US social security system
12.4% levy on first 168,600 of each individuals earned income each year(half paid by employer half paid by employee) used to pay existing retirees retirement benefits
what do self employed pay for social security
full 12.4% on income under 168000
what is done with excess social security $ after paying off retirees
invested into treasury bonds
what is a defined benefit plan
employers provide a specific retirement benefit based on salary and years of service (defined output)
what is a defined contribution plan
provide means for both employees and employers to contribute a steady stream revenue into the participants retirement account. end is based on contributions
who bears risk in defined benefit vs contribution
Benefit: gov and teachers
Contribution: employee
applying TVM TO PENSIONS
the asset is the present value but the obligations are the future value (as pension obligation increases so does more profit gets taken away by the business)
TVM and interest rate with pension funds (discount)
when interest rates are low the money invested grows more slowly but to meet future obligations that means the company needs to start with larger Present value
what is a pension fund
pool of money set aside to pay people after they retire
when can you claim retirement benefits from social security
as early as 62 and as late as 67
challenges of defined contribution
employees do not have efficienct knowledge and the skill (ex financial crisis) + leads to saving too little too late
whats a 401k
a defined contribution plan that is sponsored by ones employer
what kind of plan is social security
defined benefit
advantages of IRR
able to know intuitively if the return is appealing
simple way to communicate the value to someone who doesnt have the full details
if the IRR is high enough you may not need to estimate a required return
what is IRR
its the actual return generated from investment
cons of a IRR
doesn’t capture the actual cash flows from the project (ex getting a 20% rate of return on a project costing 10 dollars vs 100 dollars)
which is the dominant and most reliable out of NPV, IRR, or PB
NPV - because we want to pick the project that gives additional more dollar amount rather than just a rate of return because they can be the Rame amount of return but the dollar amount can be way bigger
payback period rule
small firm especially older CEOS and CEOS without MBAs are more likely to use payback periods especially smaller corporations cause they will not want to wait to see cash back in many years into the future but as soon as possible
Disadvantages of IRR
it is just an implied rate that is return from the project doesnt capture amount of cash
what is the disadvantages of the payback period method
its a quick valuation but doesnt consider TVM, requires an arbitrary cut off point, ignores cash flows beyond cut off date, biased against long term projects such as RandD and new projects
advantages of the payback period
easy to understand
adjust for uncertainty of cash flows
biased toward liquidity
what method will Ceos with MBAs and large firm more likely to choose
NPV- more straight forward way of finding the new level of stock price
issue with early pension funds
you had tow work for a certain amount of time to get the benefits, they were rarely funded because if declared bankrupt they wouldn’t get paid. even after they saved up in case they went bankrupt they were usually under funded
Modern innovations for pension plans
ERISA (employment retirement income security act+ pension benefits guarantee act) where the pension goes into a fund separate from company to be managed but hard to measure
