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Copyright 2009, The National Underwriter Company 1
Defined Benefit Pension Plan
Chapter 14Employee Benefit & Retirement Planning
What is it?
A qualified employer pension plan that guarantees a specified benefit level at and during retirement
Copyright 2009, The National Underwriter Company 2
Defined Benefit Pension Plan
Chapter 14Employee Benefit & Retirement Planning
When is it indicated?
• employer’s plan design objective is to provide an adequate level of retirement income to employees regardless of their age at plan entry
• employer wants to allocate plan costs to the maximum extent to older employees
• older controlling employee in a small business wants to maximize tax-deferred retirement savings
Copyright 2009, The National Underwriter Company 3
Defined Benefit Pension Plan
Chapter 14Employee Benefit & Retirement Planning
Advantages
1. employees gain tax-deferred retirement savings
2. can provide adequate retirement levels for employees regardless of age at plan entry
3. benefit levels guaranteed by employer and Pension Benefit Guaranty Corporation (PBGC)
4. plan generally allows maximum amount of tax-deferred retirement saving for older highly compensated employee
Copyright 2009, The National Underwriter Company 4
Defined Benefit Pension Plan
Chapter 14Employee Benefit & Retirement Planning
Disadvantages
1. higher plan installation and administrative costs than defined contribution plans
2. complex design; difficult to explain to employees
3. employees who leave before retirement may receive relatively little benefit from plan
4. employer has recurring annual funding obligation regardless of business profit levels
5. employer assumes investment risk
Copyright 2009, The National Underwriter Company 5
Defined Benefit Pension Plan
Chapter 14Employee Benefit & Retirement Planning
Design Features
Several formulas can be used to determine benefit promised at retirement
Flat amount formulaprovides stated dollar amount to each plan participant
Copyright 2009, The National Underwriter Company 6
Defined Benefit Pension Plan
Chapter 14Employee Benefit & Retirement Planning
Design Features
Flat percentage formula
– retirement benefit is % of employee’s average earnings
– typically requires minimum service for full % benefit with % scaled back for fewer years of service
Copyright 2009, The National Underwriter Company 7
Defined Benefit Pension Plan
Chapter 14Employee Benefit & Retirement Planning
Design Features
Unit credit formula
– retirement benefit based on employee’s service with employer
– typically provides % of earnings for each year of service
– two common methods to compute average earnings
Copyright 2009, The National Underwriter Company 8
Defined Benefit Pension Plan
Chapter 14Employee Benefit & Retirement Planning
Design Features
Unit credit formula – average earnings
career average
average earnings over employee’s entire
career with employer
final average
average earnings over number of years;
usually 3-5 years before retirement
Copyright 2009, The National Underwriter Company 9
Defined Benefit Pension Plan
Chapter 14Employee Benefit & Retirement Planning
Tax Implications
1. employer contributions to plan are deductible when made
2. contributions and earnings tax deferred for employee for qualified plans
3. IRS Code Section 415 places maximum limit on projected annual benefit plan can provide
Copyright 2009, The National Underwriter Company 10
Defined Benefit Pension Plan
Chapter 14Employee Benefit & Retirement Planning
Tax Implications
4. rules for qualified plan distributions must be followed; premature distributions may be subject to penalty
5. IRS Code Section 412 sets minimum funding rules; employer penalized if minimum not met
Copyright 2009, The National Underwriter Company 11
Defined Benefit Pension Plan
Chapter 14Employee Benefit & Retirement Planning
Tax Implications
6. mandatory coverage by PBGC, employer must pay premium of $30 per participant plus amount calculated on basis of plan’s unfunded vested benefits, if any
7. certain employers adopting new plan may be eligible for business tax credit up to $500
Copyright 2009, The National Underwriter Company 12
Defined Benefit Pension Plan
Chapter 14Employee Benefit & Retirement Planning
Tax Implications
8. plan may permit employer contributions to “deemed IRA”; such contributions reduce limit for other traditional or Roth IRA contributions
Copyright 2009, The National Underwriter Company 13
Defined Benefit Pension Plan
Chapter 14Employee Benefit & Retirement Planning
ERISA Requirements
Plan subject to ERISA requirements for qualified plans, including:
– participation
– funding
– vesting
– reporting
– disclosure
Copyright 2009, The National Underwriter Company 14
Defined Benefit Pension Plan
Chapter 14Employee Benefit & Retirement Planning
Alternatives
Money purchase plans
– lack employer guarantee of benefit levels
– provide adequate benefit only for younger employees
Target benefit plans
– lack employer guarantee of benefit levels
– may provide adequate benefit for older employees
Copyright 2009, The National Underwriter Company 15
Defined Benefit Pension Plan
Chapter 14Employee Benefit & Retirement Planning
Alternatives
Cash balance pension plan
– employer guarantees principal and investment earnings on plan fund
– provide adequate benefit only for younger employees
Profit sharing and similar plans
– benefit adequacy tied closely to employer financial success
Copyright 2009, The National Underwriter Company 16
Defined Benefit Pension Plan
Chapter 14Employee Benefit & Retirement Planning
Alternatives
Section 401(k) and similar plans
– employees have some control over amount saved
Private savings outside qualified plan
– except certain IRAs, lack tax benefits of saving in a qualified plan
Copyright 2009, The National Underwriter Company 17
Defined Benefit Pension Plan
Chapter 14Employee Benefit & Retirement Planning
Application Exercise
Jill Cummings is retiring this year. She has worked for Allied Enterprises for 25 years. Her last five years of salary are: $55,000, $56,000, $58,000, 60,000 and $61,000. Her average earnings over her career with Allied are $42,000.
Compute Jill’s retirement income from Allied under the following situations:
Copyright 2009, The National Underwriter Company 18
Defined Benefit Pension Plan
Chapter 14Employee Benefit & Retirement Planning
Application Exercise
Consider each situation independent.1. Allied provides retirees $600 per month per life
2. Allied provides retirees with 15 years or more years of
service 50% of average annual pay 3. Allied provides retirees with 1.6% of earnings for each
year of service usinga. career average earnings
b. final average earnings
4. Name each of the previous defined benefit plan formulas.
Copyright 2009, The National Underwriter Company 19
Defined Benefit Pension Plan
Chapter 14Employee Benefit & Retirement Planning
Discussion Question
What is the impact of nondiscrimination regulations on defined benefit plan design, especially for older owner-employees of closely held businesses?