Module 2 Fundamentals of Defined Benefit Plans

CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMRetirement Planning & Employee Benefits Module 2Fundamentals of Defined Benefit Plans

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.

Questions to Get Us Warmed Up

What Makes a Plan Qualified? • ERISA • Minimum participation and coverage requirements • Non-discriminatory • Minimum vesting requirements • Minimum funding requirements (pension plans) • Protection of assets

Qualified & Nonqualified Plans

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)

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

Benefit Formula Examples

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.

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

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

Defined Benefit Plan Employer Participant

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.

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.

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: • 40% of all the company’s ERISA eligible employees, or • Two employees (one employee if there is only one employee)

Minimum Coverage Tests • A qualified plan must satisfy one of two coverage tests for at least one day of each quarter: • Ratio Percentage Test: Percentage of eligible non-HCEs benefiting under plan must be at least 70% of percentage of HCEs benefiting • 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

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

Defined Benefit Social Security Integration—Excess Plan Social Security Earnings Limit Permitted disparity of 26.25% + 30% plan benefit = 56.25% above the integration level Plan Benefit: 30% of compensation Social Security = 26.25% of covered compensation Note: for Unit Credit plans, the permitted disparity is .75% per year of service (35 yr max.) reduced for early retirement provisions.

Social Security Integration

Social Security Offset Integration: Defined Benefit Plan Example

Qualified Plan Vesting Schedules

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)

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: • accelerated vesting, and • minimum benefit of 2% of compensation for each year of service that the plan is top heavy up to 10 years.

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)

Actuarial Assumptions • interest rate • turnover rate (impacts forfeitures and potential benefits) • salary scales (takes into account increasing salaries) • benefit costs • mortality

Impact of Actuarial Assumptions

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.

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.

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%.

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.

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.

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.

PPA Disclosure Requirements • New under PPA • Disclosures include • summary of plan participants, • information about funding status of plan, and • allocation of assets. • PBGC overview and what it guarantees must also be provided.

Defined Benefit/ Cash Balance Plans (1)

Defined Benefit/Cash Balance Plans (2)

Defined Benefit/Cash Balance Plans (3)

Multiple Choice Question 1 Which of the following could be expected to reduce the annual cost of a defined benefit plan? • a high turnover assumption • use of salary scales • a high interest rate assumption • a high benefit cost assumption • a low turnover assumption • I and II only • I and III only • II and IV only • I, II, and III only • II, IV, and V only

Multiple Choice Question 2 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? • The integration level is each participant’s covered compensation level. • The maximum percentage benefit for compensation in excess of the plan’s integration level is 30%. • The maximum percentage benefit for compensation in excess of the plan’s integration level is 56.25%. • The plan’s permitted disparity is 26.25%. • The plan’s permitted disparity is 30%. • I and II only • II and IV only • III and IV only • I, III, and IV only • I, III, and V only

Multiple Choice Question 3 Which of the following best describes the ratio percentage test? • The percentage of NHCs benefited by the plan must be at least 70% of the percentage of HCs benefited by the plan. • Plan benefits for NHCs must be 70% of all employees’ benefits. • 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. • The plan must benefit at least 70% of all employees.

Multiple Choice Question 4 Which of the following best describes the average benefits test? • The percentage of NHCs benefited by the plan must be at least 70% of the percentage of HCs benefited by the plan. • Plan benefits for NHCs must be 70% of all employees’ benefits. • 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. • The plan must benefit at least 70% of all employees.

Multiple Choice Question 5 Which of the following are characteristics of a voluntary standard termination? • The plan must have sufficient assets to meet benefit liabilities. • The plan has insufficient assets to meet benefit liabilities. • Plan assets must be distributed in accordance with ERISA requirements. • This type of termination would be used if the employer wanted to terminate a defined benefit plan and offer a defined contribution plan instead. • The employer is assessed a 50% penalty tax on asset reversions. • I and IV only • II and III only • I, III, and IV only • II, III, and V only • I, III, IV, and V only

CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMRetirement Planning & Employee Benefits Module 2End of Slides

Module 2 Fundamentals of Defined Benefit Plans