Introduction to the American Pension System Professor Paul M. - - PDF document

Bijzonder actualiteitscollege Leergang Pensioenrecht 28 juni 2011

Introduction to the American Pension System

Professor Paul M. Secunda Associate Professor of Law Marquette University Law School Milwaukee, Wisconsin USA

Chapter Three

FOUR PILLARS OF AMERICAN PENSION LAW

First Pillar Compulsory Pay-as-you-go (PAYG) Federal Pension “Social Security” Second Pillar Supplementary Funding-Based Occupational Pensions ERISA Third Pillar IRAs Low Personal Savings Rate in US Fourth Pillar Extension of Working Life Based on Longer Life Expectancy

Bijzonder actualiteitscollege Leergang Pensioenrecht 28 juni 2011

US Pension “Exceptionalism”

First Pillar (minor)

Social Security alone does not provide adequate retirement For large majority of US workers, Social Security will lead to about 40% income replacement ratio (SSA 2011). Yet, to maintain a comfortable lifestyle in post-retirement years, a US worker will need at least 70% to 80% income replacement ratio

Second Pillar (major)

As proportion of retirement income replaced by Social Security decreases, proportion replaced by

• ther sources has to increase

Consequently, many higher-salaried US employees must receive much larger percentage of retirement from

• ccupational pensions to have

adequate retirement Or, of course, additional personal savings (third pillar)

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US Social Security Basics

• Social Security Act (SSA) enacted in 1935 by FDR as part of “New Deal”
• Purpose: provide for economic security of its citizens for: disability, death,
• ld-age, and unemployment
• Federal Old-Age Benefits (Title II): Pay retired workers age 65 or older a

continuing income after retirement

• Mandatory for private-sector employees
• Participation for federal, state and local employees varies
• Benefit payment affected by age at which worker decides to retire

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US Social Security Basics - Continued

• PAYG – benefits based on payroll tax (FICA Tax) contributions worker

makes while working

• Current contributions largely paid out in current benefits (but baby boomer

issue; intergenerational transfers)

• 1 in 7 Americans (2008) receives social security benefits
• When workers pay Social Security taxes, they earn “credits” toward Social

Security benefits

• The number of credits workers need to get retirement benefits depends on

when they were born. If they were born in 1929 or later, workers need 40 credits (10 years of work)

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Bijzonder actualiteitscollege Leergang Pensioenrecht 28 juni 2011

The Importance of Retirement Age

• For instance, if retire at 62 (the earliest possible retirement age for

Social Security), benefit will be lower than if you wait until later to retire

• Normal retirement age moving from 65 to 67 for individuals born

1960 or later

• May choose to keep working even beyond normal retirement age. If

do, can increase future Social Security benefits in two ways

– Each additional year of work adds another year of earnings to Social Security

• record. Higher lifetime earnings may mean higher benefits when retire.

– Also, benefit will increase automatically by a certain percentage from the time

• ne reaches full retirement age until start receiving benefits or until reach 70.

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Coverage vs. Non-Coverage

• 96% of workers are currently in jobs covered by social security
• Not covered: some federal, state, and local employees and

employees of non-profits

• Most public employees now have Social Security protection

because their states and the Social Security Administration entered into special agreements called “Section 218 agreements”

• Others public employees are covered by a US federal law passed in

July 1991 when Social Security was extended to state and local employees who were not covered by an agreement and were not members of their agency’s public pension system.

• Receiving Benefits: 222,000 (1940) v. 44 million (2008)

The Finances of Social Security

• Workers and employers both subject to Social Security taxes on earned

income up to $106,800 for 2010 at a rate of 6.2% for both the employee and employer

• So, for worker earning $55,000 in 2010, a total of $6,820 will be paid
• The average monthly Social Security benefit for a retired worker was about

$1,177 at the beginning of 2011or $14,124 per year. The poverty line for

• ne person in US in 2009 was $10,830 per year
• Maximum benefit depends on age a worker chooses to retire. For example,

for a worker retiring at age 66 in 2011, the amount is $2,366 per

• month. This figure is based on earnings at maximum taxable amount for

every year after age 21

• If years when did not work or had low earnings, benefit amount may be

lower than if had worked steadily.

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Bijzonder actualiteitscollege Leergang Pensioenrecht 28 juni 2011

How is Social Security Amount Determined?

• Social Security benefits are based on lifetime earnings
• Actual earnings are adjusted or "indexed" to account for changes in

average wages since the year the earnings were received

• Then Social Security calculates average indexed monthly earnings

during the 35 years in which the worker earned the most

• A formula is then applied to these earnings and a basic benefit, or

"primary insurance amount" (PIA), is determined

• The calculated amount is how much a worker would receive at full

retirement age—65 or older, depending on date of birth

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US Second Pillar: Occupational Pension Law

Relevant Statutes

• Employee Retirement Income Security Act
• f 1974 (ERISA)

– Goal to protect assets of the benefits plan and benefits promised to employees

• Internal Revenue Code of 1986 (Code)

– Provide tax incentives so that employers voluntarily adopt employee benefit plans

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Which Employees and Benefit Plans are Covered Under ERISA?

• Private vs. Governmental and Church employees
• Distinction between employees v. independent

contractors (Darden Criteria – hiring party's right to control the manner and means by which the product is accomplished)

• Covered Benefit Plans (Dillingham and Ft. Halifax

Factors)

Bijzonder actualiteitscollege Leergang Pensioenrecht 28 juni 2011

June 28, 2011

PLANS SUBJECT TO ERISA

Employee Benefit Plan §4(a) Exclusions §4(b) §3(3) Welfare Benefit Plan §3(1) Pension Benefit Plan §3(2)

Characteristics of Retirement Plans: Shift From DB To DC

Type Defined Contribution Defined Benefit Design Employer Contribution Individual Accounts Employer Contribution Benefit amount defined by plan

$ $

DB vs. DC Plans

DEFINED BENEFIT PLANS DEFINED CONTRIBUTION PLANS  Benefits determined by set formula (e.g., 2 percent times years of service times final average pay)  Benefits determined by contributions and investment earnings (e.g., 10 percent of annual pay)  Funding flexibility  Possible discretion in funding  Reward older and longer service employees (backloaded)  Significant accruals at younger ages  Employees face financial penalties for working past normal retirement age  No disincentives for working past normal retirement age  Long vesting period (e.g., 5 years)  Often a short vesting period (e.g., 1 year)  Employer bears the investment risk  Employee bears the investment risk  Employee has no investment discretion  Employee has investment discretion  High rates of return  Significantly lower average rates of return  Often not portable  Portable  Require actuarial valuation  Does not require actuarial valuation  Relatively low employee understanding and appreciation  Relatively high employee understanding and appreciation  Unfunded liability exposure  No unfunded liability exposure  Provide benefits targeted to income replacement level  Does not provide benefits targeted to income replacement level  Usual form of benefit payment is monthly income (annuity)  Usual form of benefit payment is lump sum distribution  Employees cannot borrow  Employees may be able to borrow

Bijzonder actualiteitscollege Leergang Pensioenrecht 28 juni 2011

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Types of Defined Contribution Plans

• Profit Sharing Plan
• Money Purchase Pension Plan
• 401(k) Plan
• ESOP

401K DESIGN FEATURES

• Selection of Investment Vehicles for Employees to

Choose From – Limited Employer Fiduciary Duties – Company stock, equities, bonds, mutual funds – No requirement to diversify or limit amount of company stock

• Plan loans
• Employer matching contributions
• Hardship distributions
• Automatic enrollment/QDIA
• Distribution and Direct Rollovers
• Reporting and Disclosure Requirements

US THIRD PILLAR: Individual Retirement Vehicles

– IRAs hold 27% of all retirement income in United States – IRAs classified into four types (EBRI):

• traditional (originating from contributions) (33.6%)
• rollovers from other retirement plans (33.4%)
• Roth IRAs (23.4%)
• SEP/SIMPLE (9.6%)

– Average and median IRA individual balance (all accounts from the same person combined) was $69,498 and $20,046 at end of 2008. – 11.1 million unique individuals with total assets of $732.9 billion as of year-end 2008.

• Low US Personal Savings Rate
• As of April 1, 2011, US Personal Savings Rate: 4.9% (lowest since

2008) (source: Bureau of Economic Analysis, U.S. Department of Commerce)