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

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

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

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

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.

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.

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.

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

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.

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.

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.

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

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

Investment Risk Defined Benefit Plans Defined Contribution Plans Investment Risk with Employer Defined Contribution Plans Investment Risk with Employee

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).

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

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

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.

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

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

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

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

Defined Benefit Plans Defined Benefit Pension Plans Cash Balance Pension Plans Money Purchase Pension Plans Target Benefit Pension Plans

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?

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

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

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

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

Cash Balance Pension Plans Employer still has investment risk Employer still has life expectancy risk

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

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

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.

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

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