Assignment 6 Flashcards
Discuss accounting of pensions from the standpoint of Financial Accounting Standards Board Statement No. 87
FAS 87 requires that cost of the pension reflected on the balance sheet included the projected benefit obligation factoring in a number of items. These items include:
- Discount or Settlement Rate
- Rate of Salary Increase
- Earnings on Plan Assets
- Prior Service Cost
- Unrecognized gains and losses
Two of the measurements reflected on the balance sheet that show the funding status of defined benefit plans are the accumulated benefit obligation and the projected benefit obligation. Comparing these two amounts with the reported fund balance indicates the amount the fund is over or underfunded.
Describe the impact of ERISA and the federal ADEA on pensions.
ERISA subjects all qualifed pension and profit-sharing plans to requirments regarding employee eligibility and vesting, disclosure and reporting, fiduciary responsibilities, fiscal needs, funding, nondiscrimination stucture and payment forms. The objective is to ensure that employee rights are protected and that pension benefits will be available to employeees when they retire from the company. Companies designing special early retirement plans to avoid having to terminate excess people need to be very careful because an analysis of group and classes may very well tilt to the higher paid, making the plan discriminatory.
The federal Age Discrimination in Employment Act prohibits companies from forcibly retiring employees at any age, but allows an exception for executives meeting certain criteria. An executive can be foced to retire if he or she is a the head of a major local or regional operation, or the head of a major department or division, and has a combined company pension, excluding Social Security and payments from other employers of at least $44,000. Such employees, assuiming they were bona fide executives at least 2 years immediately preceding retirement, may be retired by the company beginning at the age of 65 without concern for violating the terms of this act. Most companies want their executives to retire not later than the age of 65 and, therefore, offer financial incentives through supplementary pension arrangements.
Briefly explain the tax treatment of pensions.
Pensions are considered income to the executive and are tax deductible to the employer. A statutory or qualifed plan allows an exception to the normal rule of permitting a tax deduction only in the year in which the executive recognizes the income. The company is permitted to take a tax deduction for the year in which it makes a contribution to the plan, even though the executive does not receive the income until a later date.
Explain different pension plan types.
The 3 types of retirement plans are defined beneft, defined contribution and a hybrid or combination of the two.
A defined benefit plan specifies the amount of annuity that the employee will recieve after meeting certain age and/or service requirement, and the contribution is determined annually to meet this annuty amount.
A defined contribution plan specifies the amount of money to be set aside each year. The value of such money at the time of retirement will be related to market value of investments made.
In other words, in one case, the amount of the pension is known, but the ultimate cose is unkown until the assets are valued. In the other instance, the amount set aside each year is known, but the pension amount is not known until the employee retires.
Defined benefit plans encourage individuals to stay with the company; defined contribution plans do not penalize the person for leaving.
How are pension plans paid for?
Pension plan are either paid for by the company of by the employee or a combination whereby both contribute. Typically, defined benefit plans are paid totally by the company, whereas defined contribution plans could be financed 3 ways:
- Company pays all
- Employee pays all
- Both company and employee contribute
Describe how Social Security is integrated with pension plans.
In the design of pension plans, companies are allowed to take into consideration the fact that Social Security provides a much higher benefit value as a percentage of compensation to lower paid employees than higher paid executives. Plans are allowed to “integrate” benefits with Social Security.
The integration threshold is the compensation level that separates the base from higher benefit levels or contributions. The permitted disparity sets the maximum difference for defined benefits or accrual rates and defined contributions or contribution rates between lower and higher paid.
Thus, recognizing that Social Security benefits are of signifigantly greater value to lower paid than higher paid employees, companies are permitted to take this into consideration when designing their tax-qualifed, defined benefit and defined contribution plans.
How much pension is needed?
While it would be nice to receive a company retirement benefit equal to last year’s pay or at least equal to after tax income, it is unlikely for pension planners to consider either seriously. Why not? There are several reasons:
- Expenses during retirement are less than while working
- Expenses that end are business-related such as clothing, lunches, and transportation.
- Payroll deductions for pension plans and other benefit programs are elimnated
- Social Security benefits will be paid to the reitree. However, becaues of their benefit level, Social Security will be more a signifigant factor for lower paid than executive level employees
What is the pension plan payout?
Payments from the pension plan are either in the form of an annuity or in a lump sum.
Typically, defined benefit plans are in the form of an annuity whereas defined contribution plan benefits are paid in a lump sum. However, the reverse is also possible.
As for lump sums, it is important to know that while all lump-sum distributions are lump sum payouts, not all lump sum payouts are lump sum distributions. Since lump sum distributions receive favorable tax treatment, namely they qualify for a tax-free roll over into and IRA or other defined contrubution plan, it is important to know what constitues a lump sum distribution. It is defined as the payment within one taxable year of the full amount the employee is eligible to receive, paid under one of the following conditons:
- The employee is at least 59 1/2
- the employee retires or otherwise separates from employment
- The employee dies
Thus, an active employee may qualify only at the age of 59 1/2. Executives may find lump-sum distributions very attractive if they either need to: need income to start up a new venture or can afford to put it aside in and IRA and live on other income. An alternative to an IRA is an annuity purchased from an insurance company.
Describe eligibilty for a retirement plan.
A retirement plan may require a minimum age and/or years of service before becoming eligible. The reason for a minimum service requirement is to minimize administrative recordkeeping for those leaving the company after only a year of employment. On the other side of the age issue, there are 3 retirement ages. Normal, early, and late. Retirement age is more signifigant with a defined benefit plan that with a defined contribution plans.
While a company may identify a normal retirement age which is usually 65, it cannot legally force a person to retire at that age or at any age without going counter to age discrimnation laws. There are bona fide exceptions. It is helpful to recognize that there are 3 types of employees: those who really want to work past normal retirement, those who might work beyond that age and thsoe who are going to retire at the age of 65 or sooner.
Describe normal, early and late retirement ages.
Normal retirement age for most plans is 65. It is the age at which there is no reduction in the accrued defined benefit. Reductions called discounts are established for defined benefit plans will be received for a longer period and the plan has less time to fund the accrued beneft. In addtion to “age-only” requirements there are service only requirements. They are more typical in the public sector than in the private sector.
Some “age-only” plan also establish an age and service combination rule that would qualify for a nondiscoutned pension. Some companies establish an earlier normal retirement age for senior executives. This is the age at which they are expected to retire. If they were not eligible to receive a nondiscount, defined benefit pension from the qualified plan, a nonqualifed plan would supplement benefts.
Early retirement age is when an employee decides to retire before reaching normal retirement eligibilty. For every year less than normal retirement, the pension benefit is reduced in 3 ways:
- One less year of service
- One less year of earnings
- Greater discount on the annuity
Initially, these discounts were based on the acturial factors of age and reduced time period for benefit accrual. However, over the years, many plans have substitued less harmful discounts in subsidizing early retirements.
The definition of late retirement is a retirement at any point in time past normal retirement age. Since, with the exception of certain senior executvies, it is no longer legally permissible to require a person to retire when reaching normal retirement age, plans will continue to accrue benefits until the individual leaves as a late retiree. While the earnings and service credit will add to benefits, there is typically no additonal percentage for late retirement to complement the discount for an early retirement. Because of mortatlity factors, late retirement may cost defined benefit plans less than normal retirement.
What is vesting?
When individuals have earned the right to receive benefits because of their years of service, they are said to be vested. Even though the indivudal may not be eligible for retirement, the person may have earned a benefit. Tax qualifed plans require that an employee’s right to receive benefits occurs after a prescribed period of time. This requirement can be met in two ways:
- Cliff Vesting- Full benefits are accrued after 5 years of service for defined benefit plans ( after 3 years for defined contribution plans), but nothing prior
- Graded vesting approach- Begins vesting 20% after the first 3 years of service, with an additonal 20% every year thereafter, reachign 100% after seven years for defined benefit plans.
Vesting protects the employee should he or she desire to leave, move to another division or if termianted by the company. Benefit rights cannot be denied to the employee to the extent that they have been vested.
What is the definition of pay for retirement plans, and what are postretirement adjustments?
Retirement plans defined earnings as salary paid during the period of employment. Many companies also include short term incentives.
Companies sometimes increase the annuities of retirees if there has been a period of signfigant inflation since the date of their retirement. Typically, the adjustment is some fraction of the inflation increase similar to inflation-indexed Social Security benefits. Retirees may also receive a postretirement increase in their annuities from a career earnings plan if the plan were “updated”, raising the retirement amount. During times of high inflation, executives are likely to defer plans for early retirement, thereby building up additional years of credit for pension payments. This is especially true when a company does not periodically improve the annuities of retired employees.
Since Social SEcurity payments represent a greater portion of lower paid employees, such individuals are less affteced by a company’s unwillingness to improve annuities of reitrees than the executive whose major portion of pension is from company plans, not Social Security.
Explain defined benefit plans.
A defined benefit plan is one in which an employer pays at retirement a definite benefit that is determinable and that is usually related to the years of service and pay for the employee. An example would be a plan that pays an employee at the age of 65 with 25 years of service a pension of 60% of his or her final average salary.
Defined benefit plans fall into 3 categories:
- Career Service Plan- typically limited to hourly paid workers and negotiated by unions. Benefits accrue with length of service.
- Career earnings plan- calculates benefits based on total earnings during employment.
- Final pay plan- more complex. Often incorporates both earnings and years of service.
Explain final pay plans
A final pay plan is more popular with employees than career service plans due to its emphasis on most recent earnings. Even updated career earnings plans have a have a drawback to employees inasmuch as there is no guarantee the company will continue such actions, and without them the pension will be signifigantly smaller.
However, corporate financial people typically perfer an updated career earnings plan, only future service is affected by future earnings. Under the updated career earnings plan, only future service is affected by future earnings. Other things being equal, the executive receiving large pay increases is more interested in reducing the number of years used in calcualting the average than a person receiving mor emodest pay increases.
In addtion to the company pension, a retired employee is usually eligible for Social Security benefits. A company plan of either career earnings or final pay will produce the same percentage of pay increases and years of service for both clerk and executive; when added to Social Security benefits, it produces a total retirement curve. Many companies integrate their pension plan benefits with Social Security to try to smooth out the percentage curve. to maintain qualifed plan status, the plan must integrate in a manner acceptable to the IRS. Essentially, this provides 2 appraoches excess and offset. Either may be used with a career earnings or final pay plan.
Explain the excess integration method for a pension plan
Somestimes called a “carve-out” or “step-up” plan, the excess integration method is more common with career average than final pay plans. It applies one benefit rate for all earnings up to the Social Security tax base and another higher figure for earnings above the base.
The exces integration method has the advantage of being relatively easy to communicate to employees. However, it has the following disadvatages:
- This form of integration does not make it clear to employees that the company’s real obejctie is to supplement Social Security up to a certain overall benefit level.
- Although an excess plan can be structured to take into consideration adjustments in the wage base, it offers no built-in cost-containing features for legislated Social Security changes. Accordingly, major decision changes in the pension formula could be necessary each time a new Social Security law is passed.
- It is not logical to relate benefits in a retirement plan to movements in the Social Security taxable wage base.
