Lecture 3: Taxes, Pension Plan Qualification, & DB Formulas

Wednesday August 30, 2006

By the end of this lecture, you should be able to:

Explain tax advantages to having a “qualified plan”Describe different types of qualified plansExplain requirements for pension to be considered a “qualified plan” Explain the different types of DB formulas Describe how benefit accruals work

Basic Overview of PensionsQualified Plan:

“Qualifies” for valuable federal tax benefitsMost employees with pension are in qualified plansDesign, funding, and administration must meet very complex set of federal statutory and regulatory requirements

Non-qualified Plan – any other retirement or deferred compensation

Less regulation, but less favorable tax treatmentMainly used as a form of executive compensation

Tax Benefits for Qualified PlansEmployer receives immediate tax deduction for contributions to the plan (within limits)

Note – this is no different than salary, etc.

Employee is not taxed at the time of the employer contribution, but is taxed when benefits are received

Note – Roth IRAs work opposite way

Earnings accumulate tax free (“inside buildup”)

THIS IS WHERE THE VALUE IS!

How Valuable is Tax Deferral?

Invest $1000 today and hold for 30 yearsBefore tax interest rate r = .10Tax rate t = .35 (assume same for all types of income)

How much is deferral worth?

How Valuable is Inside Build-Up?

Tax Deferral

• To have $100k in account in 30 years, how much do I need to save today with and without tax deferral?

• Assume 10% return and t=.35

Tax Deferral

Tax Revenue Loss

In general, contributions to qualified plans are not taxed until withdrawalAccording to the President’s FY 2004 budget, annual cost to federal treasury in 2004 of preferential tax treatment for pensions was nearly $150 billion Sometimes called a “tax expenditure”

Types of Qualified Plans

Two ways to classify plans1. DB versus DC

• Discussed last time• Distinction that we will focus on

2. “Pension plans” versus “profit-sharing plans”• Pension – provide income at retirement• Profit sharing – allow for deferral of

income, perhaps based on corporations profitability, and may allow earlier access to funds

Specific Types of Plans

Figure 20-1 from Beam & McFadden

Plan Qualification Requirements

Eligibility and ParticipationAge and Service RequirementsCoverage Tests

VestingRetirement AgeNondiscrimination RulesNon-tax regulations

Eligibility and ParticipationAn employer must decide what group of employees is to be covered by a plan

In “closely held” corporation, there is often desire to maximize benefits to key employees and to be less generous to rank-and-file workersLarge corporations may want different plans for different groups

• Ex: Most airlines have separate pensions for pilots vs. flight attendants vs. mechanics vs. office workers

Public policy designed to prevent firms from discriminating in favor of highly compensated employees

Age and Service RequirementsWhile not required, most employers prefer age & service requirements to avoid administrative expense of short-term employees

No need to cover college students in summer jobs

Generally, cannot require more than 1 year of service before eligibility

(Exception: may require 2 year waiting period if then provide 100% vesting upon entry)

An employee age 21+ must be allowed to participate (if meets other requirements)

Age & Service Example

If employee is hired at age 18, employer may require that she wait 3 years to participateIf employee hired at age 30, employer may require only a 1 year waitSmall employers with high turnover may benefit from 2-year / 100% vesting rule (if few employees last that long!)

Older AgesIn a defined benefit plan, the cost of funding a fixed monthly retirement benefit rises steeply with age

Ex: To fund a fixed monthly benefit starting at age 65 will cost the firm 30 times more for a 60 year old than a 30 year old

Age discrimination law prohibits exclusion from pension based on ageMay define “normal retirement age” such that employee requires 5 years of service no matter their age

Definition of Service

“Year of service” is generally 12-month period during which employee has 1,000 of work. Complex set of “breaks in service” rules

Allows employee with break in service to lose credit for service prior to the break

Coverage Tests for Non-Discrimination

A qualified plan must satisfy one of two “coverage tests”

Ratio Percentage Test: The plan must cover a % of non-highly compensated employees (NHCE) that is at least 70% of the % of highly compensated employees (HCE) coveredAverage Benefit Test: The average benefit as a % of compensation for NHCEs must be at least 70% of that for HCEs

HCE: Owns more than 5% of employer, OR, received compensation exceeding a threshold ($90,000 in 2004 – indexed for inflation)

Example of Ratio Percentage Test

Suppose firm has 5 HCEs, 4 of which participate in the plan = 80% participation rate by HCEsIf there are 20 NHCEs, then at least 70% * 80% * 20 = 11.2 of these NHCEs must participate to meet coverage test

Vesting

A “vested” benefit means that it is non-forfeitable, i.e., cannot be taken awayEmployee contributions are always 100% vestedEmployer contributions must vest at least as fast as two methods

Cliff vestingThree- to Seven-Year Vesting

Cliff Vesting

Cliff vesting, also known as “five-year vesting,” requires that an employee with at least 5 years of service be 100% vested in the employer provided portion of the accrued benefit

It is okay to have 0% vesting up until the five year mark

Three- to Seven-Year Vesting

Requires at least 20% vesting after 3 years, 40% after 4 years, … 100% after 7 years.

Note: all years of service must be considered, even years prior to plan participation • Exception – can ignore years before age 18

“Top heavy” plans (defined later) must vest more quickly

Cliff vs. 3-to-7-Year Vesting

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Cliff Vesting 3- to 7-year vesting

Years of service

%Vested

Retirement Age

A plan’s Normal Retirement Age is the age at which individual can retire and receive full benefitsUnder IRC, can be no greater than

Age 655th anniversary of plan entry if participant entered within 5 years of NRA

A plan may designate an early retirement age at which person can take actuarially reduced benefits

Nondiscrimination

In addition to coverage tests, plan must provide same percentage of compensation for all employees covered under the planThree exceptions allowed:

1. Permitted disparity rules when integrated with Social Security

2. 401(k) plans allow HCEs to contribute higher % if meet separate ADP rules (we will discuss later)

3. DC plans can be age-weighted (discuss later)

Integration with Social Security

Social Security benefit formula is similar to a DB pension formula

– Career average compensation up to a cap– Wage indexed pre-retirement, CPI indexed post-

retirement

Qualified plans are permitted to “integrate” with participant’s Social Security benefit

– Avoid benefit duplication– Lower employer costs by making benefit less generous– The vast majority of DB plans are integrated in some

way

Integrated Plan Example: % of final average compensation (FAC) provided by OASDI and private DB

Benefits as % of FAC

FAC

SocialSecurity

DBPlan

50%

$10,000 $30,000 $50,000 $100,000

Section 415 Limits

DB plans: The plan benefit at age 65 cannot exceed the lesser of 100% of the participant’s compensation over the three years of highest compensation, or $165,000 (in 2004, indexed for inflation)DC plans: Limits annual contribution to the account. Contribution cannot exceed the lesser of 100% of annual compensation or $41,000 (2004, indexed)

Top Heavy Rules

Policy goal: To reduce “excessive discrimination” in favor of business ownersA “Top Heavy” plan is one in which more than 60% of benefits or balances are for key employeesIf plan is top heavy, it must:

Meet more rapid vesting scheduleProvide min benefits for non-key employees

Payout Restrictions

10% tax penalty if withdrawn before early retirement, age 59½, disability or deathPayouts must begin by April 1 of the year after the participant reaches 70½

Minimum distribution requirements specified by IRS

Restrictions on loans

Non-Tax Regulations

Civil Rights Act of 1964What does sex discrimination mean?• Same contributions, or same benefits?

Age Discrimination in Employment ActAmericans with Disabilities ActFamily and Medical Leave Act of 1993

How Do DB Plans Work?

Formula specifies benefit to be paid to the employeeInvestment risk rests with plan sponsorPayment of benefit is obligation of the employer, and thus employer is required to fund the plan in advance so that the funds will be there to payTypically insured by the PBGC (within limits)Formulas and funding can be complex

DB Formula CharacteristicsEmployer objectives

Provide reasonable income “replacement ratio”Maximize value of tax shelter for key employees“Manage” work force (e.g., encourage retention, incentives for early retirement, etc.)

Two useful characteristics of DB formulasBenefit need not be function of total compensation

• Can design plan around desired retirement income for employee

Permitted to favor employers who enter plan at later ages

• At plan inception, often favors key employees of closely held businesses

Replacement RatioAlso known as “replacement rate”= retirement income / earnings while working

• Generally < 1 is required to maintain living standard• May need to be higher for lower income employees

Many plans aim for income from qualified plan plus Social Security to provide 50-75% of pre-retirement income

• Still leaves important role for the “3rd leg of the stool”

Types of DB Formulas

Wide variationLimited by:

Accrual rulesSocial Security integration rulesNon discrimination requirements

Allowable DB Formulas

Flat-Benefit FormulaDoes not take into account years of service

• Flat-Amount Formula ($10,000 per year during retirement)

• Flat-Percentage Formula (50% of final salary)

Unit-Benefit FormulaBenefit is based on length of service$10 per month x (Years of Service)Annual Benefit = (2%) x (Yrs. of Service) x (Final Salary)

Role of Past service

What is Compensation?

Firms have some flexibilityTwo categories

Career AverageFinal Average

Base salary or total compensation Bonuses, overtime, etc. If use something other than total compensation, must be careful about discrimination

Inflation

Since 1926, inflation has averaged a bit over 3% annuallyCan reduce purchasing power by 25% in only 10 years, 45% in 20 years.Inflation uncertainty is also important

Double digit in late 1970sDifference between inflation indexation and fixed growth rate

How Protect Workers from Inflation?

Pre-retirement InflationFinal average compensation formulaIndex wages (Social Security)

Postretirement InflationAd Hoc Adjustments (quite common)Increase Benefits by a FormulaIndex Benefits to CPI

DB Benefit AccrualsBenefits owed to employees if:

Terminate of employment prior to retirementTerminate plan before retirement

DB Plans: benefits must accrue at least as fast as one of these 3 rules:

1. 3% Rule• Accrual > 3% of max accrual if in plan for entire

career

2. 133% Rule• Accrual < 133% of prior year’s accrual

3. Fractional Rule• Proportional to normal retirement benefits

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3% Rule ExampleData:

If individual entered plan and stayed until retirement: Benefit = $100,000

Question:If individual leaves after 10 years what is benefit?

Answer:

133 1/3% Rule Example

Benefit Accrual RateYears Accrual1-5 $ 5,000/year6-10 $ 6,000/year11-20 $ 8,000/year21-35 $16,000/year

Does this meet the rule?

Fractional Rule Example

Data:Benefit at retirement after 40 years is $50,000/year

Question:If employee leaves after 10 years what is benefit?

Answer:

Death & Disability BenefitsPre-retirement Survivor Annuity

Mandated for spouse of vested plan participantProvides income to surviving spouse

Qualified Joint and Survivor Annuity (QJSA)Post retirement death benefitSurvivor benefit must be >50% of amount paid when both aliveAutomatic, unless spouse provides notarized signature

Treatment of disability (access to benefits, accrual and vesting)

Funding

Complex set of funding rules to ensure solvency of the plan in the event of plans sponsor’s bankruptcyPBGC provides insuranceMore in next lecture