1. Copyright © 2007, The American College. All rights reserved. Used with permission. Planning for Retirement Needs Defined-Benefit, Cash-Balance, Target-Benefit, and Money-Purchase Pension Plans Chapter 4

2. Copyright © 2007, The American College. All rights reserved. Used with permission. Chapter 4: Pension Plans Traditional defined benefit Cash balance Money purchase Target benefit

3. Copyright © 2007, The American College. All rights reserved. Used with permission. Defined-Benefit Formulas Unit-benefit 2 percent of FAC x years of service Flat percentage of earnings 40 percent of FAC Flat amount per year of service $200 x years of service Flat benefit $1,200 a month

4. Copyright © 2007, The American College. All rights reserved. Used with permission. Elements of unit benefit formula Definition of compensation ₋Base/bonus/overtime/salary deferrals Final average compensation ₋Highest 3/highest 5/highest 3 of final 5 Years of service ₋Past service/years of participation Form of benefit ₋Life annuity, 10 year certain and continuous Normal retirement age ₋65 and 5 years of participation

5. Copyright © 2007, The American College. All rights reserved. Used with permission. Choosing Defined Benefit Provide adequate retirement benefits for long-service employees Provide benefits based on service prior to establishment of the plan Maximizing tax shelter for older businessowner

6. Copyright © 2007, The American College. All rights reserved. Used with permission. Cash-Balance Pension Plans Defined-benefit plan Pension plan Looks like defined-contribution plan Example: The participant’s benefit is stated as a lump sum which consists of an allocation of 5% of compensation each year plus an investment credit based on the current year’s 10 year treasury bond.

7. Copyright © 2007, The American College. All rights reserved. Used with permission. Cash Balance Conversions A llowed to amend formula prospectively Can not reduce benefit that has already accrued Conversion usually results in smaller total benefits for older participants Older participants can be protected PPA cash balance conversion provisions ₋Prescribes accrued benefit calculation ₋Must retain early retirement subsidies

8. Copyright © 2007, The American College. All rights reserved. Used with permission. Pension Protection Act Takes cash balance out of legal limbo Confirms that cash balance approach is not discriminatory Lump sum can equal account balance Plans must use 3 year cliff vesting Interest credits can not exceed market rate

9. Copyright © 2007, The American College. All rights reserved. Used with permission. Cash Balance as a New Plan Alternative to traditional defined-benefit plan Advantages Contribution for owner can exceed 415 (c) limits ($45,000 in 2007) Benefit structure more like a defined-contribution plan Disadvantages (same as traditional defined- benefit) PBGC coverage Administrative costs Required contributions

10. Copyright © 2007, The American College. All rights reserved. Used with permission. Money-Purchase Pension Plan Defined-contribution plan Individual account Maximum annual allocation for each participant Maximum deductible contribution 25 percent of compensation Pension plan no in service withdrawals contributions are required 10 percent of plan assets invested in employer securities

11. Copyright © 2007, The American College. All rights reserved. Used with permission. Unique Characteristic Stated contribution –The heart of the plan is the contribution formula –Usually stated as a percentage of compensation

12. Copyright © 2007, The American College. All rights reserved. Used with permission. Choosing Money Purchase Sense of security Same limitations as other defined contribution plans Employer’s today are choosing the more flexible profit-sharing plan

13. Copyright © 2007, The American College. All rights reserved. Used with permission. Target-Benefit Plan Defined-contribution/pension plan Each year a contribution will be made in the amount necessary to fund a specified benefit Example: 3 percent of final average compensation times years of service Contribution is based on the level-funding actuarial method Benefit equals account balance

14. Copyright © 2007, The American College. All rights reserved. Used with permission. Why Target? Larger contributions required for older employees Allows large contributions for older owners and smaller contributions for younger rank and file

15. Copyright © 2007, The American College. All rights reserved. Used with permission. True/False Questions As a general rule, if the employer’s primary concern for employees is a stable retirement benefit that reflects a standard of living comparable to that enjoyed prior to retirement, a defined-benefit plan should be chosen. A plan that defines compensation as base salary will not have a problem under the nondiscrimination rules if the only additional pay is to rank-and-file employees for overtime. A cash-balance plan is a type of defined-benefit plan that is more easily communicated to employees than the traditional defined-benefit plan.

16. Copyright © 2007, The American College. All rights reserved. Used with permission. True/False Questions A money-purchase pension plan is a type of defined-benefit plan. A unit-benefit formula considers both years of service and compensation. A target-benefit plan is a defined-contribution plan that contains some advantages of a defined-benefit plan. A cash-balance plan is generally subject to the PBGC insurance program.

17. Copyright © 2007, The American College. All rights reserved. Used with permission. True/False Questions A traditional defined-benefit plan allows an employer to take into consideration service prior to the establishment of the plan. A flat-percentage of earning formula takes into consideration compensation but not years of service. A life annuity beginning at age 60 is a more valuable benefit that the same payments beginning at age 65.