CERTIFIED FINANCIAL PLANNER CERTIFICATION
PROFESSIONAL EDUCATION PROGRAM
Retirement Planning & Employee Benefits
Module 2
Fundamentals of
Defined Benefit Plans
©2013, College for Financial Planning, all rights reserved.
Learning Objectives
LO 2–1 introduces you to traditional defined benefit plans and how the
retirement plan benefit is determined.
LO 2–2 introduces you to cash balance plans, and how they differ from
defined benefit pension plans by guaranteeing a return rather than a
retirement benefit.
LO 2–3 introduces you to plan participation and eligibility rules.
LO 2–4 introduces you to the concept of Social Security integration and
the two methods available for defined benefit plans.
LO 2–5 requires you to understand the basic funding methods for
defined benefit plans and the impact of various actuarial assumptions
on plan funding.
LO 2–6 deals with plan termination.
LO 2–7 introduces you to the far-reaching impact that the Pension
Protection Act (PPA) has had on defined benefit plans.
LO 2–8 walks you through a case analysis example of a company
considering the installation of a defined benefit plan.
2-2
Questions to Get Us Warmed Up
2-3
Learning Objectives
LO 2–1 introduces you to traditional defined benefit plans and how the
retirement plan benefit is determined.
LO 2–2 introduces you to cash balance plans, and how they differ from
defined benefit pension plans by guaranteeing a return rather than a
retirement benefit.
LO 2–3 introduces you to plan participation and eligibility rules.
LO 2–4 introduces you to the concept of Social Security integration and
the two methods available for defined benefit plans.
LO 2–5 requires you to understand the basic funding methods for
defined benefit plans and the impact of various actuarial assumptions
on plan funding.
LO 2–6 deals with plan termination.
LO 2–7 introduces you to the far-reaching impact that the Pension
Protection Act (PPA) has had on defined benefit plans.
LO 2–8 walks you through a case analysis example of a company
considering the installation of a defined benefit plan.
2-4
What Makes a Plan Qualified?
• ERISA
• Minimum participation and coverage
•
•
•
•
requirements
Non-discriminatory
Minimum vesting requirements
Minimum funding
requirements (pension plans)
Protection of assets
2-5
Qualified & Nonqualified Plans
Qualified Plans
Nonqualified Plans
Pension Plans
Profit Sharing
Plans (DC)
Tax-Advantaged
Plans
Other Nonqualified
Plans
Defined Benefit (DB)
Profit Sharing
Traditional IRA
Section 457 Plans
Cash Balance (DB)
Thrift Plan
Roth IRA
Stock Bonus
SIMPLE IRA
ISO
Money Purchase (DC)
ESOP (LESOP)
SEP
ESPP
Target Benefit (DC)
Age-Weighted
(SARSEP)
NQSO
403(b) (TSA)
Deferred
Compensation Plans
Cross-Tested
(Comparability)
401 (k) Plan
SIMPLE 401 (k)
2-6
Defined Benefit Plan
• A promised pension benefit
•
guaranteed by the sponsor
Maximum contribution:
the actuarially determined
amount needed to fund a
pension of the lesser
of 100% of salary or
$205,000 (2013)
2-7
Defined Benefit Plan Benefit Formulas
Flat benefit: Service is not considered
• Benefit is flat amount or percent of earnings
• Service reduction may be used: reduced benefit
for <X years of service
Unit benefit: Service increases benefit
• Benefit is a dollar amount per year of service or
a percentage of earnings per year of service
• Participant accrues additional benefit each year
• Service limitation may be used; considers years
of service up to specified maximum
2-8
Benefit Formula Examples
Funding
Formula
Flat Amount
Formula
Benefit
Calculation
Flat amount per
month
Flat
Percentage
Formula
Flat percentage
based on
compensation
10% of comp.
Per year
Unit Credit
Formula
Benefit
determined on a
combination of
service and
compensation
2% x years of
service x average
3 highest years
pay
Example
$250 per month
Comments
No incentive for
participants to continue
employment after attaining
maximum flat amount
Incentive to increase
compensation through
raises but not to continue
employment after attaining
a desired benefit
Incentive to attain
additional years of service
and additional
compensation to increase
ultimate benefit
2-9
Defined Benefit Plan Earnings Definition
• Career-average pay:
•
average earnings over
plan participation period.
Final-average pay:
average earnings over
final 3 or 5 years, or
average highest 3 or 5 of
last 10 years.
2-10
Survivor Annuities
• Required of all pension plans
• QJSA 50% then a 75% QOSA (qualified optional
•
•
survivor annuity) must be offered or
QJSA 75% then a 50% QOSA must be offered
QPSA must also
be offered
2-11
Factors Affecting Annual Retirement Benefits in a Defined Benefit Plan
Retirement Age
• Normal retirement: Stated by plan document, typically
age 65.
• Retirement after normal retirement is adjusted upward,
and before normal retirement the benefit is adjusted
downward
Years of Plan Participation
• (if maximum benefit formula of $205,000 is used)
• 10% reduction in maximum dollar limitation on normal
retirement benefit for each year of plan participation (or
year of service) less than 10
2-12
Defined Benefit Plan
Advantages
Disadvantages
Employer
Generally, greater tax-deductible
contributions than through defined
contribution plan.
Employer is obligated to pay benefits in
accordance with plan provisions.
Participant
Benefit is assured—backed by PBGC (up to
$4,563).
Generally, more beneficial to participants
close to retirement age.
Younger participant may benefit more from
defined contribution plan over many years.
Plan benefits are not portable. Retirement
distributions generally are not cost-of-living
adjusted.
2-13
Cash Balance Pension Plans (1)
•
•
•
A defined benefit plan with specific
annual employer contributions that
accumulate at a guaranteed
investment return.
Plan assets are pooled, but
participants have simulated
investment accounts that are
treated very much like accounts in
a defined contribution plan.
Like the traditional defined
benefit pension plan, the
cash balance plan provides
security for employees
through its guarantees,
and through PBGC insurance.
2-14
Cash Balance Pension Plans (2)
•
•
•
Cash balance plans may be used
to simplify and reduce the high
cost of a traditional defined
benefit pension plan without
actual termination.
A defined benefit plan can be
amended into a cash balance plan
that looks and feels to the
employees just like a money
purchase plan.
Cash balance plans are more
beneficial for younger employees,
but not favorable for older
employees.
2-15
Learning Objectives
LO 2–1 introduces you to traditional defined benefit plans and how the
retirement plan benefit is determined.
LO 2–2 introduces you to cash balance plans, and how they differ from
defined benefit pension plans by guaranteeing a return rather than a
retirement benefit.
LO 2–3 introduces you to plan participation and eligibility rules.
LO 2–4 introduces you to the concept of Social Security integration and
the two methods available for defined benefit plans.
LO 2–5 requires you to understand the basic funding methods for
defined benefit plans and the impact of various actuarial assumptions
on plan funding.
LO 2–6 deals with plan termination.
LO 2–7 introduces you to the far-reaching impact that the Pension
Protection Act (PPA) has had on defined benefit plans.
LO 2–8 walks you through a case analysis example of a company
considering the installation of a defined benefit plan.
2-16
Defined Benefit Plan Minimum Participation Test
Defined benefit plans also must satisfy the minimum
participation (50/40) test. The plan must benefit at least
the lesser of
• 50 employees, or
• The greater of:
o 40% of all the company’s ERISA eligible employees,
or
o Two employees (one employee if there is only one
employee)
2-17
Minimum Coverage Tests
• A qualified plan must satisfy one of two
•
coverage tests for at least one day of each
quarter:
o Ratio Percentage Test: Percentage of eligible
non-HCEs benefiting under plan must be at
least 70% of percentage of HCEs benefiting
o Average Benefits Test: Average benefit, as a
percentage of compensation, for non-HCEs
must be at least 70% of that for HCEs
Employees excluded from the coverage tests:
under age 21, or less than one year of service,
or covered by a collective bargaining agreement
2-18
Highly Compensated Employee
• Was a “5% owner” (ownership of >5%) in the
determination year or in the preceding plan year or
• In 2013, a person whose compensation was in
excess of $115,000 in the previous
year (2012) is a highly compensated
person.
o Employer has the option to
limit highly compensated to
the top-paid 20% employees
based upon preceding year’s
compensation.
2-19
Defined Benefit Social Security Integration—Excess Plan
Social
Security
Earnings
Limit
Permitted disparity of 26.25% +
30% plan benefit = 56.25%
above the integration level
Plan Benefit: 30% of compensation
Social Security = 26.25% of covered compensation
Note: for Unit Credit plans, the permitted disparity is .75% per year
of service (35 yr max.) reduced for early retirement provisions.
2-20
Social Security Integration
Base
Contribution % +
10%
20%
30%
Permitted
Disparity =
10%
20%
26.25%
(max.)
Excess
Contribution %
20%
40%
56.25%
2-21
Social Security Offset Integration: Defined Benefit Plan Example
Allen’s Retirement Benefits:
Nonintegrated DB Plan
Allen’s Retirement Benefits:
DB Plan Using Offset Integration
DB Pension ($15,000)
DB Pension
($15,000 – $9,000 = $6,000)
but cannot lose more than 50% of
pension, so pension benefit = $7,500
Primary Social Security Retirement Benefit ($12,000)
Company A’s nonintegrated DB
plan entitles Allen to a $15,000
annual benefit at age 65
If Company A’s DB plan is integrated
using a 75% offset (75% of $12,000 =
$9,000), it would entitle Allen to a
$7,500 annual benefit at age 65 since
maximum offset is 50%
2-22
Qualified Plan Vesting Schedules
Completed
Service Years
Defined benefit
pension plans
(non-top heavy)
Top-heavy
defined benefit
pension plans
1-2
3
4
5
6
7
1
2
3
4
5
6
Cliff Vesting
% Vested
Graded Vesting
% Vested
5-Year Cliff
3-to-7-Year Graded
0%
0%
0%
100%
100%
100%
0%
20%
40%
60%
80%
100%
3-Year Cliff
2-to-6-Year Graded
0%
0%
100%
100%
100%
100%
0%
20%
40%
60%
80%
100%
2-23
Vesting
Vesting schedules are based upon years of service,
not years in the plan
Maximum vesting schedules are:
• Non-top heavy defined benefit plans can use
5-year cliff or 3- to 7-year graded
• Top heavy defined benefit plans can use
3-year cliff or 2- to 6-year graded
• Cash balance plan maximum vesting schedule is
3-year cliff (PPA requires)
2-24
Top Heavy Plans
A plan is top heavy if more than 60% of plan
benefits are attributable to “key” employees.
If a defined benefit plan is top heavy there are two
requirements:
1. accelerated vesting, and
2. minimum benefit of 2% of compensation for
each year of service that the plan is top heavy
up to 10 years.
2-25
Key Employee (for Top Heavy Testing)
• a “5% owner”
•
•
(ownership of >5%),
or
owned >1% of the
company and received
compensation
>$150,000, or
Was an officer of the
company and received
compensation
>$165,000 (2013)
2-26
Actuarial Assumptions
• interest rate
• turnover rate
•
•
•
(impacts forfeitures and
potential benefits)
salary scales
(takes into account
increasing salaries)
benefit costs
mortality
2-27
Impact of Actuarial Assumptions
Direct Relationship
Expected
inflation
Expected
wage
increases
Life
expectancy
Indirect Relationship
Expected
investment
returns
Expected
mortality
Expected
forfeiture/
employee
turnover
Change
Impact
on plan
costs
4-28
Entry Age Normal & Attained Age
• Entry age normal takes into account past
•
service when the plan is installed.
Attained age starts service when the plan is
installed, in other words no credit is given for
past service.
2-29
Learning Objectives
LO 2–1 introduces you to traditional defined benefit plans and how the
retirement plan benefit is determined.
LO 2–2 introduces you to cash balance plans, and how they differ from
defined benefit pension plans by guaranteeing a return rather than a
retirement benefit.
LO 2–3 introduces you to plan participation and eligibility rules.
LO 2–4 introduces you to the concept of Social Security integration and
the two methods available for defined benefit plans.
LO 2–5 requires you to understand the basic funding methods for
defined benefit plans and the impact of various actuarial assumptions
on plan funding.
LO 2–6 deals with plan termination.
LO 2–7 introduces you to the far-reaching impact that the Pension
Protection Act (PPA) has had on defined benefit plans.
LO 2–8 walks you through a case analysis example of a company
considering the installation of a defined benefit plan.
2-30
The Funding Standard Account
• Actual plan results are compared to
•
•
•
estimated amount needed to provide
promised plan benefit.
Minimum funding standard:
employer must
contribute at least a
minimum amount to
fund the plan benefit.
If account value exceeds
minimum required to
fund benefit, contribution
is decreased.
If plan is underfunded there
is a 10% penalty tax.
2-31
Defined Benefit Plan Termination (1)
Overfunded plans must either
• transfer 25% of the potential
reversion to a qualified
replacement plan, or
• increase the participants
accrued benefits by at
least 20%.
2-32
Defined Benefit Plan Termination (2)
Underfunded plans (involves PBGC)
• voluntary standard termination
• voluntary distress termination
• involuntary termination
• Maximum monthly amount
guaranteed by PBGC at
age 65 is $4,789.77
paid out over participant’s
lifetime; lump sum option
is not available.
2-33
DB Plans Exempt From PBGC
• Plans maintained for substantial business
•
owners only ( such as sole business owners or
greater than 10% business owners).
Plans maintained by professional service
employers that have never had more than 25
active participants.
2-34
Fully Insured Plans
A plan is “fully insured” if it complies with
IRC 412(i):
• It is funded exclusively with life insurance or fixed
annuity contracts (at least 51% in fixed annuities).
• These contracts must provide guaranteed benefits
equal to the benefits provided by the plan.
• Contracts must exhibit level
premium characteristics
beginning with issue date
and ending with retirement.
2-35
Learning Objectives
LO 2–1 introduces you to traditional defined benefit plans and how the
retirement plan benefit is determined.
LO 2–2 introduces you to cash balance plans, and how they differ from
defined benefit pension plans by guaranteeing a return rather than a
retirement benefit.
LO 2–3 introduces you to plan participation and eligibility rules.
LO 2–4 introduces you to the concept of Social Security integration and
the two methods available for defined benefit plans.
LO 2–5 requires you to understand the basic funding methods for
defined benefit plans and the impact of various actuarial assumptions
on plan funding.
LO 2–6 deals with plan termination.
LO 2–7 introduces you to the far-reaching impact that the Pension
Protection Act (PPA) has had on defined benefit plans.
LO 2–8 walks you through a case analysis example of a company
considering the installation of a defined benefit plan.
2-36
PPA Disclosure Requirements
• New under PPA
• Disclosures include
o summary of plan participants,
o information about funding
status of plan, and
o allocation of assets.
• PBGC overview and
what it guarantees
must also be
provided.
2-37
Defined Benefit/ Cash Balance Plans (1)
Traditional Defined
Benefit Plan
Cash Balance Plan
Qualified plan that provides a
specified retirement benefit
based on a flat or unit formula
Qualified defined benefit plan the
provides specified employer
contributions and a guaranteed
return
Factors
affecting
suitability
• Favors participants nearer
retirement age
• Only plan that can enable
owner to meet retirement
objective
• Favors younger participants
• Allows company to amend
defined benefit plan to simplify
and reduce cost
Contribution/
benefit limits
Annual contributions are required, therefore,
1. the business must have stable (or increasing) cash flow, and
2. the owner must be willing to commit to annual payments.
Benefit
formula
Contribution limit equals the
amount necessary to fund
benefit up to dollar and
compensation limits.
Definition
Employer contributes a specified
percentage of pay and guarantees
an investment return each year.
2-38
Defined Benefit/Cash Balance Plans (2)
Adequacy of
funding
Traditional Defined
Benefit Plan
Cash Balance Plan
Flat benefit formula
or
Unit benefit formula
Employer contributes a specified
percentage of pay and guarantees
an investment return each year.
Plan earnings
and
forfeitures
•
•
•
•
Subject to minimum funding standard
Annual actuarial determination on funding standard
PBGC can terminate plan if inadequately funded
Employer assumes investment risk
Allocation
methods of
benefits and
contributions
• Earnings affect employer contributions
• Forfeitures can only be used to reduce employer contributions
Benefit
determination
Per plan formula (employer
assumes the risk)
Per plan formula
2-39
Defined Benefit/Cash Balance Plans (3)
Traditional Defined
Benefit Plan
Factors
affecting
contributions
•
•
•
•
Participants’ salary levels
Investment returns
Forfeitures
Participants proximity to
retirement age (contributions
are weighted toward
participants closer to
retirement age)
Cash Balance Plan
•
•
•
•
Participants’ salary levels
Investment returns
Forfeitures
Contributions allocated based
on relative compensation
2-40
Multiple Choice Question 1
Which of the following could be expected to reduce
the annual cost of a defined benefit plan?
I. a high turnover assumption
II. use of salary scales
III. a high interest rate assumption
IV. a high benefit cost assumption
V. a low turnover assumption
a. I and II only
b. I and III only
c. II and IV only
d. I, II, and III only
e. II, IV, and V only
2-41
Multiple Choice Question 2
LMN Corporation’s defined benefit plan provides a flat benefit of
30% of final average compensation. If the plan uses permitted
disparity (Social Security integration), which of the following
statements can be made regarding this plan?
I. The integration level is each participant’s covered
compensation level.
II. The maximum percentage benefit for compensation in excess
of the plan’s integration level is 30%.
III. The maximum percentage benefit for compensation in excess
of the plan’s integration level is 56.25%.
IV. The plan’s permitted disparity is 26.25%.
V. The plan’s permitted disparity is 30%.
a. I and II only
b. II and IV only
c. III and IV only
d. I, III, and IV only
e. I, III, and V only
2-42
Multiple Choice Question 3
Which of the following best describes the ratio
percentage test?
a. The percentage of NHCs benefited by the plan
must be at least 70% of the percentage of HCs
benefited by the plan.
b. Plan benefits for NHCs must be 70% of all
employees’ benefits.
c. The plan must benefit a nondiscriminatory
classification of employees and the average
benefit percentage for NHCs must be 70% of
the average benefit percentage for HCs.
d. The plan must benefit at least 70% of all
employees.
2-43
Multiple Choice Question 4
Which of the following best describes the average
benefits test?
a. The percentage of NHCs benefited by the plan
must be at least 70% of the percentage of HCs
benefited by the plan.
b. Plan benefits for NHCs must be 70% of all
employees’ benefits.
c. The plan must benefit a nondiscriminatory
classification of employees and the average
benefit percentage for NHCs must be 70% of
the average benefit percentage for HCs.
d. The plan must benefit at least 70% of all
employees.
2-44
Multiple Choice Question 5
Which of the following are characteristics of a voluntary standard
termination?
I. The plan must have sufficient assets to meet benefit liabilities.
II. The plan has insufficient assets to meet benefit liabilities.
III. Plan assets must be distributed in accordance with ERISA
requirements.
IV. This type of termination would be used if the employer wanted
to terminate a defined benefit plan and offer a defined
contribution plan instead.
V. The employer is assessed a 50% penalty tax on asset
reversions.
a. I and IV only
b. II and III only
c. I, III, and IV only
d. II, III, and V only
e. I, III, IV, and V only
2-45
CERTIFIED FINANCIAL PLANNER CERTIFICATION
PROFESSIONAL EDUCATION PROGRAM
Retirement Planning & Employee Benefits
Module 2
End of Slides
©2013, College for Financial Planning, all rights reserved.