105-2 Defined Benefit & Other Pension Plans Flashcards
Traditional Defined Benefit Pension Plan
Employer-sponsored qualified retirement plan that guarantees a specified benefit level (pension) at the employee-participant’s date of retirement
All retirement plan assets are commingled in a single overall retirement fund
Typically most suitable for businesses that have a stable cash flow and predominately older workforce
Advantages, Disadvantages of Traditional Defined Benefit Plans
Advantages:
- Benefit levels are guaranteed
- (both by employer and Pension Benefit Guaranty Corporation - PBGC)
- For older, highly paid employees, this plan type generally allows the max amount of contributions to be made for their benefit
- May encourage early retirement
Disadvantages:
- expensive to administer
- complex, both in operation and design
- employer assumes risk of poor investment results
- the plan determines the adequacy of retirement income that will be addressed by the plan
Section 415 of Tax Code
Limits projected annual benefit that the defined benefit plan can provide to the employee-participant at age 65
For 2019, this max benefit is the lesser of:
A) $225k annual compensation
B) 100% of the participant’s compensation averaged over the participant’s highest 3 consecutive years of earnings
Pension Protection Act of 2006 (PPA)
Special reduced premium is effective for employers w/ 25 or fewer employees
-DBP maintained by a professional service employer (such as a physician or attorney) w/ 25 or fewer employees does not have to be covered by the PBGC
2019 Max Monthly Benefit (for those who retire at age 65) guaranteed by the PBGC for a DBP
$5,607.95/month
$67,295/annually
3 Formulas Used by DBP to calculate amount of participant’s promised benefit
- Flat amount formula: specified dollar amount promised to employee per month for life, beginning at 65
- Flat % formula: retirement benefit that is a % of the employee’s avg earnings and will usually require a certain amount of minimum years of service before the full % benefit is payable
- Unit benefit formula: % of earnings is paid for each year of employee service, usually 1-2%; for example, with a 30-yr service career and 2% /yr accrual
- Career avg method or final avg method
- Only first $280k of employee compensation may be taken into account when calculating the promised benefit
Plan costs when investment returns increase or decrease in a Defined Benefit Plan
If plan investment returns increase, the cost to the employer in the form of a plan contribution for that year decreases
If the investment return decreases, the plan costs increase
DB(k) Plan
Hybrid plan designed to address the potential shortfalls in Section 401(k) plans and a decline in the establishment of DBP plans
Typically most appropriate when the workforce is relatively large and young (younger than 50)
Employer with no more than 500 employees may offer the DB(k) plan
Employee advantages:
- Guaranteed monthly income at retirement
- Encourages employers without pension plans to establish a plan
- Combines the security employees get through traditional defined benefit pension plans w/ individual investment control
- Allows automatic enrollment provisions which encourage employees to save more than they may have in a traditional Section 401(k) plan
Employer advantages:
- exemption from the top-heavy rules
- Allows small employers to sponsor a DBP plan w/ more predictable costs
- Specifications & defined benefit formula are defined
- Offers simplified administration and potentially lower costs than having 2 individual plans
- Requires only 1 plan doc, 1 trust, 1 form 5500 filing, one SPD, 1 set of statements
Cash Balance Pension Plan
Type of DBP that includes features of a DCP
Provides for annual employer contributions at a specified rate to a hypothetical individual account - but all investment decisions are made by a fiduciary employed by the plan
Credits an IR credit (known as a guaranteed return)
This ROR may be fixed or tiered to some market rate of interest
Pension benefits that may be provided under the plan limited to lesser of $225k or 100% of the participant’s highest consecutive 3-yr average compensation
Advantages:
- certain level of plan benefits guaranteed by the PBGC
- significant cost savings by for employer as compared to traditional DBP
Disadvantages:
- employer bears risk of poor investment perf
- cash balance plan withdrawals subject to income taxes and 10% early withdrawal penalty rules
- Cash balance plans subject to minimum funding standard rules
- Retirement benefits may be inadequate for older plan entrants
- If plan is converted from traditional DBP, the lump-sum payout at the employee’s retirement date may be considerably less under the cash balance formula
- Actuaries are still required for cash balance plans
Fully Insured Pension Plan
This is a type of traditional DBP funded exclusively by cash value life insurance or annuity contracts
No qualified plan trust exists as is common
Benefits from the plan are guaranteed by the insurance company w/ the employer transferring all investment risk to the 3rd party
A fully insured plan is inappropriate for an employer who cannot commit to regular premium payments
A stable business rather than 1 experiencing (or expecting to experience) fluctuating cash flow, is the best prospect.
Money Purchase Pension Plan
A type of defined contribution plan in which an employer makes annual mandatory contributions to each employee’s individual account
No actuary required, contribution is annual % of employee’s annual compensation
Max for 2019 is 100% of employee’s compensation or $56,000 whichever is less
Advantages:
- Relatively straightforward
- Account balance generated may be distributed as a lump sum or an annuity or rolled over into an IRA
- % of compensation is used to determine the contribution
Primary disadvantage: lack of contribution flexibility
Appropriate when an employer wants a plan that’s simple to administer, has a younger workforce, and can assume the burden of mandatory funding
Forfeitures
Created when nonvested or partially vested employees terminate their service w/ the sponsoring employer
The unvested portion reverts back to the plan
DBP plans may only be used toward plan expenses or future employer contributions
Target Benefit Pension Plan
Qualified DCP pension plan in which employer contributions are made for each participant in an actuarially determined amount to reach a target benefit at the plan’s specified normal retirement age
Similarities w/ DBP plans:
- Favor older participants
- Initially require an actuary
- Type of pension plan
- Mandatory minimum funding standards apply
Similarities w/ DCP plans:
- employee bears risk of plan investment performance
- each employee has a separate (individual) account
- PBGC insurance is not available
- Final actual dollar benefit is not guaranteed
- Max deductible employer contribution is limited to 25% of covered payroll w. max payroll for an individual limited to $280k
- The most an individual may receive in their account is limited to lesser of 100% of compensation or $56k
Pension
If the word “pension” is included in the name, it means the annual contributions are mandatory
Easy way to remember, “Be my cash target” =
DBP, Money purchase plans, Cash balance plans, target benefit plans
Maximum annual benefit under defined benefit pension plan in 2019
=$225,000
Note* - the maximum amount of compensation that may be used in calculating benefits is $280,000.
