What is it?

1. What is it? A qualified employer pension plan that guarantees a specified benefit level at and during retirement

2. When is it indicated? • employer’s plan design objective is to provide an adequate level of retirement income to employees regardless of their age at plan entry • employer wants to allocate plan costs to the maximum extent to older employees • older controlling employee in a small business wants to maximize tax-deferred retirement savings

3. Advantages 1. employees gain tax-deferred retirement savings 2. can provide adequate retirement levels for employees regardless of age at plan entry 3. benefit levels guaranteed by employer and Pension Benefit Guaranty Corporation (PBGC) 4. plan generally allows maximum amount of tax-deferred retirement saving for older highly compensated employees

4. Disadvantages 1. higher plan installation and administrative costs than defined contribution plans 2. complex design; difficult to explain to employees • employees who leave before retirement may receive relatively little benefit from plan 4. employer has recurring annual funding obligation regardless of business profit levels 5. employer assumes investment risk

5. Design Features Several formulas can be used to determine benefit promised at retirement Flat amount formula provides stated dollar amount to each plan participant

6. Design Features Flat percentage formula • retirement benefit is % of employee’s average earnings • typically requires minimum service for full % benefit with % scaled back for fewer years of service

7. Design Features Unit credit formula • retirement benefit based on employee’s service with employer • typically provides % of earnings for each year of service • two common methods to compute average earnings

8. Design Features Unit credit formula – average earnings career average average earnings over employee’s entire career with employer final average average earnings over number of years; usually3-5 years before retirement

9. Tax Implications 1. employer contributions to plan are deductible when made 2. contributions and earnings tax deferred for employee for qualified plans 3. IRS Code Section 415 places maximum limit on projected annual benefit plan can provide lesser of (a) $195,000 (2011) or (b) 100% of participant’s compensation averaged over 3 highest-earning consecutive years

10. Tax Implications 4. rules for qualified plan distributions must be followed; premature distributions may be subject to penalty 5. IRS Code Section 412 sets minimum funding rules; employer penalized if minimum not met

11. Tax Implications 6. mandatory coverage by PBGC, employer must pay premium of $35 (2011) per participant plus amount calculated on basis of plan’s unfunded vested benefits, if any 7. certain employers adopting new plan may be eligible for business tax credit up to $500

12. Tax Implications 8. plan may permit employer contributions to “deemed IRA”; such contributions reduce limit for other traditional or Roth IRA contributions

13. ERISA Requirements Plan subject to ERISA requirements for qualified plans, including: • participation • funding • vesting • reporting • disclosure

14. Alternatives Money purchase plans • lack employer guarantee of benefit levels • provide adequate benefit only for younger employees Target benefit plans • lack employer guarantee of benefit levels • may provide adequate benefit for older employees

15. Alternatives Cash balance pension plan • employer guarantees principal and investment earnings on plan fund • provide adequate benefit only for younger employees Profit sharing and similar plans • benefit adequacy tied closely to employer financial success

16. Alternatives Section 401(k) and similar plans • employees have some control over amount saved Private savings outside qualified plan • except certain IRAs, lack tax benefits of saving in a qualified plan

17. Application Exercise Jill Cummings is retiring this year. She has worked for Allied Enterprises for 25 years. Her last five years of salary are: $55,000, $56,000, $58,000, 60,000 and $61,000. Her average earnings over her career with Allied are $42,000. Compute Jill’s retirement income from Allied under the following situations:

18. Application Exercise Consider each situation independent. • Allied provides retirees $600 per month per life • Allied provides retirees with 15 years or more years of service 50% of average annual pay • Allied provides retirees with 1.6% of earnings for each year of service using • career average earnings • final average earnings • Name each of the previous defined benefit plan formulas.

19. Discussion Question What is the effect of nondiscrimination regulations on defined benefit plan design, especially for older owner-employees of closely held businesses?