DB Plans Part I So What Am I Getting? Kevin J Donovan, CPA, EA, MSPA, FCA Managing Member, Pinnacle Plan Design, LLC

Transcription

1 DB Plans Part I So What Am I Getting? Kevin J Donovan, CPA, EA, MSPA, FCA Managing Member, Pinnacle Plan Design, LLC

2 Kevin J Donovan, CPA, EA, MSPA, FCA Managing Member, Pinnacle Plan Design, LLC Kevin is a shareholder in the accounting firm BeachFleischman PC, where he heads up the firm s pension subsidiary Pinnacle Plan Design, LLC. Kevin is a CPA and an Enrolled Actuary. He is a founding member of the ASPPA College of Pension Actuaries (ACOPA) and recently served as ACOPA's Vice President. In addition to being a member of NIPA, Kevin is a member of the American Society of Pension Professionals and Actuaries (ASPPA), as well as the American Institute of Certified Public Accountants (AICPA). Kevin is a frequent author and lecturer on qualified retirement plans. He has spoken at numerous conferences sponsored by ASPPA, NIPA, the AICPA, ACOPA, the Conference of Consulting Actuaries. In 2015 Kevin was the recipient of the ASPPA Educator s award.

3 DC plans IRC Section 415 Maximum contribution on behalf of any individual lesser of 100% compensation, or Dollar limit ($53,000 for years ending in 2016, $54,000 for 2017) Additional catch-up contribution of $6,000 available if participant at least 50 years of age at calendar year-end and 401(k) plan maintained IRC Section 404 Maximum deduction 25% of total participant comp.

4 DB plans IRC Section 415 Maximum benefit payable to any individual lesser of 100% of average compensation (hi-3 consecutive years) Reduced for years of service less than 10 Dollar limit ($210K for years ending in 16; $215K for 17) Reduced for years of participation less than 10 Reduced if commenced before age 62 Increased if commenced post age 65 Subject to 401(a)(17) comp limit around age 68 Payable as straight life annuity (SLA) Adjusted if paid other than as SLA

5 DB plans 415 $ limits at various ages Age 45 $ 72,354 Age ,669 Age ,863 Age ,000 Age ,000 Age ,569 Age ,000 / 31,548/yr Post 68 dollar eclipsed by comp limit if 10 years in plan, but this does not translate to 1/10 of $270K per year in plan. For example, a 70-year old with 10 years of service but 8 years in plan can accrue benefit of $31,548 * 8 = $252,384 Presuming of course enough average comp.

6 DB plans Why a Defined Benefit Plan (vs a DC plan)? Provides larger (additional) limits than DC plan Sample approximate DB contributions: Age 40 $ 90,000 Age ,000 Age ,000 Age ,000 Age ,000 Represents approximate value of accrual of 1/10 $$ limit

7 DB plans IRC Section 404 Maximum greatest of Target Normal Cost (TNC) + Shortfall amortization TNC + Funding Target (FT) + Cushion - Assets Cushion generally 50% of FT TNC + FT Assets as if plan At - risk Generally this is amount needed to fully fund benefits

8 DB plans DB plans are PENSION plans Benefit must be definitely determinable Contributions subject to minimum funding Not totally discretionary Clients tend to want flexibility DB plan is NOT a super PS plan Client needs to understand they are making a commitment e.g., 3 5 years, subject to change due to business conditions

9 DB plans Benefit payment restrictions With limited exceptions, prior to PPA 2006, DB plans were restricted from making lump sum payments to top-25 HCEs if plan was 110% funded Treasury Regulation 1.401(a)(4)-5(b)(3) Post PPA, IRC 436 restricts benefit payments to all participants where plan funding level below 80% 50% lump sums allowed if funded between 60 and 80% Lump sums under $5,000 still allowed It is important that client be made aware of these rules when considering any type of DB plan

10 DB plans - benefits The benefit payable in a DB plan is generally the normal retirement benefit (NRB) The accrued benefit is the portion of the NRB that an employee has earned to date In a traditional DB plan the accrued benefit is normally defined as an annual (or monthly) benefit payable at normal retirement age (NRA) Whereas in a cash balance plan the accrued benefit is the actuarial equivalent of the theoretical account balance

11 DB plans - benefits Accrued benefits normally earned under either the fractional accrual method, or unit credit accrual method Under the fractional method we first determine the benefit (the NRB) that would be payable if the employee worked to NRA The accrued benefit is then this benefit multiplied by a fraction Numerator of which = number of years of credited service to date Denominator of which = projected years of credited service at NRA

12 DB plans - benefits Assume GDB has a defined benefit plan that provides participants with a normal retirement benefit of 75% of average compensation, fractionally accrued over service The benefit is reduced for employees with less than 25 years of service with GDB, NRA = 65 There are three participants Bob joined the plan at age 35 Jerry joined the plan at age 40 Phil joined the plan at age 43 Each has average comp of $200,000 Each has 5 years of credited service

13 DB plans - benefits Bob s accrued benefit is as follows NRB = $200,000 * 75% * 25 / 25 = $150,000 AB = $150,000 * 5 / 30 = $25, Jerry s accrued benefit is as follows NRB = $200,000 * 75% * 25 / 25 = $150,000 AB = $150,000 * 5 / 25 = $30, Phil s accrued benefit is as follows NRB = $200,000 * 75% * 22 / 25 = $132,000 AB = $132,000 * 5 / 22 = $30,000.00

14 DB plans - benefits The net result of the previous example is as follows Employees with 25 or less years in the plan accrue at the rate of 3% per year i.e. 75% / 25 years Employees with more years in the plan accrue at a rate dependent on the number of projected credited years of service at NRA i.e. 75% / credited years of service at NRA In Bob s case 75% / 30 = 2.5% 2.5% * 5 (yrs) * $200,000 = $25,000

15 DB plans - benefits Under the unit credit method employees accrue their benefits each year dependent on the plan formula So in the prior example instead of fractional accrual assume the plan uses unit accrual and provides that each participant earns a benefit of 3% of average compensation for each year of credited service, capped at 25 years. Bob s benefit would be $200,000 * 5 * 3% = $30,000 As would Jerry and Phil s

16 DB plans - benefits Each person s projected NRB is the same as before Bob s NRB = $200,000 * 3% * 25 = $150,000 Jerry s NRB = $200,000 * 3% * 25 = $150,000 Phil s NRB = $200,000 * 3% * 22 = $132,000 The only real difference is that Bob s benefit is earned over 25 years instead of 30 It is therefore common in a plan where the favored group has less years to NRA to use fractional accrual Or at least it was until we started using combined plans Note that using a minimum of 25 years under fractional accrual is generally required for a safe harbor formula (i.e. a formula that won t require rate group testing)

17 DB plans - funding Since PPA, funding is performed based on the accrued benefit Pre PPA it was common to fund based on the projected benefit and fund the plan on a level basis each year So let s look back at Bob (now age 40), Jerry (45) and Phil (48) Let s assume each had an increase in accrued benefit of $6,000 such that their beginning accrued benefit was $24,000 and their ending accrued benefit was $30,000 These are annual benefits so let s restate to monthly Beginning accrued benefit therefore = $2,000 per month Increase = $500 per month

18 DB plans - funding Various interest rates impact DB plans 430 segment rates (aka adjusted rates) Used for funding 404 segment rates (aka unadjusted rates) Used for maximum deduction (and PBGC if elected) 417(e) segment rates Used for determining minimum lump sums PBGC rates Used for determining variable rate premium May elect to use 404 rates (we usually do)

19 DB plans - funding We ll assume our plan uses the 2017 applicable mortality table and a post retirement interest rate of 5.5% This results in an annuity purchase rate at age 65 of $ i.e., $ would produce a benefit of $1 per month for life beginning at age 65 Our segment rates are as follows (430 / 404 / 417): S1 (payment in less than 5 years) = 4.43% / 1.51% / 1.79% S2 (payment in 5-20 years) = 5.91% / 3.83% / 3.80% S3 (payment thereafter) = 6.65% / 4.82% / 4.71%

20 DB plans - funding Recall each has an increase in accrued benefit of $500 The Target Normal Cost is the present value of the increase in accrued benefit For funding the TNCs would be as follows Bob $500 * / ^ 25 = 14,027 Jerry $500 * / ^ 20 = 19,354 Phil $500 * / ^ 17 = 26,428 For maximum deduction the TNCs would be Bob $500 * / ^ 25 = 21,621 Jerry $500 * / ^ 20 = 27,360 Phil $500 * / ^ 17 = 37,026

21 DB plans - funding Recall each has a beginning accrued benefit of $2,000 The Funding Target is the present value of the accrued benefit as of the beginning of the year For funding the FTs would be as follows Bob $2,000 * / ^ 25 = 56,109 Jerry $2,000 * / ^ 20 = 77,417 Phil $2,000 * / ^ 17 = 105,712 For maximum deduction the FTs would be Bob $2,000 * / ^ 25 = 86,487 Jerry $2,000 * / ^ 20 = 109,439 Phil $2,000 * / ^ 17 = 148,104

22 DB plans - funding The minimum required contribution (MRC) for a plan year is a function of Target Normal Cost Plan Assets Funding Target Where assets > FT, MRC = TNC such excess Where FT > assets, MRC = TNC plus amortization of deficiency over a 7 year period (factor of about 1/6)

23 DB plans - funding Total TNC and FT for 430 / 404 are as follows: 430 TNC = 59,809 (14, , ,428) 430 FT = 239,238 (56, , ,712) 404 TNC = 86,007 (21, , ,026) 404 FT = 344,030 (86, , ,104) Let s assume assets = $250,000 MRC = $59,809 (250,000 - $239,238) = 49,044 Which if deposited would bring assets to $299,047 i.e., assets would = liabilities on 430 basis

24 DB plans - funding Maximum deductible contribution would be 404 TNC FT + 50% FT (cushion) - assets $86,007 + $344,030 + $172,015 $250,000 = 352,052 So the contribution could be anywhere from $49,044 to $352,052 If maximum deposited assets would = $602,052 Recall min would bring assets to $299,044

25 DB plans - funding But what are the real liabilities? i.e., if one of the participants left what would their lump sum be? The law provides that the lump sum must be no less than what it would be if the applicable interest rates are used Using above 417 rates the lump sums would be Bob $ 111,819 Jerry $ 141,253 Phil $ 168,872 Total $ 421,944 So funding for the minimum would be dangerous!

26 DB plans - limits Let s assume Jerry has a separate, unrelated company called JGB Assume his compensation has been at the max for several years and he wants to set up a max DB plan Recall his current age is 45 Recall DB maximum benefit at age 62 is $215,000 With max comp his 3-year average for is average of $265K + $265K + $270K = $266,667 Maximum accrual in one-year is $21,500 so formula might be % for each year in the plan Or maybe $21,500 per year of service (i.e. benefit of dollar amt)

27 DB plans - limits Recall from above that the maximum benefit is reduced for years of participation, or fractions thereof, less than 10 A special rule however provides that this is no less than 1 So as long as there is prior service and enough prior comp. the beginning accrued benefit can be the full $21,500 (annual) Making the formula $21,500 for each year of service, limited to one year of service prior to the plan effective date, allows an accrual of $21,500 as of the first day of the first plan year This then puts the liability attached to this benefit in funding target allowing for the use of the cushion in year 1

28 DB plans - limits When determining the maximum lump sum for a DB plan the interest rate used is the lesser of the rate in the plan or 5.5% and the applicable mortality table (aka 417e) So when you re looking to set up max lump sum use a post retirement rate of no more than 5.5% and the 417e table With a normal retirement age of 62, the maximum lump sum attributable to the year one accrual at age 62 is 21,500 / 12 * = $268,879 The law provides that this is the maximum that can be funded for For 430 /404 the funding target would be $268,879 / ^ 17 = $101,304 $268,879 / ^ 17 = $141,928

29 DB plans - limits The minimum contribution would be approximately $101,304 / 6 = $16,884 The maximum deductible contribution would be approximately $141,928 * 1.5 = $212,892 Recall from earlier slide that maximum payable at age 45 for 1/10 th of dollar limit is about $115,000 What happens if Jerry dies before year 2 and the maximum was funded? There s $212K in the plan but only $115K can be paid Wait until after end of year 1 to fund amount over $115K i.e. fund before following 9/15 (or earlier tax return due date)

30 DB plans flexible? Consider same facts except Jerry has extra income this year but not certain about the future Instead of benefit of $21,500 based on one prior year possibly set up as $4,300 per year of service with service credited for 5 prior years Beginning accrued benefit same as before so all funding amounts the same If full $212K funded then there should be enough to cover additional benefits that will accrue for another 2 3 years without any additional funding required Let s look closer using another example

31 DB plans flexible? Trey, age 58 at 1/1/17, 15 years prior service No other ees Reg (a)(4)-5(a)(3) N/A Reg limits ability to use past service if NHCs in past Wants to retire 12/31/2021 at age 62 Consistently earned $250K annually 2015 will earn $550K Likely back to $250K in 2018 And he needs it all to live Wants to shelter the $300K excess But with no future obligation

32 DB plans flexible? Adopts DB plan Normal retirement age 62 Monthly benefit $100 per year of service Benefit at 1/1/17 effective date $1,500 Annual accrual thereafter $100 Total benefit at retirement $2,000 Assume lump sum, 5% (e) table B.O.Y. valuation January 2017 unadjusted S1 1.57%

33 DB plans flexible? FT = $218,045 1,500 * * ^ (-5) TNC = $14, * * ^ (-5) Max deduction = $341,605 (218,045 * 1.5) + 14,536 Deposit of $300,000 will be enough to cover all 20 years of benefits assuming 1% ROR Again be careful of deposit dates to avoid over-funding

34 DB plans flexible? i.e. benefit at age 62 will be $2,000 Value (liability) at age 62 (assuming current table) will be $314,278 (2,000 * ) At 1% ROR assets will grow to $315,303 Greater growth fine Maximum lump sum under IRC 415 at age 62 with 5 years in plan exceeds $1.3 million If larger deductions are desired in years 2 or later formula can be amended upward

35 DB plans Data Prior examples used formulas based on prior comp What if all not available? Or what if not entirely confident in data provided Recall from above that 415 limits benefit to 10% of average compensation (or dollar limit if lower) Average compensation for this purpose is highest 3 consecutive years while employed by the employer Assume your formula is 10% of average compensation per year of participation You re told that comp for each of 3 previous years was $50K so your accrued benefit is $5,000 and you use that for funding

36 DB plans Data You later find out that back in the 80s, before the company elected S status, comp was $100K per year Accrued benefit should have been $10K and plan is underfunded Excise taxes could apply for failure to meet minimum funding When you re not sure you have all prior years limit comp period to that for which you have data E.g. document ignores comp before some date (e.g. 1/1/14) Or use dollar benefit $5K was the annual benefit accrual you wanted so define the benefit as $5K per year of participation I particularly like this approach when dealing with SE folks