Bryant - Course 5. Retirement Planning & Employee Benefits. 6. Investment Considerations for Retirement Plans Flashcards
(41 cards)
There are many different types of retirement plans and each will require different investment considerations. A fiduciary is responsible for making the investment considerations for retirement plans. The fiduciary - a person, company or association holding assets in trust for a beneficiary of a retirement plan - has many responsibilities. These responsibilities can range from selecting the types of investments to be offered in the retirement plan to deciding whether or not life insurance should be purchased and owned by the plan. As a financial planner, you will need to be familiar with these considerations because you may work with a client to select investments for their retirement plan when reviewing their overall financial situation.
The Investment Considerations for Retirement Plans module, which should take approximately three hours to complete, will present to you issues that fiduciaries need to consider when selecting investments for retirement plans.
Upon completion of this module you should be able to:
* Discuss investment suitability,
* Define prudent man standard of care,
* Identify breaches of fiduciary duty,
* Define prohibited transactions,
* Identify exemptions to prohibited transactions,
* Discuss the advantages and disadvantages of life insurance in a qualified plan,
* Define the types of annuities, and
* Discuss the annuity payout options.
Module Overview
In this module, we will look at different items that should be considered when selecting investments for a retirement plan. In addition, we will review the role of the fiduciary and how it is key to ensuring that participants and their beneficiaries are provided with options that are in their best interest. The module looks at how insurance in a qualified plan can be offered favorably to employees. It will also discuss annuities as a retirement planning vehicle. As a financial planner, you will need to be knowledgeable in these areas to ensure that your client is getting the maximum benefit from his or her retirement plan.
To ensure that you have a solid understanding of investment considerations for retirement plans, the following topics will be covered in this module:
* Investment Suitability
* Fiduciary Considerations
* Prohibited Transactions
* Life Insurance
* Annuities
Exam Tip: employer risk in defined benefit, individ risk in defined cont
Types of Investments Offered
* ERISA, the Employee Retirement Income Security Act of 1974, is the federal law which established legal guidelines for private pension plan administration and investment practices. ERISA states in Section 404 (c) that individual account plans such as 401(k)s, must provide a participant or beneficiary the opportunity to choose from a broad range of investment alternatives. The ERISA code also dictates that the account holder be given control over the assets in his or her account. Providing at least three investment alternatives is considered a broad range of investments according to Section 404 (c), and providing participants the opportunity to trade at least once every three months is considered control over their assets.
* The Pension Protection Act of 2006 (PPA06) has added some additional considerations for qualified plans. Based on language in the Act, plans are adding “Target Based” funds to plans that allow participants to invest in a single fund which will diversify the assets, within the fund, according to a projected future date of withdrawal. These are usually constructed as a “fund of funds”, meaning that within the single fund, assets are invested in diversified mix of different types of funds. Often these funds are associated with a future date, such as 2020, 2025, etc. That time frame determines the mix of stocks, bonds and cash within the fund. The Department of Labor had blessed this type of investment as a proper choice.
* Qualified plans may invest in a wide variety of options including cash, stocks, bonds, real estate, mortgages, life insurance, annuities, hard assets, collectibles, and even more esoteric investment options. However, most plans offer stock, bond, and cash equivalent options, which cover the three investment alternatives that are suggested in IRC Section 404(c). When employees control the investments, the investment vehicle of choice in retirement plans has been mutual funds. Most plans will offer a variety of options in each of the three categories so that every participant can choose an investment that meets his or her individual needs. In addition, most plans allow participants to trade on a daily basis.
* In regard to pension plans, pension managers are generally not allowed to put all the plan’s money into a single investment, such as a stock. They are expected to spread the money across a variety of investments, which is called diversification, to keep the pension fund from being exposed to undue risk. By spreading the money into multiple investments, there is less likelihood that one poor investment will expose the entire pension plan to large losses. This is extremely important to the employer with a defined benefit plan because the employer assumes all the investment risk. This means that the employer will still have to pay the full benefit even if there is little money in the fund because of adverse investment results.
TEST TIP
The employer assumes all the investment risk in a defined benefit plan. The individual assumes all the investment risk in a defined contribution plan.
As a financial planner, you may assist your client in selecting investment options in his or her retirement account. By knowing the rules about the types of investments that need to be offered in the plan, you can also help to ensure that the plan is keeping the participants and their beneficiaries in mind and notify your client if his or her plan is not in order.
PRACTITIONER ADVICE
Employers are not required by ERISA to provide investment control to participants in Profit Sharing, Money Purchase, and Target Benefit plans. Despite the fact that the employees are subject to investment risk, the employer can elect to control the investment choices. However, the employer is held to the “Prudent Person” standard as a Fiduciary of the plan.
ADVICE It is not timing market makes investor do well but time in market
Describe the consideration of Time Horizon
- Investments that are offered in retirement plans should not only match participants’ risk tolerance and goals, but should be consistent with their time horizon.
- For example, a 60-year-old nearing retirement might start looking for investments that preserve his principal as opposed to a 30-year-old that is looking for long-term growth in his or her investments.
- Generally, stocks or stock funds are used for long-term time horizons.
- Bonds or bond funds are used for medium-term time horizons.
- Cash equivalents, such as money markets funds, are used for short-term time horizons.
- It is important that all three types of investments are offered in retirement plans because all the participants in a retirement plan are not going to have the same time horizon for retirement.
- As a financial planner, you may assist your clients in selecting the investments in their retirement account.
- Keep not only their risk tolerance and goals in mind, but also their time horizon.
- Not only should a plan have diversified investment options, but participants should also diversify their accounts to hedge against the risk of one investment exposing the entire account to large losses.
- Enron employees are a perfect example of how having all one’s investments in one option can have a huge effect on one’s account.
- A well-diversified portfolio will include many investments from various asset classes and smooth out the ups and downs of the market. This will usually help a client stay invested.
PRACTITIONER ADVICE
* It is not timing the market that makes an investor do well but time in the market.
* As a financial planner, it is your job to help your clients create a well-diversified portfolio that meets their needs and risk tolerance, so that they will stay in the market.
Who are the fiduciary’s main concerns? Click all that apply.
* The fiduciary’s company
* The retirement plan
* Beneficiaries
* Participant
Beneficiaries
Participant
* According to Title 29 section 1104 of the U.S Code of Law, a fiduciary shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries.
A participant exercises control over and makes an exchange in his account. The plan is liable if the exchange eventually causes a loss within the participant’s account.
* False
* True
False
- No person who is otherwise a fiduciary shall be liable for any loss, or by reason of any breach, which results from such participant’s or beneficiary’s exercise of control.
Which of the following would be considered part of the Prudent Person Standard of Care? (Select all that apply)
* Offering a variety of investment options from all the different asset classes.
* Offering loan and withdrawal options in the plan.
* Providing education material on the investment options in the plan.
* Looking for plan administration that offers reasonable fees.
Offering a variety of investment options from all the different asset classes.
Providing education material on the investment options in the plan.
Looking for plan administration that offers reasonable fees.
* A fiduciary must act with care, skill, prudence and diligence of a prudent person with the participant or beneficiary’s best interests in mind. And they have an obligation to diversify the plan’s assets to reduce the risk of loss.
Bill, a fiduciary of the CAP pension plan, took $10,000 of the pension plan and invested it in his own account. The $10,000 grew to $15,000 and then Bill’s breach was discovered. What will Bill be responsible for?
* He has no liability for the $10,000.
* He must return the $10,000 to the plan.
* He must return the $10,000 and the $5,000 profits to the plan.
* He must return the $5,000 earning to the plan only.
He must return the $10,000 and the $5,000 profits to the plan.
* Any person who is a fiduciary with respect to a plan who breaches any of the responsibilities, obligations, or duties imposed upon fiduciaries shall be personally liable to make good to such plan any losses to the plan resulting from each breach. They will have to restore to such plan any profits of such fiduciary, which have been made through use of assets of the plan by the fiduciary.
Section 3 - Prohibited Transactions
Title 29 Section 1106 of the Internal Revenue Code outlines transactions that are prohibited between the plan and other parties.
To ensure that you have a solid understanding of prohibited transactions, the following topics will be covered in this lesson:
* Plan and Party in Interest
* Plan and Fiduciary
* Transfer of Real or Personal Property
* Exemptions from Prohibited Transactions
Upon completion of this lesson, you should be able to:
* Define prohibited transactions, and
* Discuss exemptions to prohibited transactions.
The Secretary of Labor may not grant an exemption under subsection 1108 unless he finds that such an exemption is which of the following? Click all that apply.
* Administratively feasible
* In the interest of the plan and of its participants and beneficiaries
* Protective of the rights of the fiduciary of the plan
* Protective of the rights of participants and beneficiaries of such plan
Administratively feasible
In the interest of the plan and of its participants and beneficiaries
Protective of the rights of participants and beneficiaries of such plan
* The Secretary of Labor may not grant an exemption under subsection 1108 unless he finds that such an exemption is: administratively feasible, in the interest of the plan and of its participants and beneficiaries, and protective of the rights of participants and beneficiaries of such plan.
Section 4 - Life Insurance in a Qualified Plan
Life insurance for employees covered under a qualified plan can often be provided favorably by having the insurance purchased and owned by the plan, using deductible employer contributions to the plan as a source of funds. It is an important consideration for employers when looking at a retirement plan and what is offered in the plan.
As a financial planner, you need to be aware of why insurance may be offered through a qualified plan and how it may benefit your client.
To ensure that you have a solid understanding of life insurance in a retirement plan, the following topics will be covered in this lesson:
* When Is It Used?
* Advantages
* Disadvantages
* Insurance Coverage
* The Incidental Test
* Life Insurance in Defined Benefit Plans
* Fully Insured Pension Plans
* Life Insurance in Defined Contribution Plans
* Tax Implications
* Alternatives
Upon completion of this lesson, you should be able to:
* Discuss the advantages and disadvantages of life insurance in a retirement plan,
* Define the incidental test,
* Discuss insurance in defined benefit plans,
* Describe the fully insured pension plan, and
* Discuss insurance in defined contribution plans.
Using the appropriate life insurance products in a qualified plan can provide unpredictable costs for the employer. State True or False.
* False
* True
False
* The use of appropriate life insurance products for funding a qualified plan can provide extremely predictable plan costs for the employer.
Which of the following statements is true regarding fully insured pension plans? Click all that apply.
* Fully insured plans may solve the problem of “overfunded” plans.
* Funded exclusively by life insurance or annuity contracts.
* Fully insured plans are very popular currently.
* There is a trusteed side fund.
Fully insured plans may solve the problem of “overfunded” plans.
Funded exclusively by life insurance or annuity contracts.
- A fully insured pension plan is one that is funded exclusively by life insurance or annuity contracts. There is no trusteed side fund. Such plans were once common, but the high interest rates of the late 1970s lured many pension investors away from traditional insured pension products.
TEST Retirement Equity Act 1984 trustee own&benef life ins qualified pla
What are other advantages to a fully insured plan?
- In addition to exemption from minimum funding, a fully insured plan is eligible for a simplification of ERISA reporting requirements (Form 5500 series).
- An insured plan need not file Schedule B, Actuarial Information, with its Form 5500 (or 5500- EZ) and thus does not need a certification by an enrolled actuary.
- This reduces the cost and complexity of plan administration to some degree.
- Finally, a fully insured plan is exempt from the requirement of quarterly pension deposits since that is also tied together with the minimum funding requirements.
- Fully insured plans are, however, subject to Pension Benefit Guaranty Corporation (PBGC) coverage and annual premium requirements.
TEST TIP:
* The Retirement Equity Act of 1984 requires that the owner and beneficiary of life insurance in a qualified plan must be the trustee.
Profit sharing plans can use 100% of the employer contribution to purchase insurance of any type after it has been in the plan two years?
* False
* True
True
* Any employer contribution that has been in the profit-sharing plan for at least two years can be used up to 100% for insurance purchases of any type as long as the plan specifies that the insurance will be purchased only with such funds.
Insurance outside the plan is paid for entirely by after-tax dollars, so the person is benefitting from tax deductibility. State True or False.
* False
* True
False
- Insurance outside the plan paid for entirely with after-tax dollars, so there is no tax deferral.
Section 4 - Life Insurance in a Qualified Plan Summary
Life Insurance for employees covered under a qualified plan can often be provided favorably by having the insurance purchased and owned by the plan, using deductible employer contributions to the plan as a source of funds.
In this lesson, we have covered the following:
* When Is It Used? When a substantial number of employees covered in the qualified plan have unmet life insurance needs, when there are gaps and limitations in other company plans providing death benefits, when a defined benefit pension plan is overfunded, when highly compensated plan participants are potentially subject to substantial estate taxes on death benefits and when an employer wants an extremely secure funding vehicle for a plan.
* Advantages: Tax treatment of life insurance in a qualified plan usually provides an overall cost advantage, as compared with individual life policies provided by the employer outside the qualified plan or those personally owned by plan participants.
* Disadvantages: Some life insurance policies may provide a rate of return on their cash values which may be relatively low. Policy expenses and commissions on life insurance products may be greater than for comparable investments.
- Insurance Coverage: Insurance coverage should be provided for all plan participants under a nondiscriminatory formula related to the retirement benefit or plan contribution formula. Insurance coverage can be conditioned on taking a medical exam as long as it does not result in discrimination in favor of highly compensated employees.
- The Incidental Test: The IRS considers any nonretirement benefit in a qualified plan to be incidental so long as the cost of the benefit is less than 25% of the total cost of the plan. If the amount of insurance meets either of the following tests, it is considered incidental:
- The participant’s insured death benefit must be no more than 100 times the expected monthly benefit, or
- The aggregate premiums paid (premiums paid over the entire life of the plan) for a participant’s issued death benefit are at all times less than the following percentages of the plan cost for that participant:
- Ordinary life insurance - 50%
- Term insurance - 25%
- Universal life insurance - 25%
- Life Insurance in Defined Benefit Plans: Life insurance is particularly advantageous in defined benefit plans because it adds to the limit on deductible contributions. This add-on feature allows greater tax-deferred funding of the plan.
- Life Insurance in Defined Contribution Plans: In defined contribution plans, a part of each participant’s account is used to purchase insurance on the participant’s life. This plan can provide that insurance purchases are voluntary by participants, that the insurance is provided automatically as a plan benefit, or that the insurance is provided at the plan administrator’s option (on a nondiscriminatory basis).
Which of the following are advantages of having life insurance in retirement plans? (Select all that apply)
* It provides a safe investment for a qualified plan.
* Policy expenses and commissions on life insurance products may be greater than for comparable investments.
* It provides predictable plan costs for the employer.
* A “pure insurance” portion of a qualified plan death benefit is subject to income tax.
It provides a safe investment for a qualified plan.
It provides predictable plan costs for the employer.
* Life insurance provides one of the safest available investments for a qualified plan. In addition, the use of appropriate life insurance products for funding a qualified plan can provide extremely predictable plan costs for the employer. Also, the “pure insurance” portion of a qualified plan death benefit is not subject to income tax. This makes it an effective means of transferring wealth.
What are the three common approaches in which life insurance can be used in defined benefit plans? (Select all that apply)
* Combination Plan
* Whole-life Plans
* Envelope Funding
* Fully Insured Pension Plans
Combination Plan
Envelope Funding
Fully Insured Pension Plans
* In a combination plan, retirement benefits are funded with a combination of whole life policies and separate assets in a separate trust fund called the “side fund” or “conversion fund”.
* In the envelope funding approach, insurance policies are simply considered as plan assets like any other assets.
* A fully insured pension plan is one that is funded exclusively by life insurance or annuity contracts. There is no trusteed side fund.
In what ways can life insurance in all defined contribution plans be provided to employees? (Select all that apply)
* The insurance is provided as an in-service distribution
* Insurance purchases are voluntary by participants
* The insurance is provided automatically as a plan benefit
* The insurance is provided at the plan administrator’s option
Insurance purchases are voluntary by participants
The insurance is provided automatically as a plan benefit
The insurance is provided at the plan administrator’s option
* In defined contribution plans, a part of each participant’s account is used to purchase insurance on the participant’s life. This plan can provide (a) that insurance purchases are voluntary by participants (using a directed account or earmarking provision), (b) that the insurance is provided automatically as a plan benefit, or (c) that the insurance is provided at the plan administrator’s option (on a nondiscriminatory basis).
John has a qualified plan that has $100,000 of life insurance on his life with his wife as the named beneficiary of his qualified plan and his children as the contingent beneficiaries. Who is the owner of the life insurance policy?
* John
* John’s wife
* The plan trustee
* John’s children
The plan trustee
* The plan trustee is the owner according to The Retirement Equity Act of 1984.
Section 5 - Annuities
An annuity is a contract between an insurance company and an individual that typically guarantees lifetime income to the person whom the contract is based in return for a single sum or periodic payment to the insurance company. Usually the objective of someone who purchases an annuity is retirement income.
Retirement plans can use annuities as a funding vehicle. Annuities have been commonly used to fund 403(b) plans for many years. As a financial planner, you will need to be aware of these products, as well as how they fit into a retirement plan if your client works for a tax-exempt organization.
Individuals might consider investing in annuities outside of retirement plans if they have utilized some or all of the tax-favored vehicles, and want to still put money aside that can grow tax-deferred.
To ensure that you have a solid understanding of annuities, the following topics will be covered in this lesson:
* Types of Annuities
* Payout Options
* Tax Treatment of Distributions
Upon completion of this lesson, you should be able to:
* Define the different types of annuities,
* Define the different payout options for annuities, and
* Discuss the tax treatment of distributions.
Jack purchases an annuity with a period certain of 10 years. Jack passes away 5 years into the 10-year period. His beneficiaries will receive payments for the rest of their lives. State True or False.
* False
* True
False
- If one dies before the end of the “certain period”, which is generally either 10 or 20 years, payments will continue to their beneficiary until the end of that period.
PRAC ADVICE: Clients be aware that annuities have own surrender charge
What is the Tax Treatment of Distributions from Annuities?
If you receive your qualified plan payout in the form of an annuity, those payments will generally be taxed as ordinary income.
However, an annuity purchased outside of a tax advantaged retirement plan is taxed as follows:
* Withdrawals will be assumed to be gain first, and therefore taxable. Once all gain is removed, then withdrawals will be determined to be basis which will not be taxed again.
* Taxable withdrawals (gain) made prior to age 59½ may be subject to a 10% penalty. This penalty can be avoided if the withdrawal is due to death, disability, as a series of substantially periodic payments or through annuitization using a commercial annuity.
PRACTITIONER ADVICE:
* Clients need to be aware that many annuities have their own surrender charges as well. A typical surrender charge might look like this:
Year 1–7%
Year 2-6 %
Year 3-5%
Year 4-4%
Year 5-3%
Year 6-2%
Year 7-1%
Year 8-0%
In addition, most annuities will allow a withdrawal during the surrender charge period of up to 10% without incurring a charge from the insurance company. Be careful not to confuse the insurance company surrender charge with the pre-59½ early withdrawal excise tax.
If an annuity, outside of a qualified plan, was purchased prior to August, 1982, that contract may be grandfathered to older language that allowed basis to be withdrawn before taxable gain. In that case, the owner would not pay income taxes or penalties on money withdrawn until they had taken out more than had been deposited.
The taxation of distributions during the annuitization stage is a little more involved. Some of the monies received are recovery of capital and some income. This is accomplished through an inclusion and exclusion ratio.
Formula for Exclusion Ratio = Investment in contract/Expected return
Formula for Inclusion Ratio = 1- exclusion ratio
REAL LIFE EXAMPLE
For example, assume Michael Orentlich has purchased an annuity with $50,000. He is now 60 years old, and the annuity will pay him $700 per month for life. Michael has a life expectancy of 20 years. Michael’s expected return is $168,000 ($700 per month x 12 months x 20 years).
Exclusion Ratio = $50,000/$168,000 = .29762
Inclusion Ratio = 1- exclusion ratio = .70238
This means that for every dollar Michael receives he will get 29.7262% tax-free and will have to pay taxes on 70.238%.
It is important to note that once the total amount of capital has been recovered, 100% of the payments are taxable.
