Chapter 4 - Qualified Pension Plans

Question 1

Define Actuary

Answer 1

An expert professional who makes quantitative calculations and assumptions about inflation, wage increases, life expectancy of the assumed retirees, investment returns on plan assets, mortality rates for retirees, and forfeitures resulting from termination in order to determine funding for a retirement plan.

Question 2

Define Back Loading

Answer 2

A practice of delaying the accrual of benefits until late in someone’s career so that if they were to leave the company they would forfeit all or a large portion of their benefits.

Question 3

Define Cash Balance Pension Plans

Answer 3

A defined benefit pension plan that shares many of the characteristics of defined contribution plans but provides specific defined benefits based on a mandatory contribution and earnings rate.

Question 4

Define Credit for Prior Service

Answer 4

To give employees credit for years of service (with the plan sponsor) prior to the establishment of the qualified plan.

Question 5

Define Defined Benefit Plan

Answer 5

A qualified retirement plan that provides its participants with pre-determined formula-based benefits at retirement.

Question 6

Define Defined Contribution Plan

Answer 6

A qualified retirement plan that provides its participants with either a contributory or noncontributory retirement account which benefits from tax-deferred growth for contributions and earnings in the plan.

Question 7

Define Flat Amount Formula

Answer 7

A benefit formula of a defined benefit pension plan that provides each of its participants with an equal dollar amount at retirement. May be used in combination with a unit credit formula or some other benefit formula.

Question 8

Define Flat Percentage Formula

Answer 8

A benefit formula of a defined benefit pension plan that provides all plan participants with a benefit equal to a fixed percentage of the participant’s salary, usually the final salary or an average of the participant’s higher salaries.

Question 9

Define Forfeitures

Answer 9

The % or amount of participant’s accrued benefit that was not vested to the employee or the employee’s termination from the plan sponsor. The forfeited amount stays in the plan and may be allocated to other plan participants (defined contribution plan) or reduce future plan costs (defined contribution or defined benefit plan).

Question 10

Define Hypothetical Account

Answer 10

An account statement that displays hypothetical allocations and hypothetical earnings. The accounts are hypothetical because the cash balance pension plan assets are managed by the plan sponsor in the same manner as a defined benefit pension plan.

Question 11

Define In-Service Withdrawal

Answer 11

Any withdrawal from a qualified retirement plan other than a loan while the employee is a participant in the plan.

Question 12

Define Mandatory Funding Requirements

Answer 12

An amount of % that must be contributed to a qualified pension plan by the employer each plan year.

Question 13

Define Money Purchase Pension Plan

Answer 13

A defined contribution pension plan that provides for mandatory employer contributions to the plan each year of a fixed percentage of the employee’s compensation. The employer does not guarantee a specified retirement benefit.

Question 14

Define Noncontributory Plans

Answer 14

Qualified retirement plans that do not include employee contribution.

Question 15

Define Pension Benefit Guarantee Corporation (PBGC)

Answer 15

Established in 1974 when President Gerald Ford signed the Employee Retirement Income Security Act (ERISA) into law. The PCGC guarantees qualified pension benefits. It is a federal corporation that acts as an insurance provider to maintain the benefits promised to employees by their defined benefit pension plans.

Question 16

Define Pension Plan

Answer 16

A qualified retirement plan that pays a benefit, usually determined by a formula, to a plan participant for the participant’s entire life during retirement.

Question 17

Define Tandem Plan

Answer 17

A combination of a money purchase pension and a profit sharing plan.

Question 18

Define Target Benefit Pension Plan

Answer 18

A special type of money purchase pension plan that determines the contribution to the participant’s account based on the benefit that will be paid from the plan at the participant’s retirement rather than on the value of the contribution to the account. Requires an actuary at inception.

Question 19

Define Term Insurance Policy

Answer 19

A life insurance contract which states if the insured dies within the term of the contract, the insurance company will pay a stated death benefit.

Question 20

Define Unit Credit Formula

Answer 20

A benefit formula of a defined benefit pension plan that utilizes a combination of the participant’s years of service and salary to determine the participant’s accrued benefit.

Question 21

Define Universal Life Insurance

Answer 21

A term insurance policy with a cash accumulation account attached to it.

Question 22

Define Whole Life Insurance Policy

Answer 22

A permanent life insurance policy that guarantees that the policy will remain in force as long as the premium is paid. The life insurance policy has a cash account that grows tax deferred.

Question 23

For the purposes of defined benefit pension plans, how might a person’s salary be defined?

Answer 23

• The participant’s final salary,
• The average of the participant’s highest salaries, or
• The average of the participant’s salary over their career.

Question 24

Who type of organization might have a defined benefit plan that mandate’s employee contributions?

Answer 24

• The government

- Not-for-profits.

Question 25

What are four pension plan requirements put in place so that there is less chance that the employer will be unable to pay their promised benefits?

Answer 25

1. Mandatory annual funding
2. Disallow most in-service withdrawals
3. Limited investment in employer securities
4. Limited investment in life insurance.

Question 26

What does the anti-cutback rule do? What does it not do?

Answer 26

It provides that benefits accrued cannot be retroactively reduced though amendment.

It doesn’t prevent the plan:

• freezing benefits,
• reducing future benefits, or
• eliminating future benefits

Question 27

What can the uncertainty regarding future costs of pension plans be attributable to?

Answer 27

Information about:

• earnings,
• mortality,
• disability,
• salary increases

Question 28

What is a defined benefit pension plan’s funding target? (definition)

Answer 28

The present value of all benefits accrued or earned under the plan as of the beginning of the plan year.

Question 29

What is a defined benefit pension plan’s target normal cost? (definition)

Answer 29

The present value of all benefits expected to accrue or to be earned under the plan during the plan year (the “current” year)

Question 30

If the value of plan assets in a defined benefit pension plan is less than the funding target, what is the minimum required contribution?

Answer 30

The sum of:

1. Target normal cost,
2. Any shortfall amortization charge, and
3. Any waiver amortization charge

Question 31

If the value of plan assets in a defined benefit pension plan is equal to or exceeds the funding target, what is the minimum required contribution?

Answer 31

The target normal costs, reduced (but not below zero) by the excess of:

1. the value of the plan assets, over
2. the funding target

Question 32

What three separate discount rates base on when the expected benefits are expected to be paid are plans required to discount future benefits using?

Answer 32

1. Benefits in the first five years: plans will use a short-term interest rate.
2. Benefits in the next fifteen years: plans will use a mid-term interest rate.
3. Benefits beyond twenty years: plans will use a long-term interest rate.

Question 33

What two tests must a plan fail to be determined to have at-risk status for a plan year? What is the exception?

Answer 33

1st test: a plan is at-risk unless the funding target attainment percentage for the preceding plan year is at least 80%.
2nd test: A plan is at-risk unless the funding target attainment percentage for the preceding plan year (determined by using additional “worst case” actuarial assumptions in computing the funding target) is less than 70%.

Plans with 500 or fewer participants on each day of the preceding year are not treated as at-risk status for the plan year.

Question 34

What are the mandatory funding requirements for defined contribution pension plans?

Answer 34

The requirement is that the plan sponsor fund the plan annually with an amount determined in the plan document.

ex. If you said you were going to make a 17% annual contribution must make an annual contribution of 17% of each employee’s covered compensation to meet the mandatory funding requirement

Question 35

What can a plan sponsor of a pension plan that does not meet the mandatory funding requirements do?

Answer 35

Apply to the IRS for a funding waiver?

Question 36

Under what circumstances is the IRS most likely to grant a funding waiver?

Answer 36

When the employer is experiencing temporary hardships that limit the availability of funding and when not waiving the requirement would negatively impact the interests of the plan participants.

Question 37

Pension plans can now provides for in-service distributions to participants who are age 62 or older. What is the distribution called and what is its purpose?

Answer 37

It is known as phased retirement.
It is intended to enable older workers to become part-time employees and receive partial benefit to maintain their current earnings level.

Question 38

What can fall under the definition of employer securities?

Answer 38

Any securities issued by the plan sponsor or affiliate of the plan sponsor, including:

• stocks,
• bonds, and
• publicly traded partnership interests

Question 39

How many years of service are required to allow a participant to diversify the investment of employer contributions made on their behalf in a DC pension plan?

Answer 39

Three years

Question 40

Why is life insurance allowed in qualified plans?

Answer 40

As long as life insurance is not the primary focus of the pension plans, the government allows this exception from the ultimate retirement benefit promise because the death benefit of the life insurance policy is payable to the employee’s spouse and other survivors at the employee’s death (who are usually the same beneficiaries who would receive survivorship benefits under plan anyways).

Question 41

How is it determined whether life insurance is the primary focus of the qualified plan or is an incidental death benefit?

Answer 41

Through a series of tests that limit the amount of life insurance coverage provides by a qualified plan or the cost of the life insurance provided by the plan. To maintain qualified plan status, a qualified plan that includes life insurance must pass either the 25% test or the 100 to 1 ratio test.

Question 42

What is the 25% Test regarding life insurance use in a qualified plan?

Answer 42

It consists of two tests, the 25% test and a 50% test.
The test used depends up the type of life insurance provided by the plan.
-If a term insurance or universal life insurance policy is purchased within the qualified plan, the aggregate premiums paid for the life insurance cannot exceed 25% of the employer’s aggregate contributions to the participant’s account.
-If a whole life insurance policy is purchased, the aggregate premiums paid for the whole life insurance policy cannot exceed 50% of the employer’s aggregate contributions to the participant’s account.

If they meet this rule, they do not have to meet the 100 to 1 ratio test.

Question 43

“What must happen to any permanent life insurance policies in a qualified plan at or before retirement? What about for term policies?

Answer 43

• The policy must be converted to cash or an annuity at or before retirement.
• For term policies the policy cannot be maintained after retirement.

Question 44

What is the 100 to 1 Ratio Test regarding life insurance use in a qualified plan?

Answer 44

Unlike the 25% test, this test puts limits in place base on the benefits provided by the life insurance protection rather than the cost of protection.
-Specifically, the 100 to 1 ratio test limits the amount of the death benefit of life insurance coverage purchased to 100 times the monthly accrued retirement benefit provided under the same qualified plan’s defined benefit formula.

Question 45

What are the tax implications of life insurance in a qualified plan to an employee?

Answer 45

The proceeds from life insurance policies are typically not subject to income tax to the beneficiary and funds in a qualified plan are typically contributed on a pre-tax basis. Therefore, premiums paid by the employer for the life insurance policy are taxable to the employee at the time the premium is paid.

Question 46

What are the tax implications of life insurance in a qualified plan to the beneficiary of the life insurance?

Answer 46

This only applies to whole life.
-Because part of premium is used to fund the cash value of the policy, similar to deferred compensation, the beneficiary of the life insurance policy purchased within a qualified plan must include into taxable income the proceeds of life insurance to the extent of the cash value of the policy (reduced by decedent’s basis).

Question 47

What is a 412(e) plan?

Answer 47

A specific type of DB pension plan that is funded entirely by a life insurance contract or an annuity.
The employer claims tax deductions for contributions that are used by the plan to pay premiums on an insurance contract covering an employee. The plan may hold the contract until the employee dies or it may distribute or sell the contract to the employee at a specified point.

Question 48

Who is the typical candidate for a 412(e) plan?

Answer 48

A sole proprietor with only a few employees.

Question 49

What are the benefits of a 412(e) plan? 4

Answer 49

• The plan allows greater contributions to the plan than a traditional DB plan because of the need to fund the life insurance or annuity.
• The plan is easier to explain to employee because the insurance/annuity is fixed and provides less risk due to the certainty of the insurance/annuity.
• The plan is less costly than a traditional DB plan.
• Because of the exclusive use of life insurance or annuities as a funding vehicle, no actuarial calculations are necessary, reducing administrative requirements and associated expenses.

Question 50

What are the drawbacks of a 412(e) plan?

Answer 50

• The plan does not provide alternative investment choices, thus sacrificing the opportunity for long-term appreciation
• The employer does not have the flexibility with regard to plan design.
• The plan cannot permit loans.

Question 51

What are the primary differences between the two categorization of DB pension plans and DC pension plans include? 8

Answer 51

• The use of an actuary
• Assumption of investment risk
• The disposition of plan forfeitures
• Coverage under the PCGC
• The use of SS integration
• The calculation of the accrued benefit or account balance.
• The ability to grant credit for prior service for funding
• The use of commingled funds vs separate funds, individual investment accounts.

Question 52

What is the payment received from the PBGC based upon?

Answer 52

1. The form of the benefit as payable under the terminated plan
2. The participant’s age, and
3. Any amounts that PBGC recovered from the employer in the case that the plan was underfunded.

Question 53

What does an employee covered by a defined benefit plan receive who terminated participation in the plan?

Answer 53

They are entitled to a benefit payable from the plan equal to the retirement benefit earned to date. This benefit is the actuarial equivalent of the benefit that would have been provided to the participant had the participant waited until retirement to receive payments.

Question 54

What is the accrued benefit equal to under a DB pension plan? DC pension plan?

Answer 54

DB - Roughly the PV of the expected future payments are retirement.
DC - The account balance of the qualified plan consisting of any combination of employer and employee contributions plus the earnings on the respective contributions reduced by any non-vested amounts.

Question 55

What is put in place that allows qualified plans to be able to provide higher benefits to higher paid workers to offset the SS system?

Answer 55

Social Security integration or permitted disparity.

Question 56

What is Permitted Disparity / SS Intergation? What does it all the plan to do?

Answer 56

A technique or method of allocating plan contributions or benefits to those employees whose compensation is in excess of the SS wage base for the plan year.
-It allows the plan to consider the SS benefits that will be provided to plan participants in the calculation of the participant’s accrual of benefit or contribution amount.

Question 57

What type of qualified plans may utilize SS integration?

Answer 57

All of them.

Question 58

What are the two methods of SS integration?

Answer 58

Offset Method

Excess Method

Question 59

What is the Offset Method of SS integration for DB pension plans?

Answer 59

This applies a benefit formula to all earnings and then reduced the benefit on earnings below the covered compensation limit.

The reduction of the benefit is limited to the lesser of:

1. .75% per year of service up to 35 years, or
2. 50% of the overall benefit funding percentage per year of service.

Question 60

What is the Excess Method of SS integration for DB pension plan?

Answer 60

Provides an increased % benefit, referred to as the excess benefit, to those plan participants whose earnings are in excess of an average of the SS wages bases over the 35 year period prior to the individual’s SS retirement age. This average is called the covered compensation limit, which is estimated to be $69,000 for 2014.

The increased % benefit only applies to income that exceeds the covered compensation limit and is limited to the lesser of:

1. .75% per year of service, or
2. The benefit % for earnings below the covered compensation limit per years of service.

This additional benefit only applies up to 35 years. Therefor, the maximum increase in benefits for compensation over the covered compensation limit is 26.25%

Question 61

What are the three most common benefit formulas for determined benefits for a DB pension plan.

Answer 61

• The Flat Amount Formula
• The Flat % Formula, and
• The Unit Credit Formula.

Question 62

What is the minimum number of years an employee must have participated in the plan to get maximum benefits?

Answer 62

10 years.

Question 63

What is the formula for determining the maximum benefit amount for an employee that has participated in the plan less than the minimally required number of years? To determine there actual benefit?

Answer 63

$210k (2014 Max Benefit for DB plans) x (Employee’s number of years of participation / 10).
Ex. If the employee participated for 5 years then $210k x (5/10) = $105k maximum benefit.

There benefit amount x years participated / 10.

Question 64

What is the Flat Amount Formula? What is the drawback?

Answer 64

It decides everyone gets the exact same benefit, such as $500/month. (It does not take into consideration years of service with the employer or the participant’ salary.)
-The drawback is it does not provide the participant with any incentive to attain additional years of service with the employer beyond the minimum required.

Question 65

What is the Flat % Formula?

Answer 65

Provides all plan participant’s with a benefit equal to a specific % of the participant’s salary, usually final salary or an average of the participant’s highest salaries.
The employee at least has incentive to raise their salary as included in the formula to increase the benefit amount. Usually needs to participate for a minimum number of years.

Question 66

What is the Unit Credit Formula?

Answer 66

Fixed % x # of years of service x Salary Base.

Gives credit for a participant’s term of employment and salary in determining the benefit.

Question 67

What three methods of benefit accrual for DB plans does ERISA and the IRC provide to ensure against back loading?

Answer 67

1. 3% Method
2. 133 1/3 % Rule, and
3. Fractional Rule

Question 68

How can a DB plan satisfy the 3% Method?

Answer 68

If the accrued benefit to which each participant is entitled upon the participant’s separation from the service is at least 3% of the normal retirement benefit to which the participant would be entitled if they had commenced participation at the earliest possible entry age under the plan and served continuously until the the earlier of 65 of the normal retirement age specified under the plan.

At least 3% per year of service x full benefit amount if they had begun at the earliest age and left at normal retirement age.

Question 69

How can a DB plan satisfy the 133 1/3 Rule?

Answer 69

If the accrued benefit payable at normal retirement age is equal to the normal retirement benefit and the annual rate at which any participant can accrue the retirement benefits payable at normal retirement age under the plan for any later plan year is not more than 133 1/3% of the annual rate at which the participant can accrue benefits for any prior plan year.

Ex. 2% of AC for 1st 15 years of part and 3% of AC for next 15 years of part. The plan would fail because 3% is more than 133 1/3% of the prior years %.
1.5% jumping to 2% would satisfy the requirement.

Question 70

How can a DB plan satisfy the Fractional Rule?

Answer 70

If the accrued benefit to which any participant is entitled upon separation from service is not less than a fraction of the annual benefit commencing at the normal retirement age to which they would have been entitles under the plan as in effect at the date of separation if the participant continued to earn annually until normal retirement age the same rate of compensation upon which the participant’s normal retirement benefit would be computed under the plan, determined as if the participant had attained normal retirement age on the date on which any such determination is made. The fraction cannot exceed 1.

Question 71

When a cash balance plan is established, what must it develop?

Answer 71

A benefit formula. A cash balance formula typically includes two elements - a pay credit and an interest credit.

Question 72

In a cash balance plan, what is a pay credit?

Answer 72

The plan specified amount that is contributed in the hypothetical account, which is generally stated as a % of compensation. The pay credit will often be a fixed % of compensation, but it can also be different for different age groups, employee classifications, or by other methods. They can be designed to benefit older employees or higher paid employees or owners, but regardless of which, must be non-discriminatory.

Question 73

In a cash balance plan, what is an interest credit?

Answer 73

The amount of earnings applied to the balance in the hypothetical account. Can be fixed rate, or a variable rate tied to an index. It can also be more complicated including a minimum interest rate combined with a variable component that is higher or lower than a specified rate by a specified number of basis points.

*Cannot provide an interest rate in excess of a “market rate of return”.

Question 74

What requirements were put in place regarding conversions from defined benefit plans to cash balance plans?

Answer 74

1. That a participant’s accrued benefit, as determined as of any date under the terms of the plan, would be equal to or greater than that of any similarly situated younger participant (Equal, and always have been, in every respect except for age).
2. The interest rate used to determine the interest credit on the account balance in the hybrid plan must not be greater than a market rate of return.
3. For plan years beginning after 2007, the hybrid plan must provide 100% vesting after three years of service.

Question 75

What are two important distinctions between Pension Equity Plans and Cash Balance Plans

Answer 75

• The salary used as part of the benefits is final average salary, vs cash balance plans pay credits are effectively career average since they are credited each year.
• Interest Credits - They don’t provide for interest credits prior to termination, rather, the benefit is structured in such a way that it reference years of service and final pay.

Question 76

What is the deductibility limit of an employer’s contribution to a MPP?

Answer 76

They cannot deduct contributions to the plan in excess of 25% of the employer’s total covered compensation plaid.