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21.5 Review and Practice

  1. Which is preferable from an employee’s point of view: a defined contribution or a defined benefit pension plan? Explain your answer.
  2. Henry Wooster meets with the employee benefits manager to discuss enrolling in the company’s 401(k) plan. He finds that if he enrolls, he must choose the amount of salary to defer and also direct his fund investment. Having no college education and no business experience, Henry lacks confidence about making these decisions.

    1. Should Henry enroll in the 401(k) plan? Do the advantages outweigh the difficulties he may have in managing the plan?
    2. What would you recommend that Henry do to educate himself about fund management? How can the benefits manager help?
    3. Is it appropriate for the employer to establish a plan that requires employees to take so much responsibility for retirement planning? Explain your answer.
  3. As an employee benefits manager, you must recommend to the firm’s CEO a defined contribution plan to add to the existing defined benefit retirement plan. First, describe a hypothetical firm, giving the size of the firm, its profitability, and the stability of its work force. Then explain your choice of a deferred profit-sharing plan, a 401(k), a money purchase plan, or some combination of these.
  4. The law firm of Dunham, Chapman, & Hart has five employees. Following is information regarding these employees:

    Employee Age Salary Position
    Dunham 57 $240,000 Partner
    Chapman 34 $180,000 Partner
    Hart 58 $110,000 Partner
    Perez 38 $60,000 Associate
    McCall 27 $40,000 Paralegal

    The partners talked to Rollings Benefits Consultants about the best-qualified pension plan for the firm in light of their major success in and anticipated growth in profits in the coming years. Rollings Benefits created a presentation of a possible plan that showed the maximum possible contributions for the highly paid employees (the partners). Under this proposal, what qualified plan do you think Rollings Consultants suggested to Dunham, Chapman, & Hart? The objective is to give highly paid employees the highest possible contributions. Explain the proposal.

  5. Cash balance plans have become increasingly popular in recent years. Why do employers like cash balance plans relative to other types of defined benefit plans?
  6. The VA Regional Bank employs 5,300 full-time employees. It is a privately owned corporation that was established in 1972 and has been very successful, despite the recession, because of the conservative investments of the owners. All employees work at least thirty hours a week. The management team has expanded and now includes 830 highly compensated employees. The VA Regional Bank has had an established traditional integrated defined benefit plan for the past twenty years. Despite its major success, management decided to follow the lead of converting traditional defined benefit plans to cash balance plans. There are many good reasons to do so, but management is worried about the impact on some segments of its work force. In a survey they conducted, they saw a high level of resistance by many employees. The case has been a topic of much discussion in the media and in Congress, and it is under the jurisdiction of the 2006 Pension Protection Act. Respond to the following:

    1. Design the formula for the traditional integrated defined benefit plan that you think the company currently provides based on what you learned in this chapter.
    2. Design the formula for the cash balance plan that you think the company is contemplating for its employees.
    3. Who benefits most from each of these plans? Compare your answers in (a) and (b). Why do you think so many employees expressed resistance to the possibility of a cash balance plan?
  7. What are the ramifications of terminating a defined benefits pension plan? (Refer to the box, “Cash Balance Conversions: Who Gets Hurt?” and the PBGC Web site.)
  8. The following table shows the five employees of the law firm of Tayka, Mooney & Ruhn, plus some information about each.

    Employee Age Salary Position
    Tayka 37 $210,000 Partner
    Mooney 34 $160,000 Partner
    Ruhn 28 $110,000 Partner
    Davies 38 $60,000 Associate
    Edmundsen 27 $40,000 Paralegal
    1. Rollings Consultants explain to the owners of Tayka, Mooney & Ruhn the problems that may occur with 401(k) plans. They show an example of how the company can fail the ADP test and how highly paid employees would not be able to take all the deductions they want. Pretend you are the Rollings consultant. Show such an example and give the firm some methods to overcome this problem. Use the table above to calculate an example and explain your answer.
    2. If the company decides to start a profit-sharing plan with $35,000 the first year, how much will be allocated to each employee?
  9. The Children Dentistry Place is a successful fifteen-year-old professional firm with five employees. Following is information regarding these employees (note their ages):

    Employees Age Salary Years of Service Position
    Marie 55 $320,000 15 Part owner
    Stan 55 $220,000 15 Part owner
    Dan 35 $70,000 5 Assistant
    Elli 30 $70,000 13 Assistant
    Shannon 50 $60,000 12 Office manager

    The firm is interested in establishing a defined contribution pension plan. Because the business is doing so well, the top employees want to maximize the contribution for themselves but not for the other employees.

    1. Given the age of the top employees, what defined contribution pension plan would you suggest?
    2. Using the plan you think will work best for them, show the contribution for each employee. Explain your answer.
    3. What types of loans and distributions are permitted under the plan you designed?
    4. Describe ERISA requirements regarding survivors.
  10. Prepare a matrix comparing the differences among the following:

    1. IRA and Roth IRA
    2. 401(k) and ESOP
    3. 403(b) or 457 (select one of the two plans)
    4. SEP or SIMPLE plans (select one of the two plans)

    Make sure to include the following:

    • Who or what organizations should use each plan? What are the limitations?
    • What are the unique characteristics of each plan?
    • Who is eligible?
    • What are the provisions for loans and distributions?
  11. Jackson Appliances has twelve employees. The owner, Zena Jackson, is considering some system to reward them for their loyalty and to provide some funds to help them with their living expenses after they retire. Explain why a SEP might be a good choice for the company and explain how it works. Are there other alternatives Zena should consider?
  12. What is the primary way in which a single premium deferred annuity differs from a flexible premium deferred annuity? How might the typical motivations for purchase differ for investors in these two types of annuities?