Defined Benefit Plans

Maximum Benefit

The maximum benefit under a defined benefit plan is measured in two ways:

Percentage: The retirement benefit cannot exceed 100% of the average of the hightes three consecutive years of compensation. 1 This is reduced by 10% for each year of service less than 10.

Dollar amount: The maximum dollar benefit is indexed at $175,000 per year (2006) for retirement at age 65, or at the Social Security full retirement age, if later than 65. This amount is actuarially reduced for retirement more than three years prior to the normal Social Security retirement age. Retirement at age 55 would typically produce a maximum annual benefit of $100,000, depending on the assumptions used, cost of living adjustments and number of years of participation. The dollar amount will also be increased for late retirement, subject to the percentage and dollar limitations. Lastly, if the individual has fewer than 10 years of participation at normal retirement age, the dollar amount is reduced proportionately.

First- and Subsequent-Year Contributions

The contributions will be the premium for the annuities or combination of annuities and life insurance policies necessary to fund the benefit. This will almost always be higher than in a traditional defined benefit plan when established and then may, or may not, decline as real earning exceed policy guarantees.

The initial contribution for the benefit and future benefit increases are based on the guaranteed rates in the policies. Future premiums will reflect actual investment experience of the policies.

Methods of Defining the Benefit

Level percentage plan:

Example – The benefit is equal to 50% of compensation,1 reduced by 1/25 for each year of participation less than 25 years.

Step rate service weighted for prior service:

Example – The benefit is equal to 4% of compensation1 for the first five years of service plus 3% of compensation1 for all other years, but not to exceed a total of 15 years.

Service plan:

Example – The benefit is 2.5% of compensation1 for each year of service. Younger participants may also be favored if the benefit formula is service related.

Participation plan:

Example – The benefit is 5% of comensation1 per year of participation with a maximum of 20 years.

Top-Heavy Plans

If the present value fo the accrued benefits of key employees2 is 60% or more of the total value of all accrued benefits, the plan is top heavy. In that instance, the plan must provide for a minimum level of benefits for non-key participants.

Accrued Benefit

Each participant’s accrued benefit is measured by the cash value of the plicies purchased for each participant.

Special Requirements

For plan to be considered as “fully insured” under IRC 403(b), certain criteria must be met:

• The total benefits must be provided by one or more annuities or a combination of annuities and life insurance policies.
• The premium on the policies must be level from date of issue until scheduled retirement. Exception: “Dividends” or “excess earnings” may reduce such premium.
• Premiums must not be in default.
• There must be no outstanding policy loans.

Special Considerations

• If a plan qualifies, no actuarial certification is needed.
• If the plan is top-heavy it may be necessary to fund top-heavy benefits with a separate “side fund.” This would require an actuarial certification.
• To convert an existing plan to full-insured status, several tings must happen:
  • All existing assets must firs be liquidated.
  • The net proceeds are then used to purchase single premium annuities for each participant based on their accrued benefits at time of conversion.
  • The difference between the projected retirememtn benefit and the benefit purchased by the single premium annuitities is then funded.
  • It may prove difficult to convert from a fully-insured plan to a traditional defined benefit plan.
• In some cases, if care is not taken, the plan may become over funded.
• Because this is a specialized type of plan, someone with experience in this area is necessary to establish a fully-insured plan.
• Converting to fully-insured status may help an “over-funded” defined benefit plan.
• The fully-insured plan is not a universal panacea but may be a useful tool in the right situation.

Advantages to Employer

1. Contributions are tax deductible
2. It can reward lon-term employees with a substantial retirement benefit even though they are close to retirement age.
3. Larger contributions for older employees may reduce corporate tax problem; e.g. excess accumulated earnings, high tax bracket current earnings, etc.
4. Forfeitures of terminating employees will reduce future costs.
5. It can provide employees with permanent life insurance benefits that need not expire or require costly conversion at retirement age.
6. A higher initial contribution will be produced than with a traditional defined benefit plan.
7. If former participants do no provide the plan with distribution instructions, the plan may roll amounts greater than $1,000 to a Rollover IRA in the former participant’s name. A plan may allow direc rolllowvers of less than $1,000.

Advantages to Employees

1. Annual employer contributions are not taxed to the participant.
2. Earnings are not currently taxed.
3. Distributions may be eligible for 10-year income averaging3, or, at retirement from the current employer, rolled over to an IRA or to another employer plan if that plan will accept such a rollover. See IRC Secs. 402 and 403.
4. Participants may also have a traditional, deductible IRA (subject to certain income level limitations base on filing status), a traditional, nondeductible IRA, ora Roth IRA.
5. There is the ability to purchase significant permanent life insurance, which is not contingent upon the company group insurance program. Purchase of life insurance will generate taxable income to the employee.
6. Employee is guaranteed a known retirement benefit.
7. Federal bankruptcy law provides significan protection from creditors to participant accounts or accrued benefits in tax-exempt retirement plans.

Disadvantages to Employer

1. In low profit or cash flow years, the employer is still obligated to make contributions, which may be substantial.
2. There is far less flexibility with thelevel of contribution even if profits are low, than with some other types of plans.
3. Even though an actuarial certification is not required, other administrative costs arise. The administrative costs will be similar to those in a traditional defined benefit plan.
4. Employer contributions may drop dramastically in future years.
5. The employer has no control over the investments.
6. Participants often do not understand the defined benefit plan as easily as they do other types of plans.

Disadvantages to Employees

1. Younger employees may not receive as great a benefit as they would under other plans.
2. The plan concoept and details are more difficult to understand.