6 - Defined Benefit Plan Overview I

Question 1

An employer adopting a qualified defined benefit pension plan must make a number of decisions about the basic _________ to be included in the plan. The employer must, for example, determine what benefits the participants will receive upon retirement, death or disability; how and _____ these benefits will be paid; and whether or not employees will _______ toward the cost of these benefits.

Answer 1

features

when

contribute

Question 2

Describe the advantages of a contributory defined benefit plan.

• From a philosophical viewpoint, employees are responsible for meeting part of their own __________.
• If employees contribute, it will mean a ________ to provide the same overall plan benefits.
• If employers do not want to use employee contributions to reduce their own contribution, then by making the plan contributory, the overall plan benefits will ______.
• Something for nothing is too often taken for granted, and the deductions from ________ will continually remind employees that the employer is assuming a large share of providing the plan benefits.
• Employees are encouraged to ______. The contributory plan also provides an employee with additional funds in the event of termination of employment.

Answer 2

• economic security needs
• smaller employer contribution
• be larger
• current earnings
• save

Question 3

Describe the disadvantages of a contributory defined benefit plan.

1. Employer contributions represent dollars that _______. On the other hand, dollars received by the employee as earnings which are then contributed under the plan are dollars that have been taxed to the employee. Hence, dollar for dollar, employer contributions provide more than those of an employee.
2. Deductions from earnings are a source of constant ________ to employees.
3. The employer might be forced to _________ to compensate for the additional deductions.
4. The number of participants required for a qualified plan might not ______.
5. Some employees may _________, in which case the employer will still have a problem when these employees reach retirement age.
6. Additional ________ must be kept by the employer, thereby increasing administrative work and costs.

Answer 3

1. have not been taxed.
2. irritation
3. increase salaries
4. enroll
5. refuse to participate
6. records

Question 4

federal law defines normal retirement age to be the age specified in the plan, but no later than the age of __ or the ______ anniversary of the participant’s date of initial plan participation, whichever is the last to occur

Answer 4

65

fifth

Question 5

A typical requirement for early retirement is that the employee must have attained at least the age of ___ and completed at least __ years of service or participation in the plan.

Answer 5

55

ten

Question 6

While some plans actually establish a normal retirement age earlier than the age of 65, a greater number encourage early retirement by not applying a full actuarial reduction if certain conditions are met. Possible approaches include:

1. Provide for no actuarial reduction if the employee retires after attaining some _______ and after completing some minimum period of service.
2. Apply no reduction factor if early retirement occurs when the employee’s age and service _____ some minimum number.
3. Apply some simple __________ for each month by which early retirement precedes normal retirement that is considerably less than the reduction that would otherwise be called for by full actuarial reduction factors.

Answer 6

minimum age

total

reduction factor

Question 7

Defined Benefit Plan

Plans also must include a provision allowing an employee to _____ retirement. This feature also could be important to the employer, since it permits a greater degree of flexibility in scheduling the actual retirement of a ______ when there is a problem in obtaining or training a replacement. The federal age discrimination law and state laws protecting employment rights require employees to continue accruing benefits without regard to any _________ age limit

Answer 7

defer

key employee

maximum

Question 8

income replacement ratios

Many employers believe that a plan should be designed to provide a higher paid career employee with an income after retirement that, together with primary Social Security benefits, will be about ______ of earnings just before retirement.

For lower paid employees, the percentage generally is set at a higher level—perhaps as much as ______.

For employees considered to be less than career employees (usually those employees with fewer than ______ years of service with the employer), these percentages would be proportionately smaller.

Answer 8

50% to 55%

80% to 85%

25 or 30

Question 9

two basic types of benefit formulas for employers to consider when establishing a retirement program.

Answer 9

• defined contribution or a money purchase formula
• defined benefit or an annuity purchase formula

Question 10

There are two types of benefit formulas for the employer to consider:

The first is called a defined contribution or a ________. Under this type of formula, contribution rates are ______, and an employee’s benefit varies depending upon factors such as the amount of the contributions made, investment earnings on plan assets, and the employee’s entry age and retirement age.

The second type is called a defined benefit or _________. Here, a definite benefit is established for each employee, and contributions are determined to be whatever is necessary to produce the desired ________________. Defined benefit formulas may be subdivided into several different _______.

Answer 10

money purchase formula

fixed

an annuity purchase formula

benefit results

classifications

Question 11

A ______ plan bases benefits on the employee’s earnings averaged, for example, over the last three or five years of employment, or over the three or five consecutive years in the ten-year period immediately prior to retirement during which the employee’s earnings are the ______.

A _________ bases benefits on earnings averaged over an employee’s entire career.

Answer 11

final pay

highest

career pay plan

Question 12

Advantages of a final pay plan include:

• The employee’s initial benefit keeps pace with any ______
• A final pay plan is more likely to meet employer objectives as to _______ than is a career pay plan.
• A final pay plan generally produces more favorable results for ________ than the career average approach.

Answer 12

preretirement inflationary trends.

benefit levels

key employees

Question 13

Disadvantages of a final pay plan include:

• This type of plan is usually _______ than one that bases benefits on career average earnings.
• It can commit an employer to increased costs during an __________.

Answer 13

more expensive

extended inflationary period

Question 14

Broadly speaking, the four basic defined benefit formulas are (which may be integrated with social security):

1. __________ —provides a flat benefit unrelated to an employee’s earnings or service
2. __________—provides a benefit related to the employee’s earnings but does not reflect service
3. __________—reflects an employee’s service but not earnings
4. __________—reflects both an employee’s earnings and service.

Answer 14

1. A flat amount formula
2. A flat percentage of earnings formula
3. A flat amount per year of service formula
4. A percentage of earnings per year of service formula

Question 15

A flat amount formula provides for a flat benefit that treats all employees alike, regardless of their _______, _____, or ______. For example, the benefit might be $500 or $700 a month. The flat amount formula, since it is considered to produce inequitable results, seldom is used ______.

On occasion, this formula is used in conjunction with some other type of formula; for example, a plan may provide a flat benefit of $700 a month for a covered employee, plus a percentage of his or her earnings in excess of the current Social Security taxable wage base.

Answer 15

• service
• age
• earnings
• by itself

Question 16

How is equity maintained between long- and short-service employees when defined benefit formulas do not explicitly take an employee’s service into account?

While the employee’s length of service is not reflected directly in this type of formula, service is in effect recognized since most plans require that an employee, upon attaining the normal retirement age specified by the plan, must have been __________________ . Plans that include such a requirement provide for a proportionately reduced benefit if the employee has accumulated fewer than the required number of years, thus creating, in effect, a formula weighted for ________.

Answer 16

employed for some period of time

service

Question 17

A flat percentage of earnings formula provides some flat percentage of earnings, usually ranging from _____, as the measure of the pension benefit. The percentage of earnings approach may be used with either career average or final average earnings, although it is used most frequently in _______.

This type of formula does not take _______ into account, except in those plans that require that the employee must have completed a minimum period of service by normal retirement date and that provide for a proportionately reduced benefit if the employee’s service is less than the required number of years.

Answer 17

25% to 50%

final pay plans

an employee’s service

Question 18

A flat amount per year of service formula provides a flat dollar amount per year of service completed by the employee. Thus, in a plan that provides for a benefit of $70 a month for each year of service, an employee with 27 years of employment would receive a monthly pension of $1,890. This type of formula frequently requires that an employee must have worked for a _________ during a plan year to receive a full benefit credit for such year. Federal tax law requires that a proportionate credit be given if the employee is credited with at least ________ hours of service in the 12-month computation period used by the plan.

Answer 18

minimum number of hours

1,000

Question 19

Percentage of earnings per year of service formula

A formula that gives specific recognition for service as well as earnings is considered by many pension practitioners to produce the most _______ results in terms of a benefit formula that provides benefits for employees in relation to their value or contributions to the firm.

A formula producing this result often is called a ______ or past and future service formula. Under such a formula, an employee receives a benefit credit equal to a percentage of earnings per year of service for each year that he or she is a participant under the plan. This benefit credit is called the employee’s ________ or __________ benefit. The percentage of earnings credited varies from plan to plan, but a typical percentage would be ______. It may be used with either career average or final earnings, and it works particularly well with _______.

Answer 19

• equitable
• unit credit
• “future service” or “current service”
• 1% or 1.25%
• career average plans

Question 20

Variable benefit plans are designed to protect against the effects of ________ on a retired employee’s pension benefit. They take either of two general forms:

1. The benefit varies to reflect changes in the value of a _________ of common stocks and similar investments; or
2. The benefit varies to reflect changes in a recognized _________ such as that published by the Bureau of Labor Statistics.

In either case, the plan attempts to adjust benefits to keep an employee’s _______ on a relatively level basis.

Answer 20

inflation

specific portfolio

cost-of-living index

purchasing power

Question 21

Social security favors the lower paid, providing a much higher level of __________ for individuals at low-income levels than it does for those who are highly paid. this difference in the relative value of social security benefits by income level is accentuated when replacement ratios are compared on an _____ basis— social security benefits are not taxed at all for individuals with low income; by contrast, up to _____ of social security benefits are taxable to the highly paid.

Answer 21

income replacement

after-tax

85%

Question 22

___________ is a type of integrated plan where a higher level of contribution or benefit is provided for pay over a certain level of compensation than is provided for compensation below that level of compensation. Both defined benefit and defined contribution plans can be established on this basis.

Answer 22

excess plan

Question 23

An offset plan is a type of integrated plan where the plan subtracts, or offsets, some amount from the gross plan benefit based on the _________. Only ________ plans use the offset plan approach.

Answer 23

• payment received from Social Security
• defined benefit

Question 24

Death benefits provided under individual policy plans and death benefits provided from plan assets are considered a part of the plan and, as such, are subject to the requirement of the internal revenue service that the death benefit must be _______. In a defined benefit plan using life insurance, the test is satisfied if the benefit does not exceed ______the expected monthly pension benefit or, if greater, the ______ for the pension benefit.

Answer 24

“incidental.”

100 times

reserve

Question 25

In the pension area, disability benefits, even in insured plans, generally have been provided on a ______ basis; that is, the benefits are paid in some form directly from plan assets, and the employer’s experience in this regard is reflected in the cost level of the plan.

A number of pension plans, particularly those funded with individual policies, provide for full vesting if an employee becomes ________.

Other plans treat such a disability as ________ if the employee has completed some minimum period of service or participation in the plan and has attained some minimum age. Unfortunately, the disability benefits provided under such provisions are either nonexistent or inadequate for disabilities occurring at ________.

Some group pension and trust fund plans, however—particularly _______ plans— provide for a separate and distinct benefit in the event of total and permanent disability.

Answer 25

• self-insured
• totally and permanently disabled
• an early retirement
• younger ages
• union-negotiated

Question 26

Describe how preretirement inflation would be treated in (a) dollar amount plans and (b) career pay plans.

• (a) Though they do not directly reflect inflation because they are not pay related, dollar amount plans are typically _______ and, in practice, the dollar amount is increased periodically via the __________ process.
• (b) In a career pay plan, unless the rates of accrual are set unusually high, or the employer has updated the benefits that have accrued for employees, or the plan also has a minimum benefit formula based on final pay, the initial level of benefit provided for a pensioner will not ___________ that has taken place during a working career. In many situations, employers periodically update career pay plans by recalculating accrued benefits on the basis of ________.

Answer 26

• union negotiated
• collective bargaining
• fully reflect the inflation
• then-current pay

Question 27

Two employer advantages from addressing preretirement inflation using a career pay approach with periodic updates are:

1. the employer retains control over the ___ and _____ to which the cost of inflation is assumed; and
2. the employer also receives credit for making periodic ___________.

Answer 27

• timing and extent
• benefit improvements

Question 28

Four basic forms of automatic adjustment techniques used for making postretirement benefit changes are:

Answer 28

1. Equity pensions
2. Cost-of-living formulas
3. Wage-related formulas
4. Specified percentage formulas

Question 29

An equity pension, often called a ________, provides retirement income that varies in dollar amounts to reflect the _______ of an underlying fund of common stocks. The equity feature (usually affecting only a portion of the retirement income amount) may operate during the years of active employment as well as during the postretirement payout period. In either case, the assumption is that stock price movement will vary with the movement of all other prices and, hence, reflect the general level of _______.

Proponents of the equity pension approach argue that active employees and pensioners have some assurance their retirement income will _______ with the general level of economic activity.

Answer 29

• variable annuity
• investment results
• inflation
• fluctuate
  *

Question 30

The major advantages of linking retirement income amounts by formula to changes in a cost-of-living or price index are that employees have advance assurance their retirement income will be adjusted periodically to help preserve their _________ and that the consumer price index (CPI), used almost exclusively in such plans, is well-known and at least partially understood by most employees. Consequently, the employer has a good chance of avoiding ________ that the pension adjustment technique is faulty.

Answer 30

purchasing power

criticism

Question 31

The major disadvantages of linking retirement income amounts by formula to changes in a cost-of-living or price index include:

1. The employer assumes a largely undeterminable future _______ tied to a government index over which it has no control. The uncertainty can be somewhat reduced with a plan provision specifying maximum cost-of-living increase limits.
2. No allowance is made for any _______ that may be experienced by active employees.
3. The CPI may, in fact, overstate _______ and the presumed needs of pensioners, thus resulting in additional and unnecessary costs.
4. The tax law requires that any automatic increases be given to _________— individuals for whom the employer may feel little or no continuing obligation.
5. If the pension plan provides for subsidized early retirement benefits, the cost of this subsidization very possibly will increase because the assurance of protection against inflation will most likely cause an increase in the incidence of ______________.
6. Providing automatic cost-of-living adjustments for pensioners could create pressure to follow the same approach for _______.

Answer 31

1. liability
2. rising standard of living
3. rates of inflation
4. vested terminations
5. early retirement
6. active employees

Question 32

Why might an employer adopt a discretionary (nonautomatic) rather than an automatic approach to pension increases?

1. Because __________ is uncertain, an organization should not commit itself to a predetermined or formula method.
2. Discretionary adjustments have a predictable cost because they remain under the employer’s control, both as to ______ and _____.
3. Both the scope and level of __________ may eliminate or reduce substantially the need for future retirement income improvements.
4. The employer receives _____ for making a plan improvement each time benefits are increased.

Answer 32

the rate of inflation

timing / amount

Social Security benefits

credit