Any meaningful description of a defined benefit pension plan (DBPP) must take in account the complexity of its nature. Certain rules governing DBPPs are unique. A DBPP is the only qualified employees retirement plan that necessitates an annual actuarial certification from an enrolled actuary in order to verify the appropriate amount of contribution and substantiate the deductibility of such funded contributions. A DBPP is designed theoretically to compute the amount of equity necessary to pay for a projected annual lifetime benefit beginning at a specified age. The determination of the exact amount of annual income that any particular participant is entitled to receive is a function of the benefit formula stipulated in the Plan document and certain reasonable actuarial assumptions projecting benefits to begin at an anticipated normal retirement age. A DBPP is predicated on a projection of the future and therefore the actual date of retirement often proves to be different from the stipulated date. Nevertheless, the Plan Sponsor can rely upon the actuarial certification as the basis for a valid required contribution and justifiable tax deduction.
DBPP document must stipulate a precise benefit formula as the basis for determining each respective eligible participant’s projected annual benefit beginning at normal retirement age. Each participant’s accrued benefit is calculated as a function of a specific average annual compensation (normally the highest three to five consecutive years of earnings coincident with participation in the plan) and the participant’s attained age at inception into the plan, as well as the participant’s attained age at the time his or her participation ceases, together with the projected retirement date. The participant’s actual entitlement is referred to as the present value of accrued benefit. The projected annual benefit is multiplied by a fraction, the numerator of which is generally the actual years of credited participation with a minimum of at least 1000 hours of service with the Sponsoring Employer and the denominator is the total number of years of participation that the participant would have accrued had he or she continued to participate in the Plan through his or her projected normal retirement date. When a participant ceases participation either because he or she leaves employment or the Plan terminates and, once the accrued benefit is precisely computed, it becomes necessary to determine the present value of this future benefit.
The projected annual flow of income must be converted into a lump-sum value by means of an annuitization computation based upon a mortality table and other actuarial assumptions stipulated in the Plan document and deemed to be reasonable by the enrolled actuary. Because the projected annual benefit is generally due at some stipulated future date from the actual date of computation, it becomes necessary to calculate the present value of that future benefit by discounting the accrued benefit by an assumed interest rate over the period of years remaining until the participant would have attained his or her normal retirement date. The computation of the required annual contribution for a DBPP is not purely an arithmetic calculation. The methodology employed to calculate the required annual contribution for a DBPP is quite distinct from that utilized in computing the participant accrued benefits. Moreover, unlike a defined contribution plan, neither of these computations is directly correlated to the means used to reconcile the accounting of the trust assets.
It is important to understand that unlike defined contribution plans, the participant in a DBPP does not share in the gains or losses of investments. Therefore the employer is at full risk if the value of the trust assets depreciate in value or increase in value at a rate of interest below the actuarially assumed interest rate of annual return (generally between a minimum of 5% and a maximum of 8%) because the participant accrued benefits are guaranteed. Lower rates of investment return result in higher required annual contributions and vice versa.
With these distinct ongoing obligations, what might prompt an employer to adopt a DBPP in the first place? The DBPP option offers significantly higher leverage in terms of funding, deductibility and cumulative retirement benefit. The highest annual contribution and deduction permissible under a defined contribution plan per individual is the lesser of $49,000 and 25% of annual compensation (with a statutory limitation of $245,000). Because a DBPP is inherently age weighted, it is often the case that a key employee is significantly older than the rank and file employees and therefore receives a disproportionately higher benefit greater than the mere disparity in compensation would warrant. For example, in a DBPP, two employees who perform the same function at the same amount of compensation, who both work until each of his or her respective retirement age, would receive the same benefit even though one works for the Sponsoring Employer while being a participant in the DBPP potentially many years longer than the other. Obviously the annual employer funding cost into a DBPP would be substantially less for the younger participant who most often is not a key-employee.
The maximum allowable annual DBPP contribution per individual could exceed $200,000 depending upon the benefit formula, the average annual compensation and attained age of a key-employee in relation to the projected normal retirement date, which must be at least five years after the initial date of participation. There is no opportunity for a key-employee participant to exceed an annual addition of $54,500 with any type of qualified retirement plan other than a DBPP. Even though it is more expensive to administer a DBPP as opposed to a defined contribution plan (typically up to 50% greater cost) the disparity in benefit can prove to be dramatically greater, in some cases over 500% larger.
The nature of a DBPP requires significantly more analysis and monitoring. All DBPPs are subject to a minimum funding standard annually as specified in Internal Revenue Code (IRC) Section 412 as well as a maximum deductibility limitation under IRC Section 404. Although this is also true of certain types of defined contribution plans called Money Purchase Pension and Target Benefit Pension Plans, changes in legislation have made both of these types of plans virtually obsolete and they will not really be a meaningful consideration in the future, which is certainly not the case with DBPPs. A Plan Sponsor of a DBPP faces the perpetual risk of having to make mandatory contributions in amounts greater than desired or even readily attainable. Moreover, if the investment returns exceed expectations, there is the genuine risk of the Sponsoring Employer having to pay significant excise taxes if the fair market value of the trust grows in excess of the actuarially permissible limits. The excise penalty itself can be 50% of the excess amount.
The amount of contribution and deduction can be enhanced by the addition of Life insurance as an incidental benefit inside a conventional DBPP or as a substantial benefit through a so-called 412(i) Plan. The latter form of DBPP is restrictive in terms of investment options because the contributions must be paid directly to a life insurance company and the commitment to fund is rigid for a minimum of five years. The contributions and deductions tend to be higher than a conventional DBPP design due to the cost of the life insurance and the fact that the guaranteed interest rates are generally in the range of 3% rather the minimum 5% interest assumption for a conventional DBPP. Yet, the statutory limits for maximum distribution essentially are the same for all types of DBPP.
In recent years there has been a proliferation of another type of DBPP referred to as a cash balance plan. Unlike conventional DBPPs, cash balance plans permit computation and creation of individual participant accounts based upon guaranteed rates of return on investments. The government is scrutinizing the methodology of cash balance plans because there is a perceived, if not a genuine risk, of greater disparities between the liabilities incurred in such plans in relation to the actual value of the trust assets available to meet these liabilities and because of potential inequitable advantages in comparison to.
Needless to say, it is critical that a Sponsoring Employer of a DBPP retain competent professional advice prior to adopting such a plan. Unfortunately, many third party pension administrators are not adequately equipped to perform these services. The evidence indicates that a good percentage of such administrators depend heavily on software systems that prove to be restrictive in achieving optimum results, even if they are well versed in utilizing them. Oftentimes the quality of the design, administration and monitoring of the DBPP depends upon the care and diligence the independent actuary takes in the matter and rarely is the actuary paid to perform all these vital services because he or she is retained by the third party administrator and not the client. It is desirable to work with a third party administrator who is well prepared to assume responsibility for all these duties and is knowledgeable in utilizing actuarial strategies rather than merely serving as a middleman between the client and the actuary.
Ultimately, perhaps the most crucial step to perform is to determine the ideal method and time to terminate the DBPP, bearing in mind that the objective is to optimize the distribution of the trust assets. It is at the time of final distribution that the key-employee participants are most vulnerable to negative consequences. A positive result will rarely occur by convention or accident. In order to achieve the most desirable outcome, the strategy must be carefully planned in advance of the final distributions.
Even though the normal form of payment specified in the Plan document, as required by law, is a periodic payment, in the vast majority of cases, particularly for DBPPs sponsored by closed corporations or other small businesses, participants receive benefit payments in the form of lump-sum distributions. There are exacting limitations in terms of the maximum amount of equity any participant is entitled to receive in the form of a lump-sum distribution from a DBPP. It is not always safe to assume that the full value of the retirement trust is eligible for payment in the form of lump-sum distributions. If trust asset values exceed the aggregate present value accrued benefits permissible for lump-sum distribution, a portion of the trust assets must remain in the trust, thereby preventing the formal termination of the Plan, or this portion of trust assets must revert back to the Sponsoring Employer resulting in a 50% excise tax.
Another perplexing phenomena unique to DBPPs is that the methodology required to compute participant accrued benefits may result in dramatic fluctuations well beyond normal expectations as a result of specialized interest rates determined by the government. Because of the potential volatility in the valuations of both participant accrued benefits and the fair market prices of pension trust assets, an Sponsoring Employer, who has acted in a prudent and responsible manner throughout the life of the DBPP and is otherwise in total compliance with the law, may easily find that the obligations owed the participants is significantly in excess of the funds available. Understanding these subtleties can be critical to orchestrating an optimal resolution for the Plan Sponsor rather than compelling key employees to accept what will inevitably be a less favorable outcome.
Beginning in 2008, the IRS has now made it mandatory for Plan Sponsors to incur the cost of at least one more annual actuarial evaluation and certification, referred to as an AFTAP. Essentially this certification specifically delineates the direct correlation between the respective amounts of the fair market value of trust assets in relation to the aggregate value of participant accrued benefits. If the fair market trust value falls below a certain percentage level of the total benefit payments due, the IRS will place certain restrictions on distribution payments to the Plan, particularly for highly-compensated key employee-participants.