Course 5 Module 6. Investment Considerations for Retirement Plans

Ted has purchased an annuity for $20,000 that is expected to pay him $300 per month for the rest of his life. Ted's life expectancy is 20 years. How much of each payment is taxable to Ted? $ 83.33 $ 216.67 $ 300 None

$ 216.67 Taxable = Exclusion Ratio (Payment) = 1-(Investment in contract/Expected payout) x payment = 1-($20,000/$72,000) x $300 = 216.67

Pete died recently and held a profit-sharing account balance of $300,000. As part of Pete's account allocation, he maintained a universal life insurance policy with a death benefit of $100,000. The cash value of the policy is $20,000 and Pete had paid total P.S. 58 costs of $3,000. What is the current tax treatment of a lump-sum distribution of the profit-sharing account and life insurance proceeds? $317,000 ordinary income and $83,000 tax-free $323,000 ordinary income and $77,000 tax-free $400,000 taxable ordinary income $300,000 ordinary income and $100,000 tax-free

$317,000 ordinary income and $83,000 tax-free. The $300,000 account balance plus the life insurance cash value, less the P.S. 58 costs paid of $17,000 is ordinary income. The balance of the life insurance death benefit, $83,000, is tax-free.

In a qualified plan, such as a Section 401(k) plan, under which a participant has investment allocation control over the assets in their account, what is the minimum number of investment alternatives that must be offered according to ERISA regulations? 4 2 3 5

3 ERISA dictates that the account holder be given control over the assets in his or her account and provide at least three investment alternatives.

What is the maximum percentage of qualified plan contributions that may be allocated to ordinary (whole life) life insurance on behalf of a participant in a defined contribution plan to comply with the "incidental" regulations for life insurance in a qualified plan? 10% 0% 25% 50%

50% In a defined contribution plan, no more than 50% of contributions on behalf of a participant may be allocated to ordinary life insurance.

Fiduciary Considerations

A fiduciary is a person, company or association that holds assets in trust for a beneficiary. In regard to retirement plans, a fiduciary holds the assets of the plan participants or the pension plan depending on the type of retirement plan that is offered. For example, if a financial institution is the administrator and record keeper of ABC Company's 401(k) plan, they hold the assets of the plan and are considered a fiduciary of the plan. In addition, the plan sponsor in charge of managing the plan is also considered to have fiduciary responsibilities for the plan. You can better serve your clients as a financial planner by understanding the duties of a fiduciary. In that way, you can ensure that your client's best interests are at the forefront. If you have trading authority in your client's account, you will have fiduciary responsibilities to uphold to that client.

Fully Insured Pension Plans

A fully insured pension plan is one that is funded exclusively by life insurance or annuity contracts. A trust is not used to hold the plan assets. Such plans were once common, but the high interest rates of the late 1970s lured many pension investors away from traditional insured pension products. Fully insured plans are being reviewed, today, as an option for overfunded plans.

Each of the following statements is correct regarding a breach of fiduciary duty by a qualified plan fiduciary EXCEPT: The fiduciary will have to restore any profits to the plan, which have been made through the fiduciary's use of the plan assets. The fiduciary may be subject to equitable or remedial relief to the plan. The fiduciary may be removed from the role for a violation. A plan fiduciary at the time a breach of fiduciary duty is discovered may be liable even if such breach was committed before he became a fiduciary or after he ceased to be a fiduciary.

A plan fiduciary at the time a breach of fiduciary duty is discovered may be liable even if such breach was committed before he became a fiduciary or after he ceased to be a fiduciary. No fiduciary shall be liable with respect to a breach of fiduciary duty if such breach was committed before he became a fiduciary or after he ceased to be a fiduciary.

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.

Fixed Annuity

All funds in a fixed annuity are placed in the general account of the insurance company and they have a guaranteed rate of return. When you decide to begin receiving income (as opposed to a withdrawal), the payout is calculated by the value of the account and your life expectancy based on mortality tables. These payments will remain consistent throughout your life. A fixed annuity is considered an insurance product because the minimum return is guaranteed by the insurance company and you do not bear any of the risk. Any one who sells annuities must have an insurance license because it is considered an insurance product. The risk involved with fixed annuities is not in the principal and interest, but the loss of purchasing power due to inflation.

Payout Options

An annuity provides you with an annual payout. This payout can go for a set number of years, it can be in the form of lifetime payments for either you or your spouse, or it can be in the form of lifetime payments with a minimum number of payments guaranteed. In short, just deciding on an annuity isn't enough, you must also decide among several variations of an annuity payout. The decision regarding how an annuity will pay out benefits does not need to be made until the distributions are ready to begin.

Economic Advantage

As compared with the tax treatment of life insurance personally owned or provided by the employer outside the plan, there is usually an economic advantage to insurance in the plan, all other things being equal. Insurance outside the plan is paid for entirely with after-tax dollars, so there is no tax deductibility. The death benefit of non-plan insurance may be entirely instead of partially tax-free. However, the deductibility of tax with plan-provided insurance potentially results in a measurable net tax benefit.

Envelope Funding

At the opposite pole from the combination plan, where the entire plan is structured around the insurance policies, is the envelope funding approach, where insurance policies are simply considered as plan assets like any other assets. In funding, the actuary determines total annual contributions to the plan to provide both retirement and death benefits provided under the plan. The employer makes the contribution as determined by the actuary. Assets, including insurance policies, are purchased by the plan trustee to fund the costs of both the death benefits and the retirement benefits. The amount of insured death benefit in this approach is kept within the incidental limits whether by providing a death benefit of not more than 100 times each participant's projected monthly pension, or by keeping the amount of insurance premiums within the appropriate percentage limits (50% of aggregate costs for whole life insurance, 25% for term insurance, and so on). The envelope funding approach tends to require lower initial contributions to the plan than a combination plan approach, since the actuary's assumptions are usually less conservative than the assumptions used to determine life insurance premiums. Long-term costs, however, will depend on actual investment results, policy dividends and benefit and administrative costs of the plan.

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.

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.

Employer Contributions

Employer contributions to the plan, including those used to purchase life insurance, are deductible if the amount of life insurance is within the incidental limits.

Indicia of Ownership

Except as authorized by the Secretary of Labor by regulations, no fiduciary may maintain the indicia of ownership of any assets of a plan outside of the jurisdiction of the district courts of the United States.

Which of the following is NOT listed as a qualified plan prohibited transaction by a fiduciary in the Internal Revenue Code (IRC)? Failing to diversify the investments of the plan to minimize the risk of large losses. Use of plan assets for the benefit of a party in interest. Sale, exchange, or leasing of any property between the plan and a party of interest. The lending of money or other extensions of credit between the plan and a party in interest.

Failing to diversify the investments of the plan to minimize the risk of large losses. Failing to diversify the investments of the plan to minimize the risk of large losses may be a breach of fiduciary duty by a plan fiduciary but is not listed as a prohibited transaction in the IRC.

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. 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.

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. Insurance outside the plan paid for entirely with after-tax dollars, so there is no tax deferral.

T or F: 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. 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.

Using the appropriate life insurance products in a qualified plan can provide unpredictable costs for the employer. State True or False.

False. The use of appropriate life insurance products for funding a qualified plan can provide extremely predictable plan costs for the employer.

Annuities can be classified in many ways. The first two types of annuities we will review are based on the type of investments that the annuity offers. The two types are:

Fixed Annuities Variable Annuities

Jack is looking for an annuity that will guarantee a rate of return and provide payments for his lifetime. What type of annuity and payout option should he choose? Variable annuity with single life payout Fixed annuity with single life payout Variable annuity with certain period payout Fixed annuity with certain period payout

Fixed annuity with single life payout A fixed annuity guarantees a rate of return because it puts the funds in the general account. With a single payout option, the annuitant will receive payments as long as he or she lives whether that is 1 year or 50 years.

Life Insurance in a Qualified Plan: How does it Work?

Fully insured funding can be used either with a new plan or an existing plan. The employer can be a corporation or an unincorporated business. Typically, a group type of contract is used, with individual accounts for each participant. All benefits are guaranteed by the insurance company. The premium is based on the guaranteed interest and annuity rates, which are typically conservative, resulting in larger initial annual deposits than in a typical uninsured plan. However, excess earnings beyond the guaranteed level are used to reduce future premiums. Using excess earnings to reduce future premiums results in a funding pattern that is the opposite of that found in a trusteed (uninsured) plan. In the insured plan (for a given group of plan participants), the funding level is higher at the beginning of the plan (or fully insured funding arrangements) and drops as participants move toward retirement. This allows maximization of the overall tax deduction by allowing more of it to be taken earlier. It also often permits deductions for an existing plan that has reached the full funding limitation with uninsured funding. By comparison, a traditional trusteed plan starts with a relatively low level of funding, which increases as each participant nears retirement.

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.

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.

Which of the following statements is NOT correct regarding "fully insured" qualified pension plans? Fully insured plans may be a solution to resolve an overfunded plan issue. High interest rates fueled the demand for fully insured pension plans in the past. A fully insured pension plan is one that is funded exclusively by life insurance or annuity contracts. A trust is not used to hold the plan assets.

High interest rates fueled the demand for fully insured pension plans in the past. Fully insured defined benefit pension plans were once very common but the high interest rates of the late 1970s lured many pension investors away from traditional insured pension products.

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).

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.

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.

If ordinary (whole life) life insurance is used in a defined benefit plan, what is the maximum death benefit the life insurance may provide without violating the "incidental" test for life insurance in a qualified plan? No more than 10 times the projected monthly pension benefit. No more than 100 times the projected monthly pension benefit. No more than 25 times the projected monthly pension benefit. No more than 50% of plan contributions.

No more than 100 times the projected monthly pension benefit. The participant's insured death benefit must be no more than 100 times the expected monthly pension benefit (100 times limit).

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.

The three investment alternatives suggested in IRC Section 404(c) for qualified plans include each of the following EXCEPT: Precious metals Bonds Cash equivalents Stocks

Precious metals The three investment alternatives suggested in IRC Section 404(c) for qualified plans include stocks, bonds, and cash equivalents.

Life Insurance in Profit Sharing Plans

Profit sharing plans have an additional feature that may allow large insurance purchases. Since profit sharing plans potentially allow in-service cash distributions prior to termination of employment, the amount available for an in-service distribution can be used without limit to purchase life insurance. Based on IRS rulings, this means that 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.

Plan Death Benefits

Qualified plan death benefits are, in general, included in a decedent's estate for federal tax purposes. However, it may be possible to exclude the insured portion of the death benefit if the decedent has no incidents of ownership in the policy. There have not yet been any decisive court cases or rulings on this issue.

Prohibited transactions: Transfer of Real or Personal Property

Some transfers of real or personal property between a plan and the party in interest are prohibited. A transfer of real or personal property by a party in interest to a plan shall be treated as a sale or exchange if the property is subject to a mortgage or similar lien which the plan assumes or it is subject to a mortgage or similar lien which a party in interest placed on the property within the 10-year period ending on the date of the transfer.

Economic Value

The economic value of pure life insurance coverage on a participant's life is taxed annually to the participant at levels specified by the IRS. The value is taxed at the lower of (a) the IRS Table 2001 costs or (b) the life insurance company's actual term rates for standard risks. However, the ability to use an insurer's published rates is much more limited. Any amount actually contributed to the plan by the participant is subtracted from this amount. If the participant is an owner-employee in a Keogh plan, the taxation is slightly different.

Which of the following statements is correct regarding the tax treatment of the economic value of pure life insurance held by a participant in a qualified plan? The economic value of pure life insurance is tax-free. The economic value of pure life insurance is taxable if it is less than any premiums contributed by the participant. The economic value of pure life insurance is taxable at the time of death of the participant. The economic value of pure life insurance is taxable annually to the participant.

The economic value of pure life insurance is taxable annually to the participant. The economic value of pure life insurance is taxable annually to the participant. Any premium contributed to the plan by the participant is subtracted from the taxable annual economic benefit amount.

Larry and Kristi select a joint and survivor annuity with a 100 percent survivor benefit. What are the disadvantages to them of selecting a 100 percent survivor benefit versus a 50 percent survivor benefit? The initial benefit will be less If Larry dies, Kristi will not receive a benefit If Kristi dies, Larry will receive a lump sum distribution If Kristi dies, Larry will not receive a benefit

The initial benefit will be less The disadvantage of a joint survivor annuity with a 100 percent survivor benefit is that the initial benefit received will be less because there is a guarantee that the survivor will receive the same payout. A joint and survivor annuity with a 50 percent payout will pay a higher initial benefit due to the fact that only 50 percent of the benefit will be paid upon one of the annuitants' deaths.

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.

There are some disadvantages to offering life insurance in a qualified plan:

There are some disadvantages to offering life insurance in a qualified plan: - Some life insurance policies may provide a rate of return on their cash values which, as compared with alternative plan investments, may be relatively low. However, rates of return should be compared on investments of similar risk. - Policy expenses and commissions on life insurance products may be greater than for comparable investments.

Prohibited Transactions

Title 29 Section 1106 of the Internal Revenue Code outlines transactions that are prohibited between the plan and other parties.

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.

Life or Period Certain Annuity

Under a life with a period certain you receive annuity payments for life. However, if you die before the end of the period certain, which is generally either 10 or 20 years, payments will continue to your beneficiary until the end of that period. Because a minimum number of payments must be made (payments must continue until the end of the period certain), an annuity for a life with a period certain pays a smaller amount than a single life annuity. In addition, the longer the period certain is, the smaller the monthly amount.

Lump Sum Versus Annuity Payments

Under a lump-sum option, you receive your benefits in one single payment. If you are concerned about inflation protection, or if you are concerned about having access to emergency funds, a lump-sum distribution, or taking part of your money in a lump sum and putting the rest toward an annuity, may be best. If you do take your benefits in a lump sum, you will be faced with the job of making your money last for your lifetime and for your loved ones after you are gone. That's not all bad - you get to invest the money wherever you choose, and you may end up earning a higher return. The big advantage to a lump-sum payout is the flexibility it provides. Unfortunately, you'll run the risk of making a bad investment and losing the money you so carefully saved.

Single Life Annuity

Under a single life annuity, you receive a set monthly payment for your entire life. Think of this type of annuity as the Energizer Bunny - it just keeps going and going, at least as long as you do. If you die after one year, the payments cease. Alternatively, if you live to be 100, so do your payments.

Assets of which type of annuity are NOT a part of the insurance company's general account? Variable Fixed

Variable Contributions made to a variable annuity are put into a separate account that is not part of the insurance company's general account.

Jane is looking for annuity that may outpace inflation and will guarantee payments for at least 10 years. What type of annuity and payout option should she choose? Variable annuity with single life payout Fixed annuity with single life payout Variable annuity with certain period payout Fixed annuity with certain period payout

Variable annuity with certain period payout To outpace inflation, a variable annuity has a better opportunity to outpace inflation than a fixed annuity because of the investment in the separate account. To ensure that Jane receives payments for 10 years, she must select a certain period payout option. Jane could select a single life payout option. However, depending upon her death she may receive more or less than 10 years.