Lesson 3: Qualified Pension Plans

interest credit rate may not exceed

"market rates of return" - 6%

Jim's employer offers a defined-benefit pension whose payout is a function of the 3 highest years of earnings. Jim currently has a 3-year average earnings of $70,000 and his accrued monthly pension is $1,500. If Jim's employer wishes to add an incidental whole life insurance policy to the pension plan, what is the maximum death benefit that can be offered to Jim?

$150,000 A qualified pension plan is limited in the amount of life insurance it is able to purchase with plan assets. Either the 25%/50% test or the 100-to-1 ratio test must be passed for the insurance to be considered incidental. Since we have no information about aggregate employer contributions, it isn't possible to apply the 25% / 50% test. Using the 100-to-1 ratio test the maximum death benefit is 100 x $1,500 = $150,000.

Bright Sun is a 30-year-old company that has grown significantly in terms of revenue and product offerings. It sponsors a pension plan that provides a benefit which can be calculated as (2 percent × years of service × the average of the final 3 years of salary) − a Social Security integration offset. The offset equals 1 percent times years of service times income below the covered compensation limit of $40,000 (assumed). Lorenzo has worked with Bright Sun for the last 30 years and earned $90,000 2 years ago, $110,000 last year, and $130,000 this year. If he is retiring this year, how much should he expect to receive as a pension benefit?

$54,000 Average Salary$110,000Benefit ($110,000 × 2% × 30 years)$66,000 Less Offset ($40,000 × 1% × 30 years)- $12,000 Actual Benefit$54,000

premiums paid by plan sponsor for PBGC

$88/yr underfunded $48 per participant per $1,000 of underfunding, with a $598 per participant cap.

common options for pay credit percentage

- fixed for all employees - increase % based on years of service - soc sec integration - IRC non-discrimination must be met

Pension benefit and contribution limits 1. Covered comp 2. Defined Benefit limit 3. Defined contribution limit 4. Employer Contribution limit

1. Covered comp - no wages > $305k may be used in pension calc. 2. Defined Benefit limit - no annual pension benefit can exceed $245,000 or 100% of average comp over 3 consecutive years 3. Defined contribution limit - EE & ER contributions can't exceed $61,000 or 100% of EE's comp 4. Employer Contribution limit - ER annual contribution can't exceed 25% of EE's covered comp

three methods of calculating ultimate pension benefit

1. Flat Amount Formula - Flat amount per month - no incentive for participants to continue employment after attaining pension 2. Flat %age Formula - Flat % based on comp - incentive to increase comp thry raises but not to continue employment after attaining desired benefit 3. Unit Credit Formula (most common) - benefit based on years of service & compensation - (2.2* years of service* FAS) incentive to attain additional years and increase compensation

how are the following components of life insurance taxed if in a qualified plan: annual premiums death proceeds Distribution of life insurance

1. annual premiums attributable to pure term are taxable income to the plan participant - creates tax basis 2. amnt received in excess of cash value is generally not subject to tax. (death ebenfit can be taxed) 3. FMV of contract less participants basis is subject to income tax unless converted into an annuity

2 methods of calculationg soc sec disparity in pension benefits

1. excess method - provides an excess benefit to those participants whose earnings are in excess of integration level (both DB & DC) 2. offset method - reduced benefit to those employees whose earnings are below integration level (DB plans only)

no more than ____ of plan assets may consist of sponsor securities at the time those securities are purchased.

10%

If Becky is a defined benefit plan participant and her current accrued monthly pension benefit is $4,000: Life insurance policy is incidental if death benefit doesn't exceed ___________ .

100 x $4,000 = $400,000.

limit on the amount of ife Insurance a plan sponsor is permited to purchase life insurance on participants

100-to-1 ratio test

in order to inlcude life insurance in a qualified plans portfolio, what testes must be passed

25% or 100-to-1 ratio test

accrual methods for rules cotorl calculation of pension benefits

3% method 133 1/3 percent rule fractional rule

Specific type of defined benefit pension plan that is funded entriely by a life insurance contract or annuity

412(e)(3) Plans (formerly 412(i) plans)

if the ratio of plan assets to benefit obligations is less than 100%, the amortize annually over ____ Years

7

Which of the following statements regarding target-benefit pension plans is true? A target-benefit pension plan cannot allocate plan forfeitures to remaining plan participants' accounts. Target-benefit pension plans may not be established after 2001. Assuming equal salaries, a target-benefit pension plan would allocate a higher percentage of its current contributions to an older employee. A target-benefit pension plan may always exclude any participant who has not attained the age of 26 and completed one year of service.

A target-benefit pension plan uses a combination of age and compensation to determine the contribution to the plan on behalf of a participant. An older participant with a salary equal to the salary of a younger participant would receive a higher allocation for the year. Statement (A) is false because a target-benefit pension plan can allocate plan forfeitures to other plan participants' accounts. Statement (B) is false because target-benefit pension plans may be established after 2001. Statement (D) is false because a target-benefit pension plan must follow the general eligibility rules of 21 and 1.

explan 25% rule

Aggregate Life Insurance policy premiums can't exceed 25% of the employer's aggregate contributions to the participants account. prior to the participants retirement, Permeant ins must be converted to cash, annuity or distributed at fair market value *For whole life --> premiums can't exceed 50%

Pension plans mus offer which payout option

Annuity * Lump sum & QJSA & QPSA are often offered as well but not required.

how does DB cashbalance plan pay out

Annuity - acutuary calculated benefit based on if survivor benefits are chosen lump sum -

plan sponsor can't amend plans to reduce already accrued benefits. This plan protects participants from employer cost-cutting schemes. This protection was created by ERISA in response to actual abuses.

Anti-Cutback Rule *Doesn't prevent amednments that freeze or reduce future benefit accruals

Joe participates in a Money Purchase pension plan. The plan holds a $90,000 death benefit term life policy payable to Joe's spouse. Since Joe became a plan participant in 2013: His employer has contributed $100,000 towards the plan. Total term life premiums paid have been $4,000.

Apply 25% Test: 25% x $100,000 = $25,000 Since $4,000 premiums < $25,000, policy is deemed incidental.

which pension plans skew benefits toward youngeremployees

Cash Balance plan and money purchase plan because ER contributions accumulate over more years Cash Balance is usually preferred over money purchase plan

vesting schedule must be 3 year cliff for which plan type

DB - Cash Balance Plan

Pension Benefits Guaranty Corportation created under ERISA for private sector pension plans. which plans are covered

DB - Yes DC - no

under what types of pension plans is a pension actuary needed

DB Pension (both DB & Cash Balance Pensions) DC (Target Benefit pension plans require a pension acctuary inly at inception & money purcahse pension plan doesn't require one at all)

which pension plans can give service credit for years past

DB pension plans only

which pension plans skew benefits toward older employees

DB: traditional DB & Target pension plans

difference between DB's & DC's accrued benefts

DB: PV of vested expected future payments at retirement CD: vested account balance

Social Security Integration levels for DB & DC plans

DB: avrg of 35 years of previous soc. sec. wage base amnts called the covered compensation amount - for 2022: $91,884 DC: Integration level is a $ amnt no larger than the Soc Sec wage base for the contribution year

small companies prefer DB or DC

DC because costs and administrative details are less burdensome

why aren't Money purchase plans very popular after 2001

EGTRRA 2001 allowed DC Profit sharing plans to make similar contributions but allow adjustment based on financial status

explain money purchase plan

ER makes contributions into EE's separate accouns each year based on annual funding formula (usually a fixed % of employee's compensation). Employer must make contributions each year, regardless of profitability. contirbutions are invested per EE's investment choices.

Gen-R-Us Inc. sponsors a Money Purchase plan which makes a company contribution of 20% of employee wages each year to their accounts: Edith is the CEO and earns $400,000 annually:

Edith's salary exceeds covered compensation limit: $305,000. Edith's account receives a 20% x $305,000 = $61,000 contribution. The contribution to Edith is the maximum allowed by the IRC (2022).

100% of the Present Value of all benefits accrued or earned under the plan as of the beginning of the year

Funding Target

Which of the following plans generally favor(s) older participants? I. Defined-benefit pension plans II. Cash-balance pension plans III. Target-balance pension plans IV. Money-purchase pension plans

I & III Cash-balance and money-purchase pension plans generally favor younger participants, while defined-benefit and target-benefit pension plans favor older participants with less time to accumulate and require higher funding levels.

explain 100 to 1 ratio test and which pension plan uses this test

Life Insurance Death benefit may not exceed 100 times the monthly accrued retirement benefit under a qualified plan *used by defined benefit plans

100 to 1 Ratio Test

Limits the death benefit amount of life insurance coverage purchased within a qualified plan to 100 times the monthly-accrued retirement benefit provided under the qualified plan.

"New" set of funding requirements aimed to have most single-employer defined benefit pension plans funded at 100% by 2015.

Minimum Funding PPA 2006

what plan types are not covered under PBGC

Money Purchase Plans Target Benefit plans DC Profit sharing plans NQ plans, 457, church sponsored plans

All of the following statements are correct EXCEPT: Defined benefit and cash balance pension plans require the use of an actuary to estimate plan funding requirements. Target benefit pension plans require the use of an actuary at the inception of the plan only. Money purchase pension plans require the use of an actuary at the inception of the plan only. Money purchase pension plans do not require the use of an actuary at all.

Money purchase pension plans do not require the use of an actuary given that they fall under the category of being a defined contribution plan.

who do DB plans favor

Older and Key Employees - longer serving employees benefit from bulk of actuarial required employer contributions. - HC or Key EE's tend to accrue larger benefits *often leads to Top Heavy Plans so vesting is shortened, and Non-Key employees get 2% per year of compensation up to 20%.

Which of the following pension plans has mandatory Pension Benefit Guaranty Corporation (PBGC) coverage? 403(b) plan sponsored by a public school system A defined benefit plan sponsored by a five-person attorney group A money purchase plan sponsored by a retail chain A cash balance plan sponsored by a large chemical company

Only qualified plans are eligible for PBGC coverage, so the 403(b) plan is ineligible. Although defined-benefits plans are generally covered, those sponsored by professional service employers with 25 or fewer employees are excluded. Defined-contribution plans such as a money purchase plan are also excluded.

a federal corporation that acts as an insurance provider to maintain the benefits promised to employees by their defined benefit pension plans. - only private sector employers - mostly individual employer pension plans - mandatory

PBGC pension benefit guarantee corp

mandatory funding for DC Pension

Plan Sponsor mus fund annually based on plan dox.

Gen-R-Us Inc. sponsors a Money Purchase plan which makes a company contribution of 20% of employee wages each year to their accounts: Rusty works on the assembly line and earns $25,000 annually:

Rusty's account receives a 20% x $25,000 = $5,000 contribution

allows qualified pension plans to adjust for social secuirty providing a larger income replacement for lower income workers by providing higher benefits or contributions to employees with income that exceeds an "integration level"

Social Security Integration (aka Permitted Disparity)

special type of money purchase pension plan

Target Benefit Pension Plan

value of plan benefits earned by employees during the current year

Target Normal Cost

Minimum required contribution to DB plan if the value of plan assets is less than the funding target

Target Normal Cost + Shortfall Amortization Charge + any waiver amortization charge

Minimum required contribution to DB plan if the value of plan assets is greater than the funding target

Target Normal Cost - excess of value of plan assets over the funding target

George, age 40, is covered by a $100,000 face value term life insurance policy as part of profit-sharing plan at his place of employment. How much taxable income will be attributed to George this year? IRS Table 2001 shows $1.10 per $1,000 of life insurance protection.

Taxable income is $1.10 x ($100,000 / $1,000) = $110.

Jay died in a freak accident. Fortunately for his girlfriend Toni there was a whole life insurance policy on Jay's life as part of his qualified plan at work. At the time of Jay's death: Policy face value was $25,000 with a cash value of $11,000. Jay had paid income taxes on $1,000 of premiums over the years.

Taxable portion of death benefit: $11,000 - $1,000 = $10,000.

Marleen is a 52-year-old participant in the XYZ cash-balance plan. She has been a participant in the plan for the last 20 years. XYZ, which has over 10,000 employees, is having financial difficulty and Marleen is concerned about the security of her pension. Which of the following is correct? A) The cash-balance plan assets may include up to 25 percent of XYZ stock. B) The cash-balance plan formula cannot be lowered in the future for current participants, but it could be changed for new participants. C) The cash-balance plan and its benefits are fully protected by the Pension Benefit Guaranty Corporation (PBGC). D) Termination of the plan may affect vesting for some employees, but Marleen's vesting will not be affected.

Termination of the plan may affect vesting for some employees, but Marleen's vesting will not be affected. (A) is incorrect because up to 10 percent of plan assets can be invested in the plan sponsor's stock. Option (B) is incorrect as the plan sponsor can modify future benefits, but cannot modify benefits that are already accrued. Option (C) is incorrect because the PBGC does not fully protect all benefits; it only protects benefits up to an annual limit. Option (D) is correct; termination accelerates vesting, but based on Marleen's tenure, she is fully vested already.

Alfred has worked for CJD, a large manufacturer, for the last 20 years and is a participant in CJD's defined-benefit plan. Alfred is concerned about the company's financial difficulties and is worried that management at CJD might modify his future benefits and cause his expected benefits at retirement to be reduced. Which of the following laws is designed to prevent that from occurring? A) Coverage B) Non-discrimination C) Anti-cutback D) There are no laws that prevent an employer from modifying future benefits, even benefits in a defined-benefit plan.

The correct answer is (D). • Future benefits can be modified by employers.• Coverage is designed to ensure that a minimum number of non-highly compensated employees are benefiting under the plan.• Non-discrimination rules do not prevent loss of benefits.• Anti-cutback is a rule prohibiting a plan sponsor from amending a plan such that the accrued benefit of an employee is decreased or reduced by such an amendment or change.

Which of the following statements concerning money-purchase pension plans is (are) correct? I. Businesses with cash-flow problems are especially good candidates for a money-purchase pension plan. II. Money-purchase pension plans have the advantages of predictable cost for the employer and understandability for the employees.

With a money-purchase pension plan, the employer (the plan sponsor) does not bear any investment risk; therefore, the employer's costs will be predictable. I is incorrect because the employer is required to fund a money-purchase pension plan annually, which requires a steady cash flow. II onlyww

A defined-contribution plan can use forfeitures to

both: reduce future plan contribtion costs for sponsor or allocate to remaining plan participants

Mandatory funding for DB Pension

defined by IRC actuarial table. Pension protection act of 06 changed previous fundng requirements

explain DB cash balance plan

each year a % of annual pay (Pay Credit) is added to an employee's hypothetical acct and each year hypothetical earnings are assigned using the plans specified interest Credit rate. eventually hypothetical account is converted by an actuary to determine annuity benefit or converted to dolllars if lump sum is chosen

Back Loading Abuse

eliminating an employee's entire pension if they leave prior to normal retirement age.

what benefit types are not covered under pbgc

health & welfare benefits, life ins., lump sum payout, COLA

how do increases in the folowwing assumptions impact the plan cost Inflation Expected wage increase life expectancy investment return expected morality employee turnover

increased inflation increases plan cost increased wages increases plan costs increase in life expectancy increases plan cost increased investment return decreases plan cost increased morality decreases plan cost increased employee turnover decreases plan cost

are in service w/d allowed in pension plans

no

does pbgc replace entire pension

no depends on age of participant when pension is taken over and benefit payout selected

do most qualified plans have life insurance

no, usually coordinated via separate benefit

who receives higher contirbutions in a target benefit plan

older and higher paid employees

who's exlcuded from PBGC

professional services that never had more than 25 employees

explain Target Benefit Pension Plan

qualified plan with separate accounts where EE bears investment risk. Annual Contirbution formula is designed to create a targeted payout benefit at normal retirement age. plan sponsor bears contirbution risk

Historically, were offered by many employers; however, over the last 30 years, many employers have replaced their pension plans with profit sharing plans in an attempt to

reduce employers' cost, eliminate mandatory funding requirements, and shift the investment responsibility from the employer to the employees.

A defined-benefit plan can use forfeitures to

reduce future plan costs. * Can't allocate to other participants

typical candidates for 412e3 plans

sole proprietor with only a few employees.

which pension plans use the 25% test rule

used with DC plans with Term & UL policies.

do most cash balance pension plans still allow account gorwth even after you leave employment

yes - growth stops when benefits are paid out

who do Cash balance plans favor

younger and shorter service employees because they have more years to grow at the interest credit rate. - thus pay credit formula is often adjusted for older employees

who do Money Purcahse Plans favor

younger employees becasue they get more contirbutions over time and have longer to invest.