Lecture 3: Taxes, Pension Plan Qualification, & DB Formulas Wednesday August 30, 2006
Jan 08, 2016
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