Account balance pension plans: a benefit program for the 1990s.
Defined benefit and defined contribution plans are traditional vehicles for providing retirement benefits. Under a defined contribution plan, the sponsor typically contributes a specific amount--usually based on a percentage of pay--to the participant's account, which is invested in an employer-sponsored fund of the employee's choice. When the employee leaves or retires, the plan pays the participant the total amount contributed--plus or minus any investment gains or losses--in a lump sum. It is not unusual, however, for plans to allow participants to opt for periodic payments over a fixed period of time in lieu of the lump sum.
Defined benefit pension plans are funded on a plan-wide basis and do not hold separate accounts for each participant. An employee's monthly retirement benefit is based on a specified percentage of pay--either final pay or career pay. Under a final pay plan, the benefit is usually based on an employee's average annual salary over the last three to five years of employment. Under a career pay plan, the benefit is based on the annual salary earned over a participant's entire career.
Defined benefit pension plan sponsors underwrite the plan's investment performance and all risks associated with adverse mortality experience and unexpected increases in benefit liabilities.
Most defined benefit plans generally make benefits available only in the form of an annuity--and only at retirement. However, some plans do allow participants to take their retirement benefits as a lump-sum distribution.
An account balance pension plan's benefit formula is similar to that of a defined contribution plan: the sponsor contributes a fixed amount for each participant. However, an account balance pension plan is funded like a defined benefit pension plan, with each participant's benefits accruing in a "phantom" account. Unlike accounts in a defined contribution plan, however, this account is credited with interest at a fixed rate for a specified time period--usually one year. Each year, the rate is adjusted to reflect current money market or other short-term rates. The plan document explains how this rate is selected.
From the perspective of plan participants, account balance pension plans resemble defined contribution plans with fixed contributions that are credited with a guaranteed rate of return. Participants receive periodic statements of their account balances. When the vested plan participant leaves or retires the plan pays the total amount contributed, plus credited interest. As a result, account balance pension plans tend to be more meaningful to employees than traditional defined benefit pension plans because participants more readily understand how the plan operates; they see their benefits accruing and they have access to these funds at termination or retirement.
From the sponsor's perspective, the account balance plan is similar to a defined benefit, career pay pension plan; participants' benefits are based on compensation earned during each year of their career.
Because retirement benefits earned under a career pay formula are generally lower than those earned under a final pay formula, account balance pension plans may be less expensive to fund. Thus, these plans enable plan sponsors to exert greater control over plan costs by avoiding automatic, accrued benefit increases attributable to higher salaries.
Based on a percentage of payroll, benefits in an account balance plan are usually substantially lower than the contribution rate communicated to participants. The plan sponsor need only contribute an amount sufficient to satisfy the minimum funding requirements of the Employee Retirement Income Security Act of 1974 (ERISA).
Although overfunded plans may not require any contributions, plan participants will still see their account balances grow from year to year.
Unlike a typical defined contribution plan, investment returns and turnover in an account balance plan can be projected and discounted in advance, and gains or losses can be amortized. If plan assets earn more than the guaranteed rate, the plan retains the excess earnings. The gain is amortized to offset future funding requirements. If plan assets earn less than the guaranteed rate, losses are amortized and serve to increase future funding requirements. Typically, however, the plan sponsor sets a guaranteed rate lower than the performance projected for the fund's assets.
Because the account balance pension plan is a defined benefit pension plan, the plan sponsor has greater flexibility in funding it than funding a defined contribution plan. Any acceptable actuarial funding method may be used.
Account balance pension plans also permit retroactive benefit improvements, and their associated costs can be amortized over a 30-year period. Such improvements are difficult to make with most defined contribution plans and, therefore, are not usually done.
Most defined benefit pension plans only provide monthly annuity benefits at retirement; a few offer the option of lump-sum distributions. On the other hand, defined contribution plans generally provide for lump-sum distributions, but they often allow participants to opt for periodic payments over time in lieu of the lump-sum amount.
Account balance pension plans generally express the retirement benefit as a lump sum, convertible to an immediate or a deferred annuity at the participant's option at the time of retirement or termination, regardless of age. (However, because the account balance plan is a defined benefit pension plan, benefits must be paid to married participants in the form of a joint and survivor annuity, unless the spouse consents to the lump sum or any other option.)
An immediate distribution of benefits rather than a deferred distribution is attractive to employees who work 10 to 20 years with a company but not until retirement. With this benefit, departing employees have the opportunity to roll over their benefits to an individual retirement account (IRA) or another account balance plan.
A company's adoption of a career pay-based account balance pension plan may yield cutbacks in retirement benefits for some employees. Various refinements in plan formulas can help mitigate the effects of these cutbacks. For example companies can adopt special transition--or grandfather--provisions to ensure that older, longer service employees nearing retirement are not financially harmed by the changeover.
In addition, account balance pension plan formulas may be designed to grant higher benefit accruals to participants as they accumulate service. The account balance pension plan formula may also be integrated with social security to weigh benefits in favor of higher paid participants.
Of course, the plan design must satisfy the proposed nondiscrimination regulations. Plan sponsors are also required to pay pension benefit guaranty corporation (PBGC) premiums and have annual actuarial valuations prepared.
In the economic environment of the 1990s, account balance pension plans offer important financial planning opportunities to certain companies. Companies that adopt these plans may realize one or more of the following financial advantages. * Constructive use of pension plan surplus: Sponsors with pension plan surpluses who are also sponsors of profit-sharing plans may redirect their allocation obligations from profit-sharing plans to pension plans, thereby conserving cash. * Easier assimilation and divestiture of acquired plans: The assimilation of newly acquired companies with different types of pension plan formulas can be facilitated by converting accrued benefits to an opening account balance. The initial contribution for each account comes from the acquired company's pension plan funds, with future accruals credited under a uniform formula. * Divestitures are also more easily handled under a cash balance formula: The discounted value of participants' account balances may be the amount of the assets to be transferred. * Management of plan costs: Plan sponsors who wish to control costs by reducing retirement benefits from final pay to career pay levels may find that the benefit cutback is more acceptable to employees when presented in the form of account balance pension plans. * Rewarding long service, non-career employees: Plan sponsors may amend their traditional defined benefit pension plans to incorporate an account balance feature. The account balance provision can produce meaningful termination benefits for the first 10 to 20 years of service, at which point the traditional defined benefit formula takes over.
Whether an account balance pension plan is appropriate depends on a company's retirement philosophy, its financial situation and the makeup of its work force. Like a defined contribution plan, an account balance pension plan may be attractive to a company that must recruit from today's younger, more mobile work force.
The table on page 229 compares the advantages and disadvantages of an account balance pension plan with a traditional final-pay pension plan. Of course, what is perceived as an advantage by one employer may be considered a disadvantage by another.
Account Balance Pension Plans: Advantages and Disadvantages Advantages Disadvantages * Benefit formula easily * Front-load benefit accruals understood by employees. and accelerated vesting * Highly visible retirement disproportionately favor program; employees can younger, shorter service watch their account employees. (Can be balances accumulate. tempered by plan design.) * Higher accruals in years of * May not adequately reward participation. career employees. (Can be * Particularly attractive for tempered by plan design.) employers that must recruit * Accelerated vesting and younger, more mobile immediate distributions employees. may be more costly. * Still a pension plan; it requires annual valuations and payment of PBGC premiums. * Tends to increase recordkeeping needs and costs. (These costs are generally offset by reduced costs of retirement benefits.)
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|Author:||Rothy, Gary H.|
|Publication:||The Tax Adviser|
|Date:||Apr 1, 1992|
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