans in which of the following areas? I. Fund assets II. Number of funds III. Number of plan participants A) B) C) D) E)

I only I and II only II and III only I, II and III II only

Answer: D Page: 515-516 Level: Medium 15. Congratulations, you have just been employed! You now have a choice between a flat benefit at retirement equal to $3,000 times your years of service, or a career average formula of 3% of your average salary times your years of service. You expect to work 35 years. At what average salary would you be indifferent between the two alternatives? A) $103,000 B) $102,500 C) $101,850 D) $105,000 E) $100,000 Answer: E Page: 514 Level: Medium Rationale: ($3000*35) / (0.03*35)

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16. At your new job you estimate that your average salary over your working years will be $75,000 per year. How many more years would you have to work to receive as much benefit from a flat benefit of $2,250 times years of service as you would receive from 4% of your average salary times years of service? A) 1.33 times as many years B) 0.75 times as many years C) 1.04 times as many years D) 2.40 times as many years E) 1.50 times as many years Answer: A Page: 514 Level: Difficult Rationale: (0.04*$75,000) / $2,250 17. An employee who has worked for his firm for 30 years can retire right now and receive a constant annual benefit of $45,000. He has a final pay plan that pays his average salary over his final 5 years times 3% times years of service. He has decided he will keep working five more years only if by doing so, his retirement benefits will grow at 6% per year. How much would his expected average salary (to the nearest dollar) have to be over the next 5 years to keep him working? A) $60,220 B) $57,353 C) $50,010 D) $66,911 E) $53,147 Answer: B Page: 515 Level: Difficult Rationale: ($45,000*1.065 ) / (0.03*35) 18. The main advantage of a profit sharing Keogh plan over a money sharing Keogh plan is that profit sharing plans A) Are eligible for PBGC insurance and money sharing plans are not B) Have higher maximum contributions than money sharing plans C) Can have contributions that vary from year to year with profits, while money sharing plan contributions are fixed D) Both A and B are advantages E) None of the above Answer: C Page: 522 Level: Medium

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19. A defined benefit pension plan has expected payouts of $15 million per year over the next 25 years. The fund can be expected to earn an average of 6% on its assets. It currently has reserves of $160 million. The fund is __________ by about ___________ million. A) Underfunded; $31.75 B) Underfunded; $215 C) Overfunded; $31.75 D) Overfunded; $215 Answer: A Page: 515 Level: Medium Rationale: Actual calculations may be more complicated than this but this is a good time value example. Not in the text. 20. Under ERISA, pension fund managers are required to invest fund assets as if wisely as if they were investing their own money. This requirement is called the A) Owl rule B) Vesting requirement C) 403(b) requirement D) Prudent person rule E) Funding rule Answer: D Page: 527 Level: Easy 21. A ___________ plan does not require the employer to guarantee retirement benefits nor to maintain a minimum level of pension reserves A) Defined benefit B) Insured pension C) Corporate pension D) Uninsured pension E) Defined contribution Answer: E Page: 515 Level: Easy

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22. Which of the following statements about 401(k) plans are true? I. They are defined benefit plans II. They allow employer and employee contributions III. Earnings accrue tax free during the employee's working years IV. They allow employee discretion in asset allocation V. They always have minimum guaranteed rates of return A) B) C) D) E)

I, IV and V only II, II and V only II and III only II, III and IV only All are true

Answer: D Page: 516-522 Level: Medium 23. An employee contributes 8% of his salary to their 401(k) plan and the employer matches with 3%. The employee earns $60,000 and is in a 28% tax bracket. If the employee also invests the tax savings generated by his contribution and earns 10% on all funds invested, what is his one year rate of return relative to the amount of money he invested? A) 10.00% B) 51.25% C) 90.07% D) 42.22% E) 29.52% Answer: D Page: 519 Level: Difficult Rationale: {[((11%*60,000) + (8%*60,000*28%))* 1.10] / (8%*60,000*1.28)} 24. Employee plus employer contributions to a 401(k) are $15,000 per year. Equity funds are earning 15%, bond funds 8% and money market funds 6%. The employee wants to retire as soon as possible with $1 million in retirement assets. How much more quickly can he retire if he puts all his money in equity than if he puts 1/3 in each? A) 3.3 years B) 9.7 years C) 4.6 years D) 2.4 years E) 12.2 years Answer: C Page: 519-520 Level: Difficult

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25. Which of the following statements are true about a traditional IRA? I. Subject to an income limit, in 2005 a single person may contribute up to $4000 per year of pretax income to an IRA II. All withdrawals are tax free III. Earnings on the IRA account are not taxed until withdrawn IV. You must begin withdrawals at age 59 ½ V. Withdrawal(s) can be a lump sum or installments A) B) C) D) E)

I, II, IV I, II, IV and V I, III and V II, IV and V III, IV and V

Answer: C Page: 521 Level: Medium 26. Which of the following are true about a Roth IRA? I. Contributions are tax deductible II. Withdrawals after retirement are not taxed III. You must begin withdrawals at age 70 ½ IV. Employers match contributions V. They are only available to individuals earning less than $50,000, or households earning less than $90,000 A) B) C) D) E)

I, II and IV II, IV and V I, III and IV II only V only

Answer: D Page: 521 Level: Medium 27. A retirement account specifically designed for self-employed persons is a A) Roth IRA B) Traditional IRA C) Keogh D) Penny Benny E) Public Pension plan Answer: C Page: 522 Level: Easy

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28. Most public pension funds are A) Overfunded B) Underfunded C) Fully funded D) Defined contribution E) Keogh plans Answer: B Page: 522 Level: Easy 29. Under ERISA the maximum time period allowed for vesting is ____ years. A) 3 B) 5 C) 8 D) 10 E) 15 Answer: D Page: 527 Level: Easy 30. ERISA established all but which one of the following? A) Prudent man rule B) Maximum vesting times C) Minimum funding requirements D) Insurance for pension plan participants E) Minimum payouts for defined contribution plans Answer: E Page: 526-528 Level: Medium 31. The PBGC A) Insures participants of defined benefit plans if plan funds are insufficient to meet contractual pension obligations B) Insures participants of defined contribution plans if investment returns are insufficient to meet expected pension obligations C) Regulates day to day pension fund operations D) Both A and C are correct E) A, B and C are correct Answer: A Page: 528 Level: Medium

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32. A defined benefit pension plan has expected payouts of $20 million per year for 10 years and then $35 million over the following 20 years. The fund can be expected to earn an average of 4.75% on its assets. It currently has reserves of $320 million. The plan is underfunded by about ___________ million. A) $900 B) $116 C) $580 D) $224 Answer: B Page: 515 Level: Medium Rationale: Actual calculations may be more complicated than this but this is a good time value example. Not in the text. 33. An employee contributes 5% of her salary to her 401(k) plan and her employer contributes another $1,900. The employee earns $75,000 and is in a 28% tax bracket. If the employee does not invest the tax savings generated by her contribution and earns 9% on all funds invested, what is her one year rate of return relative to the amount of money she invested? A) 9.00% B) 41.25% C) 64.23% D) 32.74% E) 19.67% Answer: C Page: 519 Level: Difficult Rationale: {[((5%*75,000) + 1,900)* 1.09] / (5%*75,000)} - 1 34. Employee plus employer contributions to a 401(k) are $14,000 per year. Equity funds are earning 11%, bond funds 6% and money market funds 4%. The employee will retire in 30 years. How much money will he have if puts 60% of his money in equities, 30% in bond funds and the rest in money market funds? A) $1,456,960 B) $1,838,526 C) $1,654,320 D) $1,978,565 E) $1,248,550 Answer: B Page: 519-520 Level: Medium Rationale: r = (60%*11) + (30%*6) + (10%*4) = 8.8%; FV30 = 14,000 * [(1.088301)/0.088]

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35. You want to have $2,000,000 when you retire and you are in a defined contribution plan. You can earn 8% per year on the money invested and you will retire in 30 years. Your employer also contributes to your plan. The employer will contribute 6% of what you put into the plan each year. How much do you have to contribute per year to meet your goal? A) $18,435.43 B) $17,654.87 C) $16,879.32 D) $16,655.53 E) $15,999.44 Answer: D Page: 519 Level: Difficult Rationale: 2,000,000 / FVIFA (8%, 30 years) = $17,654.87 total payment required. Your contribution must be $17,654.87 / 1.06 = $16,655.53 36. Vesting refers to A) How long until an employee owns any employer contributions to the employee's pension plan B) How long until an employee can transfer any of their own contributions to a new plan if they switch jobs C) Eligibility requirements to retire early D) Restrictions on asset allocations with in a defined contribution plan E) The extent to which an employee materially participated in a given business in a given year Answer: A Page: 527 Level: Easy Rationale: The book uses the word vesting in a different manner to refer to the time until one is eligible to receive any pension benefits. 37. IRAs are A) Self directed investment vehicles designed to provide supplemental retirement income B) Corporate retirement plans for self employed individuals and small businesses C) Specific classes of investments such as equities or bonds issued by certain corporations D) Investment vehicles created by ERISA Answer: A Page: 520 Level: Easy

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38. Countries where the link between public pension benefits and amounts paid in are weak include A) Sweden B) Italy C) Great Britain D) Chile E) France Answer: E Page: 528-529 Level: Easy 39. In 2004, PBGC had a A) Small deficit of $1.5 billion B) Record surplus of $9.5 billion C) Record deficit of $23.5 billion D) Small surplus of $2.25 billion Answer: C Page: 528 Level: Medium 40. Social Security is projected to begin running deficits in the year A) 2010 B) 2018 C) 2028 D) 2042 E) 2052 Answer: B Page: 523 Level: Medium Short Answer Questions 41. Why do insured pension plans invest in less risky assets than uninsured pension plans? Answer: Insured pension plans are plans that are managed by insurance companies; pension plan assets are owned by the insurance company, not the pension plan. The life insurer promises to pay a rate of return to the plan and is liable for losses, which makes them leery of risk. In a noninsured plan, the fund owns its own assets and the fund advisers are often willing to take on more risk in hopes of earning a higher rate of return and thereby minimizing the corporate employer's required contribution. Page: 512-513 Level: Medium

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42. A 55 year old has just changed jobs and has a choice between a defined benefit plan [final pay] and a defined contribution plan. He will work for 10 more years. What should he consider in making his decision? Answer: The final pay formula, his expected salary over the final pay period, and whether that salary will keep up with and hopefully surpass inflation. For the DC plan, the variables include his tax bracket, contribution amount by him and his employer, and rates of return offered in the markets. The amount of choice in asset allocation may also be a factor and the short length of time to invest. The individual's level of risk aversion would also play a part in the decision. Page: 514-515 Level: Difficult 43. Suppose that a corporate defined benefit plan must keep pension fund reserves equal to the present value of expected future pension benefits to be fully funded. The plan has expected payouts of $15 million per year for 20 years and then $20 million per year for the subsequent 10 years. All payments are at year end. At the current 6% rate of return on the plan's assets, the plan is currently fully funded. If the plan can increase the proportion of stock investments the fund holds and raise the expected rate of return to 7%, how many dollars of pension assets can be freed up by the corporation? Answer: Current fund assets = [$15 mill * PVIFA(6%, 20 yrs)] + [$20 mill * PVIFA(6%, 10 yrs)* PVIF(6%, 20 yrs)] = $217,947,017 Assets required at 7% = [$15 mill * PVIFA(7%, 20 yrs)] + [$20 mill * PVIFA(7%, 10 yrs)* PVIF(7%, 20 yrs)] = $195,210,752 Assets freed up by rate change $22,736,265 (Note: Actuaries have to approve the rate change) Actual calculations may be more complicated than this but this is a good time value example. Not in the text. Page: 515 Level: Difficult 44. Why do employees increasingly prefer defined contribution plans to defined benefit plans? Answer: Employees like the chance to manage their own retirement portfolios in hopes of earning more. The public is better educated about investments today than at any time in the past and employees wish to incur greater amounts of risk in the hope of earning higher retirement benefits than DB plan sponsors can promise. The strong bull markets of the 1990s also significantly contributed to the interest in DC plans in the past. Page: 515-516 Level: Medium

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45. You are 30 years old and you make $70,000 per year. You calculate that you can't retire until you have accumulated a lump sum amount of $2,000,000 to live on after retirement. You contribute 6% of your salary to your 401(k) and your employer contributes 4% of your salary. You plan on investing 60% of your funds in equities on which you expect to earn an average rate of return of 12%, and the rest in bonds projected to earn 6%. If your salary does not grow, how old will you be when you can retire? Answer: Employee contribution per year: $4,200 Employer: $2,800 Total contribution per year: $7,000 Expected rate of return = (0.60 * 0.12) + (0.40 * 0.06) = 0.096 or 9.6% $7,000 * (FVIFA(9.6%,N)) = $2,000,000 N = 36.5 years so you will be 66 years old when you hit your retirement goal. Page: 519-520 Level: Difficult 46. An individual is considering contributing $4,000 per year to either a traditional or a Roth IRA. Payments would begin in one year. If she uses the traditional IRA her contributions would be fully deductible. She is 40 years old and is in a 28% tax bracket. On either IRA she can earn 7% pretax. When she retires at age 65 she believes she will be in a 15% tax bracket. Which type of IRA should she choose if she invests not only the $4,000 per year, but any tax savings due to the deductibility of her contributions in a taxable investment earning a pretax rate of 7%. She will withdraw all her money upon retirement and may owe taxes then depending of the type of IRA chosen. Answer: Traditional IRA + Taxable investment Amount invested per year $4,000 Tax Savings = (0.28 * $4,000) = $1,120 The IRA earns 7%, and the taxable investment earns 7% * (1 - 0.28) = 5.04% after tax After tax future value of the IRA + Future value of the invested deductions (after tax): [$4,000* (FVIFA7%, 25yr) * (1-.15)] + $1,120*(FVIFA5.04%, 25yr) = $215,046.73 + $53,750.08 = $268,796.81 Roth IRA: $4,000 * (FVIFA7%, 25yr) = $252,996.15 The expected FV of the Roth IRA is less than the expected FV of the traditional IRA plus the invested tax savings; so she should choose the traditional IRA and invest the tax savings. Page: 519-520,521 Level: Difficult

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47. An individual is considering contributing $3,000 per year to either a traditional or a Roth IRA. Payments would begin in one year. If she uses the traditional IRA her contributions would be fully deductible. She is 40 years old and is in a 28% tax bracket. On either IRA she can earn 8% pretax. When she retires at age 65 she believes she will be in a 15% tax bracket. Which type of IRA should she choose assuming she does not invest any tax savings that arise from the deductibility of her IRA contributions? She withdraws all her money upon retirement. Answer: Traditional IRA Tax savings per year is 28% of $3,000 = $840 After tax future value of the IRA: [$3,000  (FVIFA8%,25) * (1 - .15)] + ($840*25) = $207,420 Roth IRA: $3,000 * (FVIFA8%,25) = $219,318 If she does not reinvest the tax savings, the expected FV of the Roth IRA is more than the expected FV of the traditional IRA and the tax savings, so choose the Roth IRA. Page: 519-520,521 Level: Difficult 48. How is Social Security different from a private defined benefit plan? When and why is Social Security projected to become insolvent? Answer: Social security is a pay as you go plan that has not been required to maintain fund reserves to meet expected future payouts the way that private defined benefit plans are. Social Security will be imperiled because longer life spans mean more payouts, fewer workers and an increasing number of retirees as the population ages mean that the plan will not generate sufficient revenue to meet planned payouts. According to current estimates the plan will go bankrupt in 2042, and face shortfalls beginning in 2018, not to mention that Medicare and Medicaid are projected to go under even sooner under current projections. Page: 522-523 Level: Medium 49. How sound is the PBGC? How much do firms pay for pension fund insurance? Describe President Bush's proposal to increase funding for PBGC. Answer: In 2004 unfunded pension liabilities reached a record $450 billion. Recently the insurer was forced to take over took over the huge pension plans of U.S. Airways and United upon these firms' bankruptcy. The plans were underfunded by $726 million and $1,400 million respectively. The PBGC does not have the resources it needs. Last year it operated at a $23 billion deficit. In January 2005 the Bush administration proposed an increase in premiums from $19 to $30 for fully funded plans and larger cost increases for underfunded plans tied to the amount of underfunding. Disclosure to employees about the extent of the deficit would also be required. Page: 525,528 Level: Difficult

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50. What are the main provisions of ERISA? Answer: Funding requirements for defined benefit plans; maximum time to vesting of benefits; prudent man rule established; transferability of pension credits from plan to plan; insurance provided by Pension Benefit Guarantee Corporation (PBGC). Page: 526-528 Level: Medium 51. What are some of the proposed changes to Social Security? What are the pros and cons of privatization? Has privatization worked for other countries? Explain. Answer: Proposals vary, but generally include some combination of the following: • increase the payroll tax or the amount of income to which the tax is applied • reduce benefits to younger people • raise the minimum retirement age to collect full benefits • stop or change method of indexing benefits to inflation • increase taxes on social security payments • privatize Privatization may help make the system more fiscally sound in the long run and give the government the political ability to reduce the benefits or raise taxes. The problem is that privatization may be costly in the short run and a tough sell to the public. Bush argues that privatization will increase people's sense of ownership and engagement in the economy and encourage them to manage their retirement on their own. The downside is that those who choose privatization take on more risk and those who believe that social security should be used to redistribute wealth to the poor will probably not be happy with privatization which allows wealthier people to benefit more. Page: 525-526 Level: Difficult 52. How do public pension plans differ in other countries? Has privatization worked overseas? Answer: In Europe some countries do not have a strong link between the amount paid in and the benefit received, notably France and Germany, and their pension plans are having funding difficulty. Other countries like Italy, Britain and Sweden have tied benefits more closely to contributions. Britain and Sweden have partially privatized their public pensions with some success. Chile has successively privatized there social security program and 11 other Latin American countries have followed suit. Tying benefits to amounts paid in and privatization help keep spending down as a percent of GDP. Page: 528-529 Level: Medium

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