Module 2 Fundamentals of Defined Benefit Plans

©2013, College for Financial Planning, all rights reserved.

Module 2Fundamentals of Defined Benefit Plans

CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMRetirement Planning & Employee Benefits

Learning Objectives

LO 2–1 introduces you to traditional defined benefit plans and how the retirement plan benefit is determined.

LO 2–2 introduces you to cash balance plans, and how they differ from defined benefit pension plans by guaranteeing a return rather than a retirement benefit.

LO 2–3 introduces you to plan participation and eligibility rules.

LO 2–4 introduces you to the concept of Social Security integration and the two methods available for defined benefit plans.

LO 2–5 requires you to understand the basic funding methods for defined benefit plans and the impact of various actuarial assumptions on plan funding.

LO 2–6 deals with plan termination.

LO 2–7 introduces you to the far-reaching impact that the Pension Protection Act (PPA) has had on defined benefit plans.

LO 2–8 walks you through a case analysis example of a company considering the installation of a defined benefit plan.

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Questions to Get Us Warmed Up

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Learning Objectives









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What Makes a Plan Qualified?

• ERISA • Minimum participation and coverage

requirements• Non-discriminatory • Minimum vesting requirements• Minimum funding

requirements (pension plans)• Protection of assets

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Qualified & Nonqualified Plans

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Qualified Plans Nonqualified Plans

Pension Plans

Profit Sharing Plans (DC)

Tax-Advantaged Plans

Other Nonqualified Plans

Defined Benefit (DB)

Profit Sharing Traditional IRA Section 457 Plans

Cash Balance (DB) Thrift Plan Roth IRA

Stock Bonus SIMPLE IRA ISO

Money Purchase (DC)

ESOP (LESOP) SEP ESPP

Target Benefit (DC) Age-Weighted (SARSEP) NQSO

Cross-Tested (Comparability)

401 (k) Plan 403(b) (TSA) Deferred Compensation Plans

SIMPLE 401 (k)

Defined Benefit Plan

• A promised pension benefit guaranteed by the sponsor

• Maximum contribution: the actuarially determined amount needed to fund a pension of the lesser of 100% of salary or $205,000 (2013)

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Defined Benefit Plan Benefit Formulas

Flat benefit: Service is not considered•Benefit is flat amount or percent of earnings•Service reduction may be used: reduced benefit for <X years of service

Unit benefit: Service increases benefit•Benefit is a dollar amount per year of service or a percentage of earnings per year of service•Participant accrues additional benefit each year•Service limitation may be used; considers years of service up to specified maximum

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Benefit Formula Examples

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Funding Formula

Benefit Calculation Example Comments

Flat Amount Formula

Flat amount per month

$250 per month

No incentive for participants to continue employment after attaining maximum flat amount

Flat Percentage Formula

Flat percentage based on compensation

10% of comp. Per year

Incentive to increase compensation through raises but not to continue employment after attaining a desired benefit

Unit Credit Formula

Benefit determined on a combination of service and compensation

2% x years of service x average 3 highest years pay

Incentive to attain additional years of service and additional compensation to increase ultimate benefit

Defined Benefit Plan Earnings Definition

• Career-average pay: average earnings over plan participation period.

• Final-average pay: average earnings over final 3 or 5 years, or average highest 3 or 5 of last 10 years.

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Survivor Annuities

• Required of all pension plans• QJSA 50% then a 75% QOSA (qualified

optional survivor annuity) must be offered or

• QJSA 75% then a 50% QOSA must be offered

• QPSA must also be offered

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Factors Affecting Annual Retirement Benefits in a Defined Benefit Plan

Retirement Age•Normal retirement: Stated by plan document, typically age 65.

•Retirement after normal retirement is adjusted upward, and before normal retirement the benefit is adjusted downward

Years of Plan Participation •(if maximum benefit formula of $205,000 is used)

•10% reduction in maximum dollar limitation on normal retirement benefit for each year of plan participation (or year of service) less than 10

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Defined Benefit Plan

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Participant

Employer

Cash Balance Pension Plans (1)

• A defined benefit plan with specific annual employer contributions that accumulate at a guaranteed investment return.

• Plan assets are pooled, but participants have simulated investment accounts that are treated very much like accounts in a defined contribution plan.

• Like the traditional defined benefit pension plan, the cash balance plan provides security for employees through its guarantees, and through PBGC insurance.

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Cash Balance Pension Plans (2)

• Cash balance plans may be used to simplify and reduce the high cost of a traditional defined benefit pension plan without actual termination.

• A defined benefit plan can be amended into a cash balance plan that looks and feels to the employees just like a money purchase plan.

• Cash balance plans are more beneficial for younger employees, but not favorable for older employees.

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Learning Objectives









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Defined Benefit Plan Minimum Participation Test

Defined benefit plans also must satisfy the minimum participation (50/40) test. The plan must benefit at least the lesser of

•50 employees, or

•The greater of:o 40% of all the company’s ERISA eligible

employees, oro Two employees (one employee if there is only

one employee)

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Minimum Coverage Tests

• A qualified plan must satisfy one of two coverage tests for at least one day of each quarter:o Ratio Percentage Test: Percentage of eligible

non-HCEs benefiting under plan must be at least 70% of percentage of HCEs benefiting

o Average Benefits Test: Average benefit, as a percentage of compensation, for non-HCEs must be at least 70% of that for HCEs

• Employees excluded from the coverage tests: under age 21, or less than one year of service, or covered by a collective bargaining agreement

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Highly Compensated Employee

• Was a “5% owner” (ownership of >5%) in the determination year or in the preceding plan year or

• In 2013, a person whose compensation was in excess of $115,000 in the previous year (2012) is a highly compensated person. o Employer has the option to

limit highly compensated to the top-paid 20% employees based upon preceding year’s compensation.

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Defined Benefit Social Security Integration—Excess Plan

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Permitted disparity of 26.25% +

30% plan benefit = 56.25% above the integration level

Plan Benefit: 30% of compensation

Social Security Earnings Limit

Note: for Unit Credit plans, the permitted disparity is .75% per year of service (35 yr max.) reduced for early retirement provisions.

Social Security = 26.25% of covered compensation

Social Security Integration

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Base Contribution % +

Permitted Disparity =

Excess Contribution %

10% 10% 20%

20% 20% 40%

30% 26.25% (max.)

56.25%

Social Security Offset Integration: Defined Benefit Plan Example

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Allen’s Retirement Benefits:

Nonintegrated DB Plan

Allen’s Retirement Benefits:DB Plan Using Offset

Integration

DB Pension ($15,000)

DB Pension ($15,000 – $9,000 = $6,000)

but cannot lose more than 50% of pension, so pension benefit =

$7,500

Primary Social Security Retirement Benefit ($12,000)

Company A’s nonintegrated DB plan entitles Allen to a $15,000 annual benefit at age 65

If Company A’s DB plan is integrated using a 75% offset (75% of $12,000 = $9,000), it would entitle Allen to a $7,500 annual benefit at age 65 since maximum offset is 50%

Qualified Plan Vesting Schedules

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Completed Service Years

Cliff Vesting% Vested

Graded Vesting% Vested

Defined benefit pension plans (non-top heavy)

5-Year Cliff3-to-7-Year

Graded

1-234567

0%0%0%

100%100%100%

0%20%40%60%80%100%

Top-heavy defined benefit pension plans

3-Year Cliff2-to-6-Year

Graded

123456

0%0%

100%100%100%100%

0%20%40%60%80%100%

Vesting

Vesting schedules are based upon years of service,

not years in the plan

Maximum vesting schedules are:• Non-top heavy defined benefit plans can

use 5-year cliff or 3- to 7-year graded

• Top heavy defined benefit plans can use 3-year cliff or 2- to 6-year graded

• Cash balance plan maximum vesting schedule is 3-year cliff (PPA requires)

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Top Heavy Plans

A plan is top heavy if more than 60% of plan benefits are attributable to “key”

employees.If a defined benefit plan is top heavy there

are two requirements:1.accelerated vesting, and2.minimum benefit of 2% of compensation

for each year of service that the plan is top heavy up to 10 years.

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Key Employee (for Top Heavy Testing)

• a “5% owner” (ownership of >5%), or

• owned >1% of the company and receivedcompensation >$150,000, or

• Was an officer of the company and received compensation>$165,000 (2013)

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Actuarial Assumptions

• interest rate• turnover rate

(impacts forfeitures and potential benefits)

• salary scales (takes into account increasing salaries)

• benefit costs• mortality

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Impact of Actuarial Assumptions

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Entry Age Normal & Attained Age

• Entry age normal takes into account past service when the plan is installed.

• Attained age starts service when the plan is installed, in other words no credit is given for past service.

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Learning Objectives









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The Funding Standard Account

• Actual plan results are compared to estimated amount needed to provide promised plan benefit.

• Minimum funding standard: employer must contribute at least a minimum amount to fund the plan benefit.

• If account value exceeds minimum required to fund benefit, contribution is decreased.

• If plan is underfunded there is a 10% penalty tax.

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Defined Benefit Plan Termination (1)

Overfunded plans must either•transfer 25% of the potential reversion to a qualified replacement plan, or•increase the participants accrued benefits by at least 20%.

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Defined Benefit Plan Termination (2)

Underfunded plans (involves PBGC)•voluntary standard termination•voluntary distress termination•involuntary termination•Maximum monthly amount guaranteed by PBGC at age 65 is $4,789.77paid out over participant’s lifetime; lump sum option is not available.

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DB Plans Exempt From PBGC

• Plans maintained for substantial business owners only ( such as sole business owners or greater than 10% business owners).

• Plans maintained by professional service employers that have never had more than 25 active participants.

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Fully Insured Plans

A plan is “fully insured” if it complies with IRC 412(i):•It is funded exclusively with life insurance or fixed annuity contracts (at least 51% in fixed annuities).•These contracts must provide guaranteed benefits equal to the benefits provided by the plan.•Contracts must exhibit level premium characteristics beginning with issue date and ending with retirement.

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Learning Objectives









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PPA Disclosure Requirements

• New under PPA• Disclosures include

o summary of plan participants,o information about funding

status of plan, and o allocation of assets.

• PBGC overview and what it guarantees must also be provided.

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Defined Benefit/ Cash Balance Plans (1)

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Traditional Defined Benefit Plan Cash Balance Plan

Definition

Qualified plan that provides a specified retirement benefit based on a flat or unit formula

Qualified defined benefit plan the provides specified employer contributions and a guaranteed return

Factors affecting suitability

• Favors participants nearer retirement age

• Only plan that can enable owner to meet retirement objective

• Favors younger participants• Allows company to amend

defined benefit plan to simplify and reduce cost

Contribution/ benefit limits

Annual contributions are required, therefore,1. the business must have stable (or increasing) cash flow,

and2. the owner must be willing to commit to annual payments.

Benefit formula

Contribution limit equals the amount necessary to fund benefit up to dollar and compensation limits.

Employer contributes a specified percentage of pay and guarantees an investment return each year.


Adequacy of funding

Flat benefit formulaor

Unit benefit formula

Employer contributes a specified percentage of pay and guarantees an investment return each year.

Plan earnings and forfeitures

• Subject to minimum funding standard• Annual actuarial determination on funding standard• PBGC can terminate plan if inadequately funded• Employer assumes investment risk

Allocation methods of benefits and contributions

• Earnings affect employer contributions• Forfeitures can only be used to reduce employer

contributions

Benefit determination

Per plan formula (employer assumes the risk)

Per plan formula

Defined Benefit/Cash Balance Plans (2)

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Defined Benefit/Cash Balance Plans (3)

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Factors affecting contributions

• Participants’ salary levels• Investment returns• Forfeitures• Participants proximity to

retirement age (contributions are weighted toward participants closer to retirement age)

• Participants’ salary levels• Investment returns• Forfeitures • Contributions allocated

based on relative compensation

Multiple Choice Question 1

Which of the following could be expected to reduce the annual cost of a defined benefit plan?I. a high turnover assumptionII. use of salary scalesIII. a high interest rate assumptionIV. a high benefit cost assumptionV. a low turnover assumption

a. I and II onlyb. I and III onlyc. II and IV onlyd. I, II, and III onlye. II, IV, and V only

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LMN Corporation’s defined benefit plan provides a flat benefit of 30% of final average compensation. If the plan uses permitted disparity (Social Security integration), which of the following statements can be made regarding this plan?

I. The integration level is each participant’s covered compensation level.

II. The maximum percentage benefit for compensation in excess of the plan’s integration level is 30%.

III. The maximum percentage benefit for compensation in excess of the plan’s integration level is 56.25%.

IV. The plan’s permitted disparity is 26.25%.V. The plan’s permitted disparity is 30%.

a. I and II onlyb. II and IV onlyc. III and IV onlyd. I, III, and IV onlye. I, III, and V only

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Which of the following best describes the ratio percentage test?a. The percentage of NHCs benefited by the

plan must be at least 70% of the percentage of HCs benefited by the plan.

b. Plan benefits for NHCs must be 70% of all employees’ benefits.

c. The plan must benefit a nondiscriminatory classification of employees and the average benefit percentage for NHCs must be 70% of the average benefit percentage for HCs.

d. The plan must benefit at least 70% of all employees.

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Which of the following best describes the average benefits test?a. The percentage of NHCs benefited by the

plan must be at least 70% of the percentage of HCs benefited by the plan.

b. Plan benefits for NHCs must be 70% of all employees’ benefits.

c. The plan must benefit a nondiscriminatory classification of employees and the average benefit percentage for NHCs must be 70% of the average benefit percentage for HCs.

d. The plan must benefit at least 70% of all employees.

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Which of the following are characteristics of a voluntary standard termination?

I. The plan must have sufficient assets to meet benefit liabilities.

II. The plan has insufficient assets to meet benefit liabilities.III. Plan assets must be distributed in accordance with ERISA

requirements.IV. This type of termination would be used if the employer

wanted to terminate a defined benefit plan and offer a defined contribution plan instead.

V. The employer is assessed a 50% penalty tax on asset reversions.a. I and IV onlyb. II and III onlyc. I, III, and IV onlyd. II, III, and V onlye. I, III, IV, and V only

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©2013, College for Financial Planning, all rights reserved.

Module 2End of Slides

CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMRetirement Planning & Employee Benefits

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Module 2 Fundamentals of Defined Benefit Plans