In a defined benefit pension plan an actuary determines the deductible contribution the employer makes each year. The actuary uses best judgment to calculate the contribution and, also, follows a complex set of rules contained in Sections 404 and 412 of the Internal Revenue Code. These Code sections were amended by 1986 and 1988 tax acts. The amendments drastically reduced deductible contributions of many small plans, in some cases eliminating the contribution completely. Such plans are said to be “fully funded” under these rules.
Higher Initial Contribution
To avoid the reduction or elimination of deductible contributions, one solution is to convert the pension plan to a “fully insured” plan under IRC section 412(i). Section 412(i) exempts a plan from other funding rules of section 412, if the plan is funded exclusively by insurance contracts, and the insurance company guarantees payment of all plan benefits to the participants.
Often, conversion of a small, trusteed, defined benefit plan to a fully insured plan increases significantly the deductible contribution, even in plans otherwise considered fully funded under the section 412 full funding limitations.
The use of lower interest rate assumptions and a different funding method causes the difference in contributions. In calculating the deductible contribution to a typical trusteed plan, the IRS often insists the actuary use at least a 6% interest rate assumption.
Conversely, an insurance company calculates premium payments to a fully insured plan based on the company’s guaranteed rate, which may not exceed 4-1/2% or 5%. The use of a 4-1/2% or 5% interest rate assumption, as opposed to 6%, and use of Individual Level Premium (ILP) funding (the method used by insurance companies to determine premiums on annuity contracts) triggers initially higher contributions to the plan.
Use of a lower interest rate assumption and the ILP funding method may not increase total contributions, but they do change the payment pattern. In a trusteed plan if the fund actually earns 6% annually, the employer will contribute the same level amount each year.
On the other hand, in a fully insured pension plan if the insurance contract earns 6%, and the insurance premium is calculated using a guaranteed rate of 4-1/2% or 5% and the ILP method, the excess credited interest reduces succeeding premiums. Typically, the premium pattern in a fully insured plan involves initially high payments, which decrease in each following year. Deductible premium payments to a fully insured plan in later years will be smaller than contributions to a similar trusteed plan, assuming the same funding target.
Different Funding Objective
Larger contributions to a fully insured plan also may be the result of different funding objectives.
Let’s assume an actuary calculates the amount of money a trusteed plan needs to accumulate to pay a benefit of, say, $9000 per month at age 65. The actuary estimates a cost of $112 per dollar of benefit and a required accumulation of $1,047,396 at the participant’s age 65, based on the 1984 unisex mortality table and a 6% interest rate.
Conversely, a typical insurance contract may have a guaranteed conversion factor at age 65 of $156 per dollar of benefit. In a fully insured plan the target accumulation necessary to pay the maximum benefit using the guaranteed factor is $1,458,912, or nearly 40% more than the trusteed plan.*
* Numbers shown are for illustrative purposes only, a client would have to consult an actuary to get an estimate of contributions and benefits in his/her actual plan.
Last Updated: 12/15/2002 11:44:00 AM