finc322 exam 2

When did pensions become available?

post-Civil War era (military pensions)

When was the first private company pension plan?

1875 (American Express)

How are military and civil service pensions funded?

Taxpayers

How are private company pensions funded?

The income of the company, often paid out of current cash flows

What happened to the Studebaker automobile plan?

It closed in 1963 and terminated its pension plan

Tax incentives for companies to offer pension plans, only minimal regulation and oversight

1900-1974 (pre-ERISA era)

Major legislation to protect the interest of workers (and their beneficiaries) who participate in employee benefit plans

Employee Retirement Income Security Act (ERISA)

What year did ERISA publish?

1974

Why is government involved in retirement planning?

it is critical to protect workers and avoid abuses by companies, to encourage responsible retirement planning, and to benefit society for individuals to save for retirement

A plan that is designed to protect and benefit rank-and-file employees and provides incentives for workers to save for retirement

Qualified plan

What are the advantages of qualified plans?

taxation of contributions to plans, tax deferral of qualified plan earnings and income, creditor asset protection, special taxation option for lump sum distributions

What is the matching principle for accounting purposes?

Recognize revenue when earned, match the expenses with the revenue

What is the matching principle from a taxation standpoint?

A tax deduction on one tax return must be matched with taxable income on another return

When one individual or entity has a tax-deductible expense, another individual or entity will have taxable income

The matching principle

How much can an employ deduct contributions to Qualified Plans?

Up to 25% of covered compensation

When do employees pay income tax on contributions to qualified plans?

Distribution date

Are earnings on a qualified plan subject to current income tax?

No

Prohibits any action that may cause the plan assets to be assigned, garnished, levied, or subject to bankruptcy proceedings while the assets may remain in the qualified retirement plan.

Anti-alienation protection

When might there be favorable tax treatments if an employee takes a lump-sum distribution from a qualified plan?

Relates to employer stock held in the plan or net unrealized appreciation (NUA) treatment

The employee was promised a guaranteed benefit at retirement (and often a surviving spouse was entitled to benefits). The employee didn’t contribute to the plan, bear any responsibility for investment decisions, or plan managements.

Pension plans

The employee is responsible for making investment decisions. The employee may need to make contributions to the plan.

Profit-sharing plan

What is the legal promise of a pension plan?

Paying a pension at retirement

What is the legal promise of a profit-sharing plan?

Deferral of compensation and taxation

Are in-service withdrawals permitted in a pension plan?

No

Are in-service withdrawals permitted in a profit-sharing plan?

Yes if plan document permits

When can in-service withdrawals be taken from a profit-sharing plan?

After two years

Any withdrawal from a pension plan while the employee is a participant in the plan other than a loan

In-service withdrawal

Is a pension plan subject to mandatory funding standards?

Yes

Is a profit-sharing plan subject to mandatory funding standards?

No

What percent of a pension plan assets is available to be invested in employer securities?

10%

What percent of a profit-sharing plan assets is available to be invested in employer securities?

Up to 100%

Must a pension plan provide qualified joint and survivor annuity and a qualified pre-retirement survivor annuity?

Yes

Must a profit-sharing plan provide qualified joint and survivor annuity and a qualified pre-retirement survivor annuity?

No

The greater of (1) the sum of the plan’s funding target, target normal cost, and a cushion amount over the value of the plan assets, or (2) the minimum required contribution for the plan year

Annual Contribution Limit of a Defined Benefit Plan

25% of covered compensation

Annual Contribution Limit of a Defined Contribution Plan

Who assumes the investment risk of a defined benefit plan?

Employer

Who assumes the investment risk of a defined contribution plan?

Employee

How are forfeitures allocated in a defined benefit plan?

Reduce plan costs

How are forfeitures allocated in a defined contribution plan?

Reduce plan costs or allocate to other participants

Is a defined benefit plan subject to Pension Benefit Guaranty Corporation (PBGC) coverage?

Yes (except professional firms with less than 25 employees)

Is a defined contribution plan subject to Pension Benefit Guaranty Corporation (PBGC) coverage?

No

Does a defined benefit plan have separate investment accounts?

No, they are commingled

Does a defined contribution plan have separate investment accounts?

Yes

Can credit be given for prior services for the purpose of benefits in a defined benefit plan?

Yes

Can credit be given for prior services for the purpose of benefits in a defined contribution plan?

No

The unvested amount of a participant’s benefit at their termination of service within the plan sponsor

Forfeiture

Describes the terms of the plan, terms must be consistent with the IRC requirements to be deemed a qualified plan, must be amended if different options are selected after the plan implementation date

Plan document

Standard eligibility requirements

Age 21 and one year of service (1,000 hours worked during one plan year)

Why are eligibility rules required?

To ensure that employers are not requiring excessive years of service or only allowing older employees for to be eligible for the plan

Cannot be more than a 6 month wait, July 1 and January 1 are common

IRS elective grace period

Eligible to participate in 401(k) plans (2 or 3 years of 500 hours worked)

Long-Term Part-Time Employees

A plan could require two years of service to be eligible for participation. There must be 100% vesting at the two year mark.

Two Year, 100 Percent Rule

A tax exempt education institution may delay eligibility to the age of 26. This provides additional incentive for educational institutions to establish and fund retirement plans. Since they are tax exempt, they don’t benefit from the tax deductions.

Educational Institutions

Eligible to participate and receive employer contributions within two months of hire. Employer contributions immediately vested. Small employer tax credit is available to offset the costs.

Accelerated Eligibility for Military Spouses

When the employee receives a benefit from the plan if the employee receives a contribution to their profit-sharing plan account, the employee accrues a benefit in a defined-benefit plan, or for 401(k) plans, an employee benefits under the plan if they meet the eligibility requirements.

Covered Employees

Either an owner of >5% (current or prior plan year) or compensation in excess of $160,000

Highly Compensated Employee

When ownership interest in benefits accrues to the employee

Vesting

An employee vests 100% upon the passage of a certain number of years

Cliff vesting schedule

An employee vests gradually over a period of years

Graduated vesting schedule

Too much of plan benefits go to key employees

Top-heavy plans

When the present value of the total accrued benefits of key employees in the defined benefit plan exceeds 60% of the present value of the total accrues benefit of the plan for all employees

Top-heavy defined benefit plan

When the aggregate of the account balances of key employees in the plan exceeds 60% of the aggregate of the accounts of all employees

Top-heavy defined contribution plan

Greater than 5% owner, a greater than 1% owner with compensation in excess of $150,000, or an officer with compensation in excess of $235,000

Key employees

Required vesting for top-heavy plans

2-to-6 year graduated or 3-year cliff

Employer must provide non-key employees with a contribution equal to at least 3% of employees’ compensation, except if key employees’ compensation is less than 3%

Minimum funding for top-heavy defined contribution plans

Employer must provide non-key employees with a benefit equal to 2% times years of service (limit 20%) times employee’s average annual compensation

Minimum funding for top-heavy defined benefit plans

Cash or deferred arrangements (CODA) must also satisfy each of the two following tests

Actual contribution percentage (ACP) test and actual deferral percentage (ADP) test

ERISA prohibits a plan sponsor from amending a plan such that the accrued benefit of an employee is decreased or reduced. This protects employees from the employer making a change to simply reduce the costs of the plan. This only applies to already accrued benefits. On a go-forward basis, employers can freeze, eliminate, or reduce benefits.

Anti-Cutback Rule

ERISA and the IRC provide rules to ensure that there will be sufficient assets available to pay the promised benefits from pension plans to participants and their beneficiaries. The amount that must be contributed to a pension plan each year by the employer.

Mandatory funding

Key variables that affect funding for defined benefit plans

Earnings, inflation, mortality, and disability

The plan sponsor must fund the plan on an annual basis with the amount within the actuary’s calculated funding range

Mandatory funding for defined benefit pension plans

The plan sponsor must fund the plan annually with the amount defined in the plan document

Mandatory funding for defined contribution pension plans

100% of PV of all benefits accrued or earned under the plan as of the begiing of the plan year

Funding target of defined benefit pension plans

Value of plan benefits earned by employees during the current year

Target normal cost of defined benefit pension plans

Types of defined contribution pension plans

Money purchase plans and target benefit pension plans

If the value of plan assets is less than the funding target, then the minimum required contribution is

the sum of (1) target normal cost; (2) any shortfall amortization charge; and (3) any waiver amortization charge

If the value of plan assets equals or exceeds the funding target, the minimum required contribution is

the target normal cost, reduced (but not below zero) by the excess of: (1) the value of plan assets, over (2) the funding target

What is the maximum aggregate life insurance policy premium of the employer’s aggregate contributions in term or universal life insurance?

25%

What is the maximum aggregate life insurance policy premium of the employer’s aggregate contributions in whole life insurance?

50%

Limits the death benefit amount of life insurance coverage purchased within a qualified plan to 100 times the monthly accrued retirement benefit provided under the qualified plan. Usually only used with defined benefit pension plans.

100-to-1 Ratio Test for Life Insurance

Uses large amounts of data along with their expertise in statistics and finance to determine how much money should be set aside now in order to pay for costly events that may randomly occur in the future. They predict the timing of events that may randomly occur in the future, then they calculate how much money should be invested now so that there will be enough money in the future to pay for any financial losses that occur as a result of the events taking place.

Actuary

A federal corporation that acts as an insurance provider to maintain the benefits promised to employees by their defined benefit pension plans. Plan sponsors pay premiums for the insurance coverage.

Pension Benefit Guaranty Corp (PBGC)

Present value of the vested expected future payments at retirement

Defined benefit plans participant’s accrued benefit

Vested account balance of the participant’s account within the qualified plan

Defined contribution plans participant’s accrued benefit

A method for making higher contributions to those employees whose compensation is in excess of the Social Security wage base

Permitted disparity

Provides an excess benefit to those participants whose earnings are in excess of the Social Security wage base. Used in both defined benefit and defined contribution plans.

Excess Method

Reduces the benefit to those employees whose earnings are below the Social Security wage base. Used only by defined benefit plans.

Offset method

Does a defined benefit plan use an actuary annually?

Yes

Does a defined contribution plan use an actuary annually?

No

Does cash balance pension plans have mandatory funding?

Yes

Participants sees hypothetical account with hypothetical earnings

Hypothetical separate accounts

Who does cash balance pension plans favor?

Younger plan entrants

What is the vesting schedule for a cash balance pension plan?

3-year cliff

What kind of pension plan is a cash balance?

Defined benefit

What kind of pension plan is a money purchase?

Defined contribution

Does money purchase pension plans have mandatory funding?

Yes