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

1. Lecture 3: Taxes, Pension Plan Qualification, & DB Formulas Wednesday August 30, 2006

2. By the end of this lecture, you should be able to: • Explain tax advantages to having a “qualified plan” • Describe different types of qualified plans • Explain requirements for pension to be considered a “qualified plan” • Explain the different types of DB formulas • Describe how benefit accruals work

3. Basic Overview of Pensions • Qualified Plan: • “Qualifies” for valuable federal tax benefits • Most employees with pension are in qualified plans • Design, 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 treatment • Mainly used as a form of executive compensation

4. Tax Benefits for Qualified Plans • Employer 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!

5. How Valuable is Tax Deferral? • Invest $1000 today and hold for 30 years • Before tax interest rate r = .10 • Tax rate t = .35 (assume same for all types of income) How much is deferral worth?

6. How Valuable is Inside Build-Up?

7. 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

8. Tax Deferral

9. Tax Revenue Loss • In general, contributions to qualified plans are not taxed until withdrawal • According 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”

10. Types of Qualified Plans • Two ways to classify plans • DB versus DC • Discussed last time • Distinction that we will focus on • “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

11. Specific Types of Plans • Figure 20-1 from Beam & McFadden

12. Plan Qualification Requirements • Eligibility and Participation • Age and Service Requirements • Coverage Tests • Vesting • Retirement Age • Nondiscrimination Rules • Non-tax regulations

13. Eligibility and Participation • An 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 workers • Large 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

14. Age and Service Requirements • While 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)

15. Age & Service Example • If employee is hired at age 18, employer may require that she wait 3 years to participate • If employee hired at age 30, employer may require only a 1 year wait • Small employers with high turnover may benefit from 2-year / 100% vesting rule (if few employees last that long!)

16. Older Ages • In 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 age • May define “normal retirement age” such that employee requires 5 years of service no matter their age

17. 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

18. 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) covered • Average 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)

19. Example of Ratio Percentage Test • Suppose firm has 5 HCEs, 4 of which participate in the plan = 80% participation rate by HCEs • If there are 20 NHCEs, then at least 70% * 80% * 20 = 11.2 of these NHCEs must participate to meet coverage test

20. Vesting • A “vested” benefit means that it is non-forfeitable, i.e., cannot be taken away • Employee contributions are always 100% vested • Employer contributions must vest at least as fast as two methods • Cliff vesting • Three- to Seven-Year Vesting

21. 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

22. 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

23. Cliff vs. 3-to-7-Year Vesting % Vested Years of service

24. Retirement Age • A plan’s Normal Retirement Age is the age at which individual can retire and receive full benefits • Under IRC, can be no greater than • Age 65 • 5th 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

25. Nondiscrimination • In addition to coverage tests, plan must provide same percentage of compensation for all employees covered under the plan • Three exceptions allowed: • Permitted disparity rules when integrated with Social Security • 401(k) plans allow HCEs to contribute higher % if meet separate ADP rules (we will discuss later) • DC plans can be age-weighted (discuss later)

26. 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

27. Integrated Plan Example: % of final average compensation (FAC) provided by OASDI and private DB Benefits as % of FAC Social Security 50% DB Plan FAC $10,000 $30,000 $50,000 $100,000

28. 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)

29. Top Heavy Rules • Policy goal: To reduce “excessive discrimination” in favor of business owners • A “Top Heavy” plan is one in which more than 60% of benefits or balances are for key employees • If plan is top heavy, it must: • Meet more rapid vesting schedule • Provide min benefits for non-key employees

30. Payout Restrictions • 10% tax penalty if withdrawn before early retirement, age 59½, disability or death • Payouts must begin by April 1 of the year after the participant reaches 70½ • Minimum distribution requirements specified by IRS • Restrictions on loans

31. Non-Tax Regulations • Civil Rights Act of 1964 • What does sex discrimination mean? • Same contributions, or same benefits? • Age Discrimination in Employment Act • Americans with Disabilities Act • Family and Medical Leave Act of 1993

33. How Do DB Plans Work? • Formula specifies benefit to be paid to the employee • Investment risk rests with plan sponsor • Payment 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 pay • Typically insured by the PBGC (within limits) • Formulas and funding can be complex

34. DB Formula Characteristics • Employer 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 formulas • Benefit 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

35. Replacement Ratio • Also 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”

36. Types of DB Formulas • Wide variation • Limited by: • Accrual rules • Social Security integration rules • Non discrimination requirements

37. Allowable DB Formulas • Flat-Benefit Formula • Does 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 Formula • Benefit 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

38. What is Compensation? • Firms have some flexibility • Two categories • Career Average • Final Average • Base salary or total compensation • Bonuses, overtime, etc. • If use something other than total compensation, must be careful about discrimination

39. Inflation • Since 1926, inflation has averaged a bit over 3% annually • Can reduce purchasing power by 25% in only 10 years, 45% in 20 years. • Inflation uncertainty is also important • Double digit in late 1970s • Difference between inflation indexation and fixed growth rate

40. How Protect Workers from Inflation? • Pre-retirement Inflation • Final average compensation formula • Index wages (Social Security) • Postretirement Inflation • Ad Hoc Adjustments (quite common) • Increase Benefits by a Formula • Index Benefits to CPI

41. DB Benefit Accruals • Benefits owed to employees if: • Terminate of employment prior to retirement • Terminate plan before retirement • DB Plans: benefits must accrue at least as fast as one of these 3 rules: • 3% Rule • Accrual > 3% of max accrual if in plan for entire career • 133% Rule • Accrual < 133% of prior year’s accrual • Fractional Rule • Proportional to normal retirement benefits

42. 3% Rule Example Data: If individual entered plan and stayed until retirement: Benefit = $100,000 Question: If individual leaves after 10 years what is benefit? Answer:

43. 133 1/3% Rule Example Benefit Accrual Rate Years Accrual 1-5 $ 5,000/year 6-10 $ 6,000/year 11-20 $ 8,000/year 21-35 $16,000/year Does this meet the rule?

44. 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:

45. Death & Disability Benefits • Pre-retirement Survivor Annuity • Mandated for spouse of vested plan participant • Provides income to surviving spouse • Qualified Joint and Survivor Annuity (QJSA) • Post retirement death benefit • Survivor benefit must be >50% of amount paid when both alive • Automatic, unless spouse provides notarized signature • Treatment of disability (access to benefits, accrual and vesting)

46. Funding • Complex set of funding rules to ensure solvency of the plan in the event of plans sponsor’s bankruptcy • PBGC provides insurance • More in next lecture