Retirement Planning and Employee Benefits for Financial Planners

1. Retirement Planning and Employee Benefits for Financial Planners Chapter 4: Qualified Pension Plans

2. Defined BenefitPension Plans (2 Types) Defined Contribution Pension Plans (2 Types) See page 127

3. Defined Benefit Pension Plan • Disappearing • 112,208 plans in 1985 • 22,697 plans in 2013 • Imperfect storm • Low interest rates • Lengthening life expectancy • Decade of below average equity returns with increased volatility • After 2006, must report pension liability on balance sheet

4. Pension Plan Requirements • Mandatory Funding • Disallowance of Most In-Service Withdrawals • Limited Investment in Employer Securities • Limited Investment in Life Insurance

5. Mandatory Funding • The amount that must be contributed to a pension plan by the employer each plan year. • Defined Benefit Pension Plans • The plan sponsor must fund the plan on an annual basis with an amount within the actuaries calculated funding range. • Pension Protection Act of 2006 requires plans to be fully funded on an ongoing basis starting in 2008 • If not fully funded as of 2008, seven years to catch up funding • Impact on terminations??? • Defined Contribution Pension Plans • The plan sponsor must fund the plan annually with the amount defined in the plan document.

6. Disallowance of In-Service Withdrawals • In-Service Withdrawal – Any withdrawal from a pension plan while the employee is a participant in the plan other than a loan. • The participant of a pension plan cannot take an in-service withdrawal from the pension plan. • Under the PPA 2006, defined benefit pension plans can now provide for in-service distributions to participants who are age 62 or older.

7. Limited Investment in Employer Securities • Limit of 10% investment of pension plan assets in employer securities. • In addition, the PPA 2006 requires defined contributions plans holding publicly traded employer securities to allow plan participants to diversity their contributions. • Protects the ability of the plan to pay the promised retirement benefit.

8. Limited Investment in Life Insurance • Limited to providing incidental death benefits. • Cannot be the primary focus of the qualified plan. • Plan must pass either one of the: • 25% Test • 100 to 1 ratio test

9. 412(i) Plans • A specific type of defined benefit pension plan that is funded entirely by a life insurance contract or annuity. • Employer claims tax deduction for contributions made to pay premiums.

10. Defined Benefit vs. Defined Contribution Pension Plans • Primary differences: • The use of an actuary. • Assumption of the investment risk. • Allocation of plan forfeitures. • Coverage under the PBGC. • Use of Social Security Integration. • Accrued Benefit versus Account Balance. • Credit for Prior Service. • Commingled versus Separate Accounts.

11. Actuary • Determine required plan funding range. • Assumptions • See Exhibit 4.4, page 149. • Required Annually • Defined Benefit Pension Plan • Cash Balance Pension Plan • Required at Inception • Target Benefit Pension Plan • No other plans require an actuary.

12. Calculation of Annual Funding based on assumptions regarding: • Assumptions • Inflation: COLA costs • Social security vs. State of Illinois • Wages • Life Expectancy • Investment Returns • In 2002 GM assumed 10%, actual -5.2% • In 2003 Ford assumed 8.8%; actual 17% • Mortality • Forfeitures

13. Calculation of Annual Funding based on assumptions regarding: • Can a pension plan become overfunded? • In 2003, GM expected returns of $6.4 billion from pension investments • Actual return $13.5 billion

14. Investment Risk • Defined Benefit Plans • Investment Risk with Employer • Defined Contribution Plans • Investment Risk with Employee

15. Allocation of Forfeitures • Forfeitures – The unvested amount of a participant’s benefit at his termination of service with the plan sponsor. • Allocation of forfeitures • Defined Benefit Plans • Reduce future plan costs for the employer • Defined Contribution Plans • Reduce future plan costs for the employer, or • Allocate to other plan participants (nondiscriminatory).

16. Pension Benefit Guaranty Corporation (PBGC) • A federal corporation that acts as an insurance provider to maintain the benefits promised to employees by their defined benefit pension plans. • Plan sponsors pay premiums for the insurance coverage. • PBGC maximum annual benefit is $59,320 for 2014. • If retiring at age 65 • May be much less than plan provided • Employers pay premiums to PBGC

17. Defined Benefit Pension Plans • Provides a specific amount of benefit at the plan’s specified retirement age • Mandatory annual funding • Determined by actuary • Benefit levels guaranteed by employer and PBGC • Employers pay premiums to PBGC: $49 per participant in 2014 up from $19 per person in 2006

18. Accrued Benefit vs. Account Balance • Defined Benefit Plans • Participant’s accrued benefit = Present value of the vested expected future payments at retirement. • Defined Contribution Plans • Participant’s accrued benefit = Vested account balance of the qualified plan.

19. Credit for Prior Service • Credit for years of service with a plan sponsor attributable for years prior to the establishment of the retirement plan. • Defined Benefit Plans • May give credit for prior service • Defined Contribution Plans • NO credit for prior service

20. Social Security Integration • Excess Method – Provides an excess benefit to those participants whose earnings are in excess of average Social Security wage base. • Can be used by both Defined Benefit and Defined Contribution Plans

21. Social Security Integration • Offset Method – Reduces the benefit to those employees whose earnings are below the Social Security wage base. • 42% of defined benefit plans were not integrated with social security in 2003 according to 2005 Watson Wyatt study • Up from 22% in 1987

22. Summary of Defined Benefit vs. Defined Contribution Pension Plans • See Exhibit 4.13 on page 160.

23. Defined Benefit Plans • Defined Benefit Pension Plans • Cash Balance Pension Plans • Money Purchase Pension Plans • Target Benefit Pension Plans

24. Defined Benefit Pension Plan Benefits What should you do in years before retirement? • Pension benefit based on a defined funding formula • Flat Amount Formula – $600 per month • Flat Percentage Formula – 60% of salary • Unit Credit Formula –2% x YOS up to 70% of average salary • Average salary • Career average: over career • Final average: over specified years prior to retirement Work for 40 years?

25. Defined Benefit Pension Plan Benefits • Maximum • Lesser of $210,000 per year in 2014 • Average compensation in three highest years of earnings

26. Cash Balance Pension Plans • Defined Benefit Plan • “Frozen pensions” • Employer guarantees contributions • Typically based on a percent of salary such as 5% • Employer guarantees rate of return • Fixed rate: 3% • Or variable rate: T-bills • Credits can be equal to actual plan earnings, if higher • Can be integrated with Social Security

27. Cash Balance Pension Plans • Changing the benefit formula to a cash balance formula • Doesn’t guarantee a percent of salary but only a percent return on contributions • 25% of workers in defined benefit plans covered by cash balance plans

28. Cash Balance Pension Plans • Participants have individual accounts • Hypothetical account because pension funds of all accounts are commingled • Can take lump sum distribution of hypothetical account balance at retirement • Requires permission of spouse • Otherwise receive benefits in form of an annuity

29. Cash Balance Pension Plans • Employer still has investment risk • Employer still has life expectancy risk

30. Cash Balance Pension Plans controversy • Conversion of defined benefit plans with older employee population • Calculate current lump sum value of vested defined benefits • May have “wearaway” period when annual credits don’t increase initial lump sum balance • Reduces pension benefits by 20 – 40% • IBM employee: work to age 78 to get same benefit from cash balance plan as expected from defined benefit plan

31. Cash Balance Pension Plans controversy • Cash balance plan increased IBM’s earnings by $4 billion over five years

32. Cash Balance Pension Plans • Favors younger plan entrants • Eligibility/Coverage/Vesting – Same as Chapter 3 • Distribution (discussed in Chapter 7) • Conversion to a cash balance plan • PPA 2006 sets forth circumstances under which hybrid plans can avoid discrimination claims.

33. Money Purchase Pension Plans • Defined Contribution Pension Plan • Mandatory annual funding of a fixed percentage of the employee’s compensation – up to 25% • Can integrate with Social Security • Participant has investment risk • Separate accounts: participants generally manage funds • Favors younger plan entrants • Eligibility/Coverage/Vesting – Same as Chapter 3 • Forfeitures: can reduce future contributions or allocate to participants • Not likely to be established after EGTRRA 2001 • Shift to profit sharing plans as no mandatory contributions

34. Target Benefit Pension Plan • Special type of money purchase pension plan • Actuary determines annual funding needed for target benefit • Then contributions are made to achieve target benefit • Contribution based on the participant’s age • Participant selects investments and has risk • May not achieve target benefit • Favors older plan entrants: can make larger contributions • Eligibility/Coverage/Vesting – Same as Chapter 3