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

2. Defined Benefit Pension Plans Defined Contribution Pension Plans
Pension Plans (4 Types)
Defined Benefit Pension Plans
Cash Balance Pension Plans
Money Purchase Pension Plans
Target Benefit Pension Plans
Defined Benefit Pension 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:
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 Defined Contribution 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