Chapters 14 and 15: funding defined benefit plans

1
Chapters 14 and 15 funding defined benefit plans

• Last updated 10/24/00

2
The choice of a particular set of assumptions

• The choice of assumptions will affect the cost
  allocated to a given year, but the ultimate cost
  is primarily dependent on actual experience over
  the life of the pension plan
• The relative magnitude of actuarial gains and
  losses under the plan will vary, but the end
  result will be an approximately similar ultimate
  cost picture
• except to the extent that investment earnings are
  affected by the incidence of contributions
  produced by the funding assumptions chosen

3
Number of employees who will be eligible for
benefits under a pension plan

• Mortality rates among active employees
• Rates and duration of disabilities among active
  employees under a plan that offers a disability
  benefit
• Layoffs and voluntary termination of employment,
  assuming the absence of full vesting
• Rates of retirement at different ages

4
Problems in using the current market values of
securities

• Market values will generally be relatively high
  in periods of high corporate earnings
• thereby reducing the apparent need for
  contributions (and also the tax deductible
  limits)
• at times when the employer may be best able to
  make large contributions toward the pension fund
  
• Measuring a plan's unfunded liabilities on any
  given date by the current market values of the
  fund's equities could produce a very irregular
  funding pattern
• the antithesis of the orderly procedure, which is
  an essential characteristic of a satisfactory
  pension funding program.

5
Actuarial valuation of assets

• The value of a plan's assets must be determined
  by a reasonable actuarial valuation method that
  takes into account fair market value
• Generally, the Internal Revenue Service has taken
  the position that this condition is satisfied if
  the asset valuation method generates an asset
  value which is within 20 of the fair market value

6
Actuarial cost method

• Technique for establishing the amounts and
  incidence of the normal costs and supplemental
  costs pertaining to the benefits of a pension
  plan

7
Advance funding approach

• Funds are set aside on a systematic basis prior
  to the employee's retirement date
• Periodic contributions to the plan are made on
  behalf of the group of active employees during
  their working years
• Plans operating under this funding approach
  invariably are qualified with the Internal
  Revenue Service

8
Advance funding can provide a buffer during
periods of financial stress

• During a period of low earnings or operating
  losses, an employer may find it advisable to
  reduce or eliminate pension contributions for a
  year or even a longer period
• This can be done in those cases where the
  pension fund is of sufficient size that a
  temporary reduction of contributions does not
  violate the minimum funding requirements imposed
  by ERISA
• This financing flexibility does not necessitate
  any reduction in or termination of pension
  benefits
• unlike defined contribution plans

9
Choice of an actuarial cost method and the
ultimate cost of a pension plan

• Having different actuarial cost methods to
  accumulate annual pension costs is analogous to
  having different methods for determining the
  annual amount of depreciation of plant and
  equipment charged against operations
• Similarly, the various actuarial cost methods
  will produce different levels of annual cost, but
  the choice of a particular actuarial cost method
  will not affect the ultimate cost of the plan
• However, if an actuarial cost method is chosen
  that produces higher initial contributions than
  other methods, the asset accumulation will be
  greater in the early years of the plan
• thereby producing greater investment income

10
Types of acms

• Actuarial cost methods can be broadly classified
  into accrued benefit and projected benefit cost
  methods.

11
Normal cost and supplemental cost

• The normal cost of a plan is the amount of annual
  cost, determined in accordance with a particular
  actuarial cost method, attributable to the given
  year of the plan's operation.
• If the normal cost under the particular cost
  method is calculated on the assumption that
  annual costs have been paid or accrued from the
  earliest date of credited service (when in fact
  they have not), the plan starts out with a
  supplemental liability.
• At the inception of the plan, the supplemental
  liability arises from the fact that credit for
  past service is granted, or part of the total
  benefit is imputed, to years prior to the
  inception of this plan.
• The supplemental cost is the portion of the
  annual cost that is applied toward the reduction
  of a plan's supplemental liability.

12
steps in the calculation of (a) the normal cost
and (b) the supplemental liability at plan
inception under the accrued benefit cost method.

• determine the present value of each participant's
  benefit credited during the plan year for which
  costs are being calculated.
• determine the normal cost for the plan as a whole
  by summing the separate normal costs for the
  benefit credited for each participant.
• The supplemental liability at the inception of
  the plan under this method is simply the present
  value of the accrued past service benefit
  credited as of that date.
• The supplemental liability for the plan as a
  whole at the inception would be the sum of the
  supplemental liabilities for each of the covered
  employees.

13
A projected benefit cost method differs from an
accrued benefit cost method in two important
respects

• (1) the normal cost accrual under a projected
  benefit cost method is related to the total
  prospective benefit credited by the retirement
  date rather than the benefit amount credited to a
  particular year or specific period of service
  and
• (2) a projected benefit cost method is applied
  with the objective of generating a normal cost
  which is a level amount or percentage of earnings
  for either the individual participants or to the
  participants as a group.

14
Distinguish between the individual level and
aggregate level cost methods.

• Under the individual level cost method, the
  normal cost accruals are determined separately
  for each employee as a preliminary step to the
  determination of total plan cost.
• under the aggregate level cost method, the normal
  cost accruals are calculated for the past as a
  whole without associating any portion of these
  cost accruals with the projected benefits of
  specific individuals.

15
amortization periods for single employer plans
that are not underfunded

• For plans in existence on January 1, 1974, the
  maximum amortization period for supplemental
  liability is 40 years
• for single employer plans established after
  January 1, 1974, the maximum amortization period
  is 30 years.
• experience gains and losses for single employer
  plans must be amortized over a five-year period.
• Changes in supplemental liabilities associated
  with changes in actuarial assumptions must be
  amortized over a period not longer than ten
  years.

16
variances from the minimum funding requirements

• the secretary of labor may extend, for a period
  of up to ten years, the amortization period for
  supplemental liabilities and experience losses
  for both single employer and multiemployer plans.
• In those circumstances where an employer would
  incur temporary substantial business hardships
  and if strict enforcement of the minimum funding
  standards would adversely affect plan
  participants, the secretary of the treasury may
  waive for a particular year payment of all or a
  part of a plan's normal cost and the additional
  liabilities to be funded during that year.
• The law provides that no more than three waivers
  may be granted a plan within a consecutive
  15-year period the amount waived, plus interest,
  must be amortized not less rapidly than ratably
  over five years.

17
exemptions from the mandated minimum funding
standards

• Government and church plans unless they elect to
  comply
• Fully insured pension plans funded exclusively
  through individual or group permanent insurance
  contracts, provided all premiums are paid when
  due and no policy loans are allowed
• Plans that are designed to provide deferred
  compensation to highly compensated employees,
  plans that provide supplemental benefits on an
  unfunded, nonqualified basis and those plans to
  which the employer does not contribute.

18
funding standard account

• All pension plans subject to the minimum funding
  requirements must establish a funding standard
  account'' that provides a comparison between
  actual contributions and those required under the
  minimum funding requirements.
• The funding standard account is charged, each
  plan year, for
• the normal cost for the year
• the minimum required amortization payment of
  initial supplemental liabilities, increase in
  plan liabilities, experience losses and
  previously waived contributions.
• an interest adjustment recognizing the period
  between the time each charge is incurred and the
  end of the year.
• The funding standard account is credited in each
  plan year for
• the employer contributions
• the amortized portions of experience gains and
  any decrease in plan liabilities
• amounts for any waived contributions for that
  year.
• an interest adjustment reflecting the period
  between the time the contribution or payment is
  credited and the end of the year.

19
impact of (a) a positive balance and (b) a
negative balance for the funding standard account
at the end of the year

• If the funding standard account has a positive
  balance at the end of the year, such balance will
  be credited with interest in future years.
  Therefore, the need for future contributions to
  meet the minimum funding standards will be
  reduced to the extent of the positive balance
  plus the interest credit.
• If the funding standard account shows a deficit
  (negative) balance (called the accumulated
  funding deficiency), the account will be charged
  with interest at the rate used to determine plan
  costs. Moreover, the plan will be subject to an
  excise tax of 5 of the accumulated funding
  deficiency. In addition to the excise tax, the
  employer may be subjected to civil action in the
  courts for failure to meet the minimum funding
  standards.

20
plans subject to the additional minimum funding
requirements established by the Omnibus Budget
Reconciliation Act of 1987

• The additional minimum funding requirements apply
  to plans covering more than 100 participants and
  that are not at least 100 funded for current
  liabilities.
• the current liability is the plan's liability
  determined on a plan termination basis.
• the unfunded liability is calculated by
  subtracting the actuarial value of assets any
  credit balance in the funding standard account
  must first be subtracted from the actuarial value
  of assets.

21
Deficit reduction contribution.

• The deficit reduction contribution is equal to
  the sum of the unfunded old liability amount and
  the unfunded new liability amount.
• The unfunded old liability amount equals an
  18-year amortization, beginning in 1989, of the
  unfunded current liability, if any, at the
  beginning of the 1988 plan year (called the
  unfunded old liability) based on the plan
  provisions in effect on October 16, 1987.
• The unfunded new liability amount equals a
  specific percentage of the unfunded new
  liability.
• The unfunded new liability equals the excess, if
  any, of the unfunded current liability over the
  unamortized portion of the unfunded old
  liability, and without regard to the liability
  for unpredictable contingent events.
• The percentage of the unfunded new liability
  recognized depends on the funded current
  liability percentage, defined as the ratio of the
  plan's actuarial value of assets, net of the
  credit balance, to its current liability.
• If this ratio is 35 or less, the percentage of
  the unfunded new liability recognized is 30. For
  every percentage point by which the funded
  current liability percentage exceeds 35, the
  percentage of unfunded new liability recognized
  declines by .25.

22
Limits on tax-deductible contributions to trust
fund plans

• permits the employer to deduct the normal cost of
  the plan plus the amount necessary to amortize
  any past service or other supplementary pension
  or annuity credits in equal annual installments
  over a 10-year period.
• the maximum tax-deductible limit cannot exceed
  the amount needed to bring the plan to its full
  funding limit.
• the full funding limit is defined as the lesser
  of 100 percent of the plan's actuarial accrued
  liability (including normal cost) or 150 percent
  of the plan's current liability, reduced by the
  lesser of the market value of plan assets or
  their actuarial value.
• the maximum tax deductible limit will never be
  less than the amount necessary to satisfy the
  Code's minimum funding standards.

23
special deduction limits for combined plans

• If both a defined benefit pension plan and a
  defined contribution plan exist, with overlapping
  payrolls, the total amount deductible in any
  taxable year under both plans cannot exceed 25
  percent of the compensation paid or accrued to
  covered employees for that year.
• When excess payments are made in any taxable
  year, the excess may be carried forward to
  succeeding taxable years, subject to the
  limitation that the total amount deducted for
  such succeeding taxable year (including the
  deduction for the current contribution) cannot
  exceed 25 percent of the compensation paid or
  accrued for such subsequent year.
• The 25 percent limitation does not eliminate the
  requirements that a currently deductible
  profit-sharing contribution must not exceed 15
  percent of the payroll of the participating
  employees and that a currently deductible pension
  contribution must not exceed the amount that
  would have been the limit had only a pension plan
  been in effect.

24
IRC Section 415 limits may influence the
deduction of employer contributions.

• No deduction is allowed for the portion of a
  contribution to a defined benefit plan to fund a
  benefit for any participant in excess of the
  Section 415 annual benefit limitation for the
  year.
• In calculating the contribution to a defined
  benefit plan, anticipated cost-of-living
  increases in the allowable annual retirement
  benefit cannot be taken into account before the
  year in which the increase becomes effective.