Life and Death Planning for Retirement Benefits

Chapter 8: Investment Issues; Plan Types

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The formula may award a lower percentage for compensation below the Social Security tax wage base than for compensation in excess of such base. This is called the “permitted disparity.” The formula will contain adjustments for early or late retirement. The employer hires an actuary to tell it, each year, the minimum amount it must contribute to the plan (and how much extra it may contribute) (both limits being set by the Code) in order to amortize the employer’s future obligations to retiring employees under the plan. Classic defined benefit plans generally are of greater value to older employees than to younger employees, because of the time value of money. Even if their eventual projected pensions are the same amount, say $36,000 per year starting at age 65, the value is greater to the employee who will be receiving that sooner. $36,000 a year starting in 10 years (how the pension looks to the 55 year-old employee) is a more significant asset than $36,000 a year starting in 30 years (how the pension looks to a 35 year-old employee). The older employee’s pension looks more valuable to the employer too, who has to contribute more for the older employee than for the younger. Classic defined benefit plans were once the normal form of retirement plan for American businesses. Their popularity has declined due to the increasingly complex tax and administrative rules applicable to these plans and due to the lower cost of defined contribution (DC) plans. However, the classic defined benefit plan remains attractive to the one-person business as a way of maximizing tax-deductible retirement contributions. If the business owner/sole employee is over age 50, approximately, a classic defined benefit plan will give him a much larger annual tax- deductible contribution than is permissible under a DC plan. B. Cash balance plans. There is another type of defined benefit plan, called a cash balance plan , that uses a different type of formula. “A cash balance plan is a defined benefit plan that defines benefits for each employee by reference to the employee’s hypothetical account. An employee’s hypothetical account is determined by reference to hypothetical allocations and interest adjustments that are analogous to actual allocations of contributions and earnings to an employee’s account under a defined contribution plan.” Reg. § 1.401(a)(4)-8(c)(3)(i) . Under a cash balance plan, contributions are more uniform across age groups, making cash plans more attractive than classic defined benefit plans for younger employees (and less generous for older employees). C. Estate planning features. From an estate planning perspective, the defined benefit plan has the following distinctive features. First, the participant does not have an “account” the way he does in a DC plan. Even under a cash balance plan, though the plan’s funding formula is determined by reference to a hypothetical “account” for each employee, the participant does not have an actual account in the plan. The benefit statement for a classic defined benefit plan will typically say the employee’s “accrued benefit” under the plan is ( e.g. ) “$1,450 a month,” of which (say) “80 percent is vested.” What this means is that the employer has already obligated itself to provide for this employee (if the employee keeps on working until retirement age) a pension of $1,450 per month for life starting at the employee’s “normal retirement age” under the plan; and if the employee quits right now, he’s vested in 80 percent of that, meaning that at normal retirement age he would receive 80 percent of $1,450 per month.