MGT 341, Chapter 24 Review-Defined-Benefit Plans

Student: Meng-Ping Lee

Instructor: Professor Smith-Smith

Agenda

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What is Defined-Benefit Plan?

Benefit Accrual Rules

Death and Disability Benefit

Inflation Protection

Funding Rules

Deductibility of Contribution

Q & A

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What is Defined-Benefit Plan(DB)?

A type of pension plan which

employers promise a specified monthly benefit for participants

predetermined by a formula

basing on the employee's earnings history, year of service,

and age instead of individual investment returns

Employers take the risk of investment results and sufficient founds

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Defined-Benefit Pension Plan

Characteristics:

1. The benefit is related to a reasonable income replacement ratio

2. Favoring employees who enter the plan at later age

3. Employers can contribute more than other retirement plans

4. Benefits are guaranteed

5. Most complex and costly plan

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Types of Defined-Benefit Pension Plan:

1. Flat-Benefit Formula: do not take an employee’s service into account

flat-amount formula: a fixed monthly benefit mount for each employee

flat-percentage formula: fixed percentage of compensation at retirement

2. Unit-Benefit Formula: being based on the employee’s service

take only service into account (ex: collective bargain plans)

take service and compensation into account

(ex: replacement ratio x compensation x year of service)

utilizing the past service

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Cash-Balance Pension Plan“Contain features of both defined-benefit and defined-contribution plans”

Features of Cash-Balance Pension Plan DC DB

Accounts are set up for each participant with no investment risk

The accounts grow with annual credits (pay credit or interest credit)

Employers’ contributions are based on compensation and minimum funding requirements not age at entry

Ultimate benefit is subject to guaranty rate of return

Participants have guaranty minimum benefit

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Fully Insured Pension PlanUnder Code Section 412(e)(3)

Transfer risk to trust company:

– Funded by purchasing individual insurance contracts with a guarantee rate

– Equal to the guarantee positive benefit ( lump sum or monthly)

the annual premium payment period is not longer than the preretirement period of employment

No Actuarial Certification (simple present value formula)

Always fully founded:

– the premiums have been paid when due or reinstatement

– no right under the insurance contract have been subject to a security interest

– no outstanding policy loans

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Benefit Accrual RulesUnder IRC section 411(b), the accrual rate must be at least one of the three rules:

1. 3 Percent Rules: must be at least 3 percent of the maximum benefit during

each year.

2. 1331/3 Percent Rules: can’t be more 1331/3 percent than prior year in any

given plan year.

3. Fractional Rules: must be proportionate to the normal retirement benefit.

Benefit on termination =

Normal retirement benefit if participant continued to normal retirement age

x

Years of actual participation

Years of participation if terminated at normal retirement

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Inflation Protection

Postretirement Inflation: for employees’ retirement life should be affordable and accurateex: CPI( Consumer Price Index)ex: Wage indexes Internal formula Ad hoc supplemental payment Code Section 415(k)(2):

allowing employers to contribute additional amount for cost of living adjustment to benefit.

Preretirement Inflation: while employee is still at work

Definition of compensation:

final-average is better than career-average

Periodically reviewing and adjusting

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Survivor Benefit

Qualified Joint And Survivor Annuity(QJSA)

– benefits are paid as life annuity to the participant’s surviving spouse.

– must be no less than 50% and no greater than 100% of the amount of the annuity paid during the participant’s life.

– must be continued even if spouses remarried

Qualified Preretirement Survivor Annuity(QPSA)

A death benefit paid as a life annuity to the surviving spouse of a participant who-– Died before retirement, or– Separated from service before

retirement

Under Code Section 401(a)(11), here are two required types of survivorship benefit:

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Disability Benefit

Provide disability benefit as an incidental benefit

No duplication coverage between disability plan and qualified plan

ex: retirement plan should be adequate when long-term disability

benefit cease

Basing on specific service and/or age requirements

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Funding of Qualified Plans

Insurance Contract

(allocated/unallocated)

Fiduciary/ Trustee

Beneficiaries/

EmployeesGrantor/

Employers

Funding method:

1. Individual Life Insurance

2. Annuity Contract

Type of insurance

contract:

1. Term insurance- incident

2. Cash value-whole life

contract

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Actuarial Method and Assumptions

• Future investment return

• characters of employee group

Assumptions

• Schedule annual contribution for a given set of benefit plan and group of employers.

Actuarial Cost Method • actuarial surplus

(experience gain)• actuarial

deficiency(experience loss)

Ongoing Actuarial Valuation

ex: maximize initial contribution, match pension cost to payroll cost

Under ERISA, valuation must be made at least once every three years

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Minimum Funding StandardsUnder IRC Section 430, if the assets value is less than funding target, the minimum required contribution of the year is sum of the target normal cost of the plan for the plan year

-except for at-risk status; if it less than 80% of funding for preceding year or 70% under certain at-risk assumption.

the shortfall amortization charge (in seven years period) the waiver amortization charge

Exemptions1. Government plan, church plans (do not elect to be covered by ERISA)2. Fully insured plans

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Deductibility of Contribution

The deduction limit is based on the actuarial consideration

A comfortable range of contribution between actual contribution and

maximum deductible limit

Penalty:

Under Code Section 4972, 10% penalty for nondeductible portion

of the contribution or carry it over in future years.

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References1. IRS: www.irs.gov2. Save for Retirement in Just 10 Years? It’s Doable, but Risky (2012), Paul Sullivan,

Retrieved from: http://www.nytimes.com/2012/12/01/your-money/defined-benefit-plans-allow-fast-retirement-saving-but-with-risks.html?_r=0

3. Overview of Hybrid Plans(2013), Al Reich, 4. Comparison of Traditional Defined Benefit with Traditional Defined Contribution

Plans(2001), David Rajnes, Employee Benefit Research Institute, Retrieved from: http://cucfa.org/news/pension_table.html

5. Fully Insured Pension Plan, Ohio National Financial Services, Retrieved from: http://www.1035life.com/ohionational/Marketing-Guide-Fully-Insured-Pension-Plan.pdf

6. IRS Issues Minimum Required Contribution Rules For Defined Benefit Plans(2008), The Prudential Insurance Company of America, Retrieved from: http://www.prudential.com/media/managed/PensAnalyst_MinimumRequiredContributions.pdf

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Q & A