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Other Risk Benefits
he aims and objectives of this chapter are to provide a comprehensive understanding of various supplementary risk benefit programs that organizations often offer to their employees. These programs go beyond basic life insurance and aim to enhance the overall coverage and protection for both employees and their dependents. The specific topics covered in this chapter include:
Group Term Life Insurance Benefits:
Explanation of group term life insurance benefits.
Understanding the coverage and benefits provided under this program.
Technical aspects such as accounting, tax implications, legal considerations, actuarial aspects, and financial implications.
Group Dependent Life Insurance Benefits:
Discussion on group-dependent life insurance benefits.
Exploring the coverage and benefits for dependents of employees.
Technical details, including accounting, taxation, legalities, actuarial considerations, and financial aspects.
Supplemental Life Insurance Benefits for Employees and Dependents:
Overview of supplemental life insurance options for both employees and their dependents.
Understanding how these additional coverages complement basic life insurance.
Technical insights into accounting, tax implications, legal considerations, actuarial calculations, and financial aspects.
Disability Benefits:
Discussion on disability benefits provided by organizations.
Understanding the types of disability coverage and associated benefits.
Technical aspects, including accounting, tax implications, legal considerations, actuarial factors, and financial implications.
Group Accidental Death and Dismemberment Plans (AD&D):
Explanation of group AD&D plans.
Understanding the coverage for accidental death and dismemberment.
Technical details encompassing accounting, taxation, legal aspects, actuarial considerations, and financial implications.
Long-Term Care Plans:
Overview of long-term care plans offered to employees.
Understanding the coverage for long-term care needs.
Technical aspects, including accounting, tax implications, legal considerations, actuarial calculations, and financial aspects.
Group Travel Accident Insurance:
Discussion on group travel accident insurance.
Understanding the coverage for accidents that occur during travel.
Technical insights into accounting, tax implications, legal considerations, actuarial factors, and financial aspects.
Tax Implications of Other Risk Benefit Plans:
Explanation of the tax implications associated with the various risk benefit plans.
Understanding how these plans may impact the tax liabilities of employees and the organization.
The chapter aims to provide a holistic view of these supplementary risk benefit programs, covering both the practical benefits they offer and the technical considerations that organizations need to address in their implementation and management.
Group Life Insurance Programs
Group life insurance programs are a prevalent and valuable component of employers' benefits packages, ranking as the second-most common group insurance benefit after group health insurance. At the core of these programs is group term life insurance, offering employees access to life insurance with the advantage of collective purchasing power, resulting in coverage at a cost-effective rate. It's important to note that these insurance provisions align with broader public programs such as Social Security and workers' compensation, forming a cohesive framework governed by fundamental principles.
The primary goal of these group life insurance programs is twofold: firstly, to align with the strategic objectives of the employer's overarching employee benefit plan, and secondly, to cater to the individual needs of employees. By leveraging economies of scale through a group-based approach, these programs aim to strike a balance between affordability and comprehensive coverage, ensuring that life insurance remains a meaningful and accessible component of the overall employee benefits strategy.
In essence, group life insurance is not merely a standalone offering but an integral part of a broader benefits strategy. It takes into account the diverse needs of a workforce while adhering to the foundational principles that guide the design and implementation of effective employee benefit plans. Through this collective approach, employers can create a robust and inclusive framework that addresses both organizational objectives and the well-being of their employees.
Introduction:
Group term life insurance stands as a collective shield, uniting individuals under a single, encompassing policy tailored for specific groups, such as the workforce within a particular organization. Typically, employers engage with a designated life insurance company to extend this coverage to their employees. This policy might be a complimentary benefit or, in some cases, employees contribute a nominal monthly amount through payroll deductions. Notably, this chapter delves into the broader spectrum of group term life insurance, exploring its facets and extensions, including coverage for employees' dependents.
The allure of group term life insurance lies in its economic accessibility. Individually procuring life insurance often entails substantial premiums, rendering it a costlier endeavor. However, participation in a company-sponsored plan represents a cost-effective alternative for individual workers. Moreover, these policies often embrace inclusivity, translating to significantly reduced costs for both employees and, potentially, their family members.
Beyond the individual advantages, group life insurance emerges as a strategic asset for employers. Within the intricate tapestry of an employee's total benefit portfolio, this type of coverage becomes a competitive cornerstone. In 2011, the United States witnessed a staggering $19.2 trillion in total life insurance coverage, with group insurance commanding an impressive 42%, amounting to $8.1 trillion. The ensuing sections, especially Table 4.1, meticulously outline the competitive advantages woven into the fabric of this program, shedding light on its significant impact in the realm of employee benefits.
Table 4.1:
The Distinctive Benefits:
The protective shield offered by a life insurance plan, as outlined in this discussion, typically takes the form of a one-year renewable policy, characterized by a standardized rate applicable to all enrolled employees. It is important to note that this type of policy does not accrue a cash surrender value or provide paid-up insurance benefits.
Group-term life insurance is defined by five key attributes that set it apart. Firstly, unlike individual policies that meticulously assess and underwrite the risk associated with each life, group insurance leverages collective coverage, ensuring the entire population is insured without the need for individual insurability examinations or evidence.
The second noteworthy feature involves the premium structure, particularly for larger groups, which often undergoes experience rating. As the group size increases, the ability to distribute risk widens. Consequently, the cost of the policy aligns with its specific loss experience. Experience rating may be either prospective or retrospective, and a favorable rating can result in credits or dividends, adjusting the renewal premium for the subsequent year.
A third distinctive element capitalizes on the economics of administration. In this context, the plan is administered by an insurance company or another entity capable of achieving administrative efficiencies through mechanisms like payroll deductions or centralized functions. This pragmatic approach enhances the overall effectiveness and efficiency of the insurance plan.
The Fourth and Fifth Distinctive Features:
The fourth distinguishing aspect revolves around the flexibility inherent in certain plans, often structured on an employee-pay-all basis. Under this arrangement, employees have the autonomy to opt out of coverage they deem unnecessary. However, this introduces the challenge of adverse selection, where younger employees may choose to opt out, potentially leaving older individuals, who may be less healthy, in the plan.
The fifth feature introduces the concept of a master contract, signaling that the plan can endure well beyond the lifetime of any individual enrollee. However, the prerogative to terminate the contract lies with the employer, plan sponsor, or the insurance company, offering a layer of discretion in the continuity of the plan.
Ensuring the efficacy of a group insurance plan involves crafting a meticulous schedule of benefits. In formulating this schedule, plan sponsors navigate considerations such as the employees' needs, the plan's cost implications, and adherence to nondiscrimination rules in alignment with an Employee Retirement Security Act (ERISA)-compliant plan. Additionally, if the plan is contributory, the employee's ability to pay becomes a crucial factor.
Various factors can influence the design of the benefits schedule, including earnings, occupation or position within the organization, or a flat benefit extended to all employees. Presently, benefits are commonly calculated as multiples of an employee's salary, typically one or two times the base salary, with the incorporation of a maximum benefit schedule. This classification-based approach allows for a nuanced determination of benefit amounts, tailored to specific employee classes within the overarching group plan.
Financing Considerations:
Group term life insurance policies commonly embrace two primary financing models: employer financing or a combination of employee and employer contributions. Each approach carries distinct advantages, tailored to the preferences and objectives of the organization.
Under complete employer financing, the entire financial responsibility rests with the employer. This arrangement ensures comprehensive coverage for all employees, simplifying administration and offering notable tax benefits. Specifically, premium contributions become tax-deductible for the employer as a standard business expense, a feature not applicable to employee contributions unless structured within a Section 125 plan.
Conversely, a contributory plan involves a blend of employee and employer contributions. This approach introduces several advantages:
Larger Benefit Payouts: The flexibility of a contributory plan allows for potentially larger benefit payouts.
Selective Participation: Healthier, single employees may choose not to participate, enabling employer contributions to be allocated toward the benefits of those who remain, provided nondiscrimination rules are adhered to.
Employee Engagement: Employees contributing towards premium costs are more likely to actively engage with and understand the plan's benefits, fostering a sense of ownership and awareness.
In the realm of group life insurance plans, premiums are intricately linked to the age distributions of employees. Group plans, characterized by a stable age distribution within the pool, generally maintain consistent premiums, experiencing only marginal fluctuations. This stability is a notable characteristic, ensuring predictability in financial obligations over time.
Plan Provisions Unveiled:
Group life insurance policies come equipped with a set of comprehensive provisions designed to cater to the diverse needs and circumstances of plan participants. These provisions contribute to the flexibility and effectiveness of the insurance plan. Here are the key provisions typically included:
Eligibility:
Flexibility characterizes life insurance eligibility provisions. Most full-time employees gain eligibility on the date of hire. This eligibility extends not only to dependents but also encompasses part-time employees and individuals in various inactive states, such as retirees, the disabled, those on leave, and laid-off workers. Different eligibility periods may apply to specific groups, ensuring inclusivity and adaptability.
Beneficiary Designation:
Participants in the plan typically designate a beneficiary upon initial enrollment. Subsequently, employees retain the flexibility to change their beneficiary designation as needed, unless a designation is explicitly made irrevocable. In the absence of a designated beneficiary or if all beneficiaries predecease the insured, death benefits are usually directed to the employee's estate.
Settlement Options:
Group life insurance plans offer various settlement options for designated beneficiaries, providing flexibility in the receipt of benefits. While a lump sum payment is a common option, alternative settlement modes can be chosen by the employee, with the ability to modify these choices during their lifetime. The installment amounts are determined based on tables specified in the master policy.
Alternative settlement options may include:
Interest-bearing deposit accounts with regular payouts.
Equal installments paid until the proceeds (including interest) are exhausted.
Lifetime payments to the beneficiary, with amounts contingent on factors such as age, gender, guarantee periods, and the total death benefit.
These provisions collectively ensure that group life insurance plans are tailored to the dynamic circumstances of participants, offering both flexibility and a range of choices for beneficiaries to receive benefits in a manner aligned with their individual needs and preferences.
Enhancing Plan Flexibility with Additional Provisions:
Assignment:
To circumvent the implications of estate taxes, beneficiaries may opt for an assignment, provided it aligns with state laws governing the policy. Insurance companies often facilitate this arrangement, enabling the transfer of benefits on behalf of the employee to another individual or an irrevocable insurance trust.
Conversion Provision:
A valuable feature in many group life insurance policies is the conversion provision, allowing terminated employees to convert their coverage into an individual-payment policy. This flexibility extends to instances of plan eligibility changes due to rule shifts or retirement. The employee must initiate the conversion process within 30 days of any status change, continue premium payments, and may experience adjustments based on factors like age, insurance type, and risk classification. Importantly, this provision often operates without the need for additional medical evidence of insurability. State laws mandate insurance companies to inform participants of their conversion rights within 30 days of any eligibility condition change. Additionally, a 31-day continuation of coverage is commonly included, affording employees the time to consider and decide on utilizing the conversion privilege.
Continuation of Insurance:
By mutual agreement with the insurance company, employers can include a provision allowing a limited continuation of insurance, typically lasting three months, during an employee's leave of absence. At the conclusion of this period, the insurance terminates, but the employee retains conversion privileges, offering a bridge between employment gaps and continued coverage.
Waiver of Premium:
A prevalent provision in most group insurance programs, the waiver of premium provision, ensures that when a covered employee becomes disabled, premiums are waived. Generally applicable until a specified age, often 60 to 65 at the date of disability, this provision allows life insurance to persist until death. Periodic proof of continued disability is required, typically on an annual basis, to maintain coverage under this provision.
These additional plan provisions not only enhance flexibility but also cater to various life circumstances, providing participants with valuable options and safeguards throughout their engagement with the group life insurance plan.
Enhanced Benefits: Within the framework of accelerated benefits, an insured individual becomes eligible to receive benefits under the following circumstances:
The employee can substantiate a terminal illness with an anticipated life expectancy of 12 months or less.
In the presence of specific catastrophic illnesses such as cancer, AIDS, stroke, and others.
Ongoing expenses related to nursing home or other long-term care requirements.
Typically, insurance companies activate accelerated benefits when a life expectancy falls within the range of six to 12 months, validated by a physician's certification. The offered amount in such instances constitutes a percentage of the basic coverage, ranging from 25% to 100%. Unaccelerated amounts are disbursed upon the insured individual's demise.
It's noteworthy that the majority of states adhere to the National Association of Insurance Commissioners (NAIC) Group Life Insurance Standards Provisions Model Bill, resulting in a uniformity of these provisions across insurance companies.
Group Dependent Life Insurance
As previously indicated, most group life insurance plans have provisions covering the insured’s dependents. Under such plans, a dependent is defined as the insured’s spouse (who is not legally separated from the insured). Dependent children are usually defined as unmarried children, including stepchildren and adopted children, between 14 years of age and some predetermined limit, usually between the ages of 19 to 21. The age limit may be extended to 25 if the child is a full-time student. Generally speaking, different coverage levels are offered for spouses versus dependent children. A plan will permit greater levels of dependent coverage only if they are fully paid by the employee. Under such provisions, death benefits are paid in a lump sum to the employee or, if deceased, the employee’s estate.
The amount of coverage for a dependent’s life is usually minimal. Any coverage over $2,000, when the employee pays premiums, may be subject to federal taxes. Adverse tax consequences might not apply if the employee pays the premiums. Occasionally, coverage amounts are lower until a dependent child reaches a certain age.
Normally, a single premium is applicable for all participating employees and is unrelated to the number of a given employee’s dependents. In some plans, premiums vary based on the age of the employee, but most premiums are uniform.
Group dependent life insurance usually carries a conversion privilege, but this privilege might only apply to spousal coverage. However, some states mandate that this privilege apply to all covered employees.
Supplemental Life Insurance
Numerous companies empower their employees to acquire supplemental life insurance through the same provider offering basic coverage, facilitated by the convenience of payroll deduction. This unique feature seamlessly integrates elements of both group and individual life insurance policies, often manifesting as a group universal life plan. Typically, obtaining coverage involves minimal individual underwriting, influenced by competitive factors and the number of employees enrolled in the company's insurance program. Notably, since this supplemental coverage is individually owned rather than company-owned, it remains with the employee even in the event of termination.
Within the framework of most group life insurance plans, participants have the option to augment their coverage with this additional layer, leaving the employer responsible solely for basic coverage. This contributory supplemental coverage can be seamlessly integrated into the basic plan or structured independently. Occasionally, companies may restrict access to supplemental coverage, confining it to a specific subset of employees.
The extent of supplemental coverage within such plans is meticulously outlined in the benefit schedule. Some plans mandate full coverage, while others offer the flexibility to opt for partial coverage. Yet, the choices made by employees in these plans introduce the potential challenge of adverse selection, necessitating stringent underwriting rules. Insurance companies typically demand evidence of insurability before underwriting full coverage. However, in the case of a sufficiently large group, insurers may waive the need for evidence of insurability for basic coverage. Any additional coverage amounts, though, remain contingent on evidence of insurability and undergo individualized underwriting assessments.
Accidental Death and Dismemberment Plans
Integrated into group life insurance benefit programs, Accidental Death and Dismemberment (AD&D) features enhance coverage by providing additional benefits in the unfortunate events of accidental death or specified injuries. Typically, these plans operate on a contributory basis, and the fundamental group AD&D coverage is commonly incorporated as a rider to the group life insurance plan.
Alternatively, employers have the option to procure distinct contracts outside the purview of a group life insurance policy, known as carve-out plans. These plans, often more cost-effective, serve to furnish employees with broader and tax-favored benefits.
In the conventional framework of AD&D insurance, individuals eligible for group life insurance automatically gain access to this supplementary coverage, provided the employer includes it in the plan, and the insurance company incorporates it into the original contract. These plans may have a probationary period, typically spanning three to six months, before AD&D coverage becomes accessible.
The benefits offered by AD&D coverage are usually double the amount of the group term life coverage. This payout is triggered only in the case of accidental death or bodily harm, encompassing the dismemberment component. Insurance providers commonly specify a timeframe within which the covered individual must pass away after an accident to qualify for the benefits.
The definition of the terms used in the table are given below:
• Quadriplegia: If an accident causes total paralysis of both upper and lower limbs, and the accident results in a covered loss, 100% of the AD&D insurance benefit is payable.
• Hemiplegia: If there is an accident which causes total paralysis of the upper and lower limb on the same side of the body, and the accident results in a covered loss, 50% of the AD&D insurance benefit is payable.
• Paraplegia: If the accident causes total paralysis of both lower limbs, and the accident results in a covered loss, 75% of the AD&D insurance benefit is payable.
• Reattachment of hand or foot: If an accident results in a covered loss of hand or foot, even if it has been surgically reattached, the insurance company will pay 50% of AD&D insurance benefit payable.
Enhanced Benefits during Business Travel
In the unfortunate event of an accident occurring during an employee's business trip, elevated benefits are often accessible. Further insights into these augmented provisions can be gleaned in the subsequent sections covering group travel accident insurance.
Under an Accidental Death and Dismemberment (AD&D) plan, death benefits are disbursed to the employee's designated beneficiary, as specified in the group term life insurance plan. Conversely, benefits related to the dismemberment segment are directed to the employee. Comprehensive coverage is extended to both occupational and nonoccupational accidents.
Upon retirement, the majority of employee plans cease coverage, and conversion privileges are typically rescinded due to the associated high costs, influenced by the retiree's age. While some employers choose to extend coverage to retired employees, the coverage is often scaled down, commonly by 50%.
Group Disability Benefits
Group disability benefits are meticulously crafted to safeguard a covered employee's income in the face of accidents or illnesses. Statistical data underscores the relevance of such coverage, revealing that approximately one-third of employees may encounter a disability lasting at least 90 days, with one-tenth facing the prospect of permanent disability. In recognition of these risks, a significant number of employers incorporate group disability protection into their benefits offerings.
This protection is structured into two distinct plans:
A short-term disability program, typically providing benefits for up to six months. Funding for these plans is derived from a combination of insured and uninsured sick-leave plans.
A long-term disability program is strategically crafted to furnish extended disability benefits, potentially spanning the entirety of an employee's life.
However, a notable challenge inherent in disability programs is the intricacy of coordinating benefits across diverse plans, encompassing both private and government-sponsored initiatives. It's crucial to acknowledge that disability benefits are not exclusive to workplace programs; they are also accessible through Social Security and various other government initiatives. The coordination of benefits extends its reach to include uninsured paid-sick-leave plans and employer-sponsored retirement plans. This coordination holds significant importance as, without it, an employee may find themselves receiving payments from multiple sources, yet encountering potential gaps in compensation during transitional periods between one plan and the next. Careful consideration of this coordination is pivotal to ensuring a seamless and comprehensive support system for the employee.
A short-term disability program, typically providing benefits for up to six months. Funding for these plans is derived from a combination of insured and uninsured sick-leave plans.
A long-term disability program is strategically crafted to furnish extended disability benefits, potentially spanning the entirety of an employee's life.
However, a notable challenge inherent in disability programs is the intricacy of coordinating benefits across diverse plans, encompassing both private and government-sponsored initiatives. It's crucial to acknowledge that disability benefits are not exclusive to workplace programs; they are also accessible through Social Security and various other government initiatives. The coordination of benefits extends its reach to include uninsured paid-sick-leave plans and employer-sponsored retirement plans. This coordination holds significant importance as, without it, an employee may find themselves receiving payments from multiple sources, yet encountering potential gaps in compensation during transitional periods between one plan and the next. Careful consideration of this coordination is pivotal to ensuring a seamless and comprehensive support system for the employee.
Sick-Leave Plans: Ensuring Income Continuity
Sick-leave plans, often referred to as salary-continuation plans, serve as insured programs offering comprehensive income protection over short durations.
Innovatively, a contemporary initiative named paid time off (PTO) consolidates various employer-sponsored time-off components, including vacations, holidays, and personal leave, under a unified framework. This versatile program empowers employees to accrue days off, providing flexibility for their utilization without restrictive conditions. Typically tailored for full-time employees, some regular part-time employees may also benefit from sick leave provisions. These plans guarantee full compensation, covering 100% of regular employee income during their time off, with accrual based on established formulas, such as ten days per year of service. To prevent excessive accumulation, plans often impose a maximum limit, seldom exceeding six months. Some variations allocate sick days annually based on years of service.
In parallel, recent legislative advancements, such as the Family and Medical Leave Act (FMLA), furnish employees with the option of unpaid leave for specific circumstances, including family or medical emergencies. Notably, group health benefits persist during sanctioned leave, reflecting a commitment to employee well-being and continuity of support.
Insured Disability Programs: Balancing Coverage and Control
Insured disability programs encompass both short- and long-term plans, with short-term coverage typically extending to all employees while long-term coverage is more selectively applied. Companies exercise caution in extending long-term coverage universally, as some employee circumstances may open avenues for potential misuse. Consequently, eligibility provisions are often more stringent, a measure driven by the imperative to contain coverage costs. Employers frequently design long-term disability plans tailored for stable and permanent employee classes, reserving short-term coverage for others. Deliberate design includes extended eligibility periods before employees can participate, particularly in long-term plans. Given that claims frequency and duration tend to be higher for lower-level employees, controlling costs is achieved by restricting long-term eligibility to salaried or managerial employees.
The skew in Social Security benefits toward lower-wage earners further supports the strategic inclination to tailor disability programs for higher-compensated employees. Prolonged eligibility periods ensure coverage for stable employees, while shorter periods optimize administrative efficiency and reduce costs. Short-term disability programs, often integral to salary-continuation programs, may encompass a broader employee spectrum after a relatively brief eligibility period, typically not exceeding three months.
Benefits under disability programs are contingent on adherence to the insurance contract's precise definition of disability, which usually requires the employee to be completely incapacitated, unable to fulfill any job requirement. Notably, these programs are confined to nonoccupational disabilities, as occupational disabilities fall under the purview of workers' compensation.
In scenarios where workers' compensation coverage is limited, employers may opt to provide coverage for both occupational and nonoccupational disabilities. Typically, long-term disability benefits extend for 24 to 36 months or as long as the individual is unable to perform in their regular occupation. Beyond this initial period, benefits persist only if the individual is unable to perform any occupation for which they are otherwise qualified, factoring in training, education, and experience. This provision aims to facilitate the rehabilitation of a disabled employee into gainful employment suitable for their skill set. It's worth noting that the definition of disability may vary between short- and long-term disability programs, and benefits offered under each may differ, with long-term plans potentially covering partial disabilities, a feature not necessarily present in short-term plans.
Exclusions in Disability Programs: Clarifying Coverage Parameters
Within the constructs of these programs, certain exclusions are explicitly outlined in their contracts to define the scope of coverage. Noteworthy exclusions include:
• No benefit is payable if the employee is not under the care of a physician.
• No benefit is extended in cases where the disability stems from self-inflicted injury.
• No benefit is provided if the employee engages in compensated work during the disability term.
For long-term plans, additional exclusions may apply:
• No benefit is awarded in the event of war, whether declared or undeclared.
• No benefit is granted if the disability arises from the commission of a crime or felony.
• No benefit is disbursed for disabilities resulting from mental illness, alcoholism, or drug addiction.
Except for pregnancy, pre existing conditions may also be subject to exclusion. The explicit exclusion of pregnancy aligns with legal provisions such as the Pregnancy Discrimination Act. This exclusion might encompass any disability initiated within the initial 12 months of coverage if the employee was undergoing treatment before eligibility or within 90 consecutive days preceding the onset of the disability period. These exclusions serve to delineate the boundaries of coverage, ensuring clarity for both employers and employees within the framework of disability benefit programs.
Benefit Schedules for Disability Programs: Striking the Right Balance
Crafting a benefit schedule for disability programs involves expressing the benefits in a format such as a flat dollar amount, variable amounts by classification, or as a percentage of an employee's earnings.
The primary challenge in designing such a schedule lies in finding the delicate equilibrium where the compensation is sufficient to support the disabled employee but doesn't disincentivize their motivation for rehabilitation and a return to work. Achieving this balance entails a thorough examination of the relationship between an employee's pre-disability earnings and potential disability earnings. Whether using a percentage or flat amount, the typical target result hovers between 50% and 70% of the employee's pre-disability gross income.
Many plans derive disability benefits from a percentage of regular earnings, spanning from 50% to a full 100%. The higher end of this spectrum risks diminishing the employee's incentive to return to work, as the net earnings, with lower taxes and reduced work-related expenses, may provide sufficient comfort. Earnings considered often include bonuses, overtime, commissions, and other incentive compensation. Occasionally, designs incorporate an initial period, perhaps the first four weeks, where benefits are provided at 100% of pre-disability income before transitioning to a decreased percentage, such as 70%, thereafter.
Long-term plans generally settle within the 50% to 70% range, with 60% and 66⅔% being commonly adopted percentages. Plans aligning disability benefits with a percentage of earnings often impose a maximum dollar limit on the benefits.
Short-term disability plans usually entail a waiting period, during which the covered employee must be disabled for benefits to commence. While accidents often bypass this waiting period, disabilities arising from illnesses may require a period ranging from one to seven days. If sick leave is available, this waiting period may be extended.
Studies have demonstrated that waiting periods effectively lower the costs of disability programs. For instance, not having a waiting period resulted in nearly 20% of all employees using disability benefits annually, whereas a 14-day waiting period reduced this figure to less than 10%. A 29-day waiting period further reduced it to less than 5%. Employers can strategically manage costs by implementing longer waiting periods within their disability programs.
Navigating Disability Benefits: Striking a Balance
Despite compelling statistics, employers are tasked with finding a delicate compromise between extended waiting periods and potential hardships for employees.
Short-term disability benefits, typically outlined in insurance policy contracts, usually extend up to a maximum of 26 weeks. Long-term benefits seamlessly follow short-term benefits and may persist for up to two years or even the lifetime of the disabled employee, contingent on the cause of the disability—whether by accident or illness.
Coordination of benefits provisions is a common feature in most disability plans, preventing benefits from surpassing the employee's pre-disability gross income. In adherence to this principle, disability income from an insured plan may be adjusted if alternative income sources are identified from other disability programs. Employer-sponsored programs strategically complement disability benefits available through various channels, including workers' compensation, Social Security, pension plans, sick-leave plans, and other sources.
Ensuring holistic support during disability, many companies sustain other benefits such as pension, life insurance, and medical insurance. The significance of life and medical coverage is underscored by the recognition that individuals in a disabled state may struggle to secure adequate coverage independently due to their health condition.
In response to evolving needs, numerous companies introduce supplemental long-term disability programs. These plans encompass employer-paid basic coverage while allowing employees to augment their coverage by contributing premiums. Termed as buy-up plans, they serve as a cost-containment measure by shifting a portion of the insurance cost to employees
A pivotal component in long-term disability programs is the rehabilitation provision, designed to encourage employees to gradually resume regular employment and reduce dependence on disability income. During this rehabilitative phase, employees receive a reduced amount of benefits. If it becomes evident that the employee is unfit for regular employment, full long-term benefits are reinstated.
Employers, recognizing the paramount importance of reintegrating disabled workers into gainful employment, often embrace integrated disability management. This approach involves a single provider overseeing rehabilitation across all disability programs, streamlining the process and fostering a comprehensive strategy to support employees on their journey to recovery and professional reengagement.
Long-Term Care Benefits: Addressing the Growing Need
The provision of long-term benefits to employees is becoming increasingly prevalent, spurred by a recognized long-term care crisis in the United States, as emphasized by the U.S. Department of Labor's Advisory Council on Employee Welfare and Pension Benefit Plans. The underlying cause is the aging American population, with the U.S. Census Bureau projecting a doubling of citizens aged 65 or older to 70 million by 2030, and a near doubling of those aged 85 and older to about 8.5 million during the same period. This demographic shift signals a heightened demand for long-term care services.
The average stay in a nursing home, approximately 2.5 years on average, is not exclusive to the elderly; younger individuals also require extended care due to various factors such as birth defects, mental illness, accidents, and more. The associated costs can range from $60,000 to $110,000 or more per year.
In response to this national concern, employers are increasingly integrating long-term care insurance into their employee benefits portfolios. The Health Insurance Association of America (HIAA) reports that over 1 million policies have been sold through 3,500 employers, with recent surveys indicating that nearly 1.5 million individuals receive long-term care protection through their employers, constituting approximately 25% of all long-term care insurance. Employees are actively seeking out this insurance during their working years when premiums are more affordable.
Long-term care insurance is tailored to provide coverage for at least one full year to employees in need of non-acute care, typically in the form of personal care services. This coverage is commonly offered through either an insurance product or voluntary plans, reflecting a strategic response to the escalating demand for extended care services in the face of demographic shifts and evolving healthcare needs.
Long-Term Care Plans: Navigating Eligibility and Coverage
Insurance companies that underwrite group life and health insurance policies often extend their offerings to include long-term care plans for groups. Conversely, those specializing in individual insurance commonly provide voluntary plans.
To qualify for ownership of a long-term care policy, an individual must meet one of the following two eligibility definitions:
Chronic Illness: Demonstrating the need for extended care due to a chronic illness or disability.
Substantial Cognitive Impairment: Suffering from severe cognitive impairment, often associated with conditions like dementia or Alzheimer's disease, necessitating supervision for the patient's health and safety.
Long-term care, as defined, extends beyond basic medical treatment or nursing care to assist individuals unable to perform Activities of Daily Living (ADLs) without substantial assistance for at least 90 days due to a loss of functional capacity. The Health Insurance Portability and Accountability Act (HIPAA) identifies six ADLs, including bathing, dressing, moving, toileting, eating, and continence.
Services covered by long-term care insurance can be administered in nursing homes, the patient's home, or through community services such as visiting nurses, home health aides, home-delivered meals, and adult daycare centers. Long-term care insurance serves as a crucial financial safeguard against the substantial costs associated with extended care, addressing a significant risk that employees must protect themselves against. Consequently, long-term care planning has emerged as a crucial workplace concern, with employer-sponsored long-term care benefits gaining considerable popularity.
Group long-term care plans are typically funded through employee contributions, and the Health Insurance Portability and Accountability Act (HIPAA) has provided employers with tax incentives for offering such plans. Insurance companies offer a range of benefit options and design flexibility to employers, ensuring premiums remain at a reasonable cost. This approach seeks to strike a balance between addressing the critical need for long-term care coverage and providing an economically viable solution for both employers and employees.
Comprehensive Coverage in Long-Term Care Insurance Plans
Long-term care insurance plans encompass a broad spectrum of care services, ensuring coverage for various needs:
Nursing Home Care: This category includes:
Skilled Care: Nursing or rehabilitative care supervised by medical personnel, following a physician's order.
Intermediate Care: Occasional nursing and rehabilitative care initiated by a physician's order.
Custodial Care: Assistance with daily personal needs, as determined by the patient.
Assisted Living Facility Care: Provided in facilities designed for elderly individuals who can no longer manage their daily needs but do not yet require nursing home-level care.
Home Health Care: Services administered in the patient's home, catering to various medical and non-medical needs.
Hospice Care: Covered under long-term care plans, hospice care focuses on alleviating physical and psychological pain associated with end-of-life situations. Counseling services for the patient's relatives are also included, and care can be provided in a facility or at home.
Alzheimer’s Facility Care: Many states mandate coverage for Alzheimer's facilities under long-term care plans. The level of care for Alzheimer's disease and other degenerative conditions is stipulated under the same terms as any other chronic illness. Consequently, nursing homes, assisted living facilities, or at-home services may be classified as Alzheimer's facilities, depending on the insurance policy's language.
In summary, long-term care insurance offers comprehensive coverage, ensuring that individuals have financial support for a range of care services, from skilled nursing to assistance with daily activities, in various settings such as nursing homes, assisted living facilities, and even in the comfort of one's home.
Comprehensive Home Healthcare Services under Long-Term Care Plans
Home healthcare services, integral components of long-term care insurance plans, encompass a wide range of provisions tailored to support individuals in their residences. These services include:
Purchase or Rental of Medical Equipment:
This covers essential medical devices, including emergency alert systems, enhancing the safety and well-being of the patient at home.
Home Modifications:
Ensures accessibility by covering modifications such as wheelchair ramps or adjustments made for restroom accessibility, facilitating a more accommodating living environment.
Adult Daycare Services:
Provides daytime care services at a center for patients living at home, particularly when family members are unavailable during the day.
Caregiver Training:
Offers training to family members to ensure they can provide appropriate care for the patient at home, enhancing the overall quality of care.
Homemaker Companion Services:
Involves assistance with household tasks like cooking, shopping, cleaning, and bill paying by a homemaker companion employed by a state-licensed home healthcare agency.
Prescription Drugs and Lab Services:
Covers essential medications and laboratory services, typically offered in hospitals or nursing homes.
Additional Benefits:
Encompasses various other benefits such as care coordination services, chore services, bed reservation reimbursement, coverage for medical equipment, home-delivered meals, spousal discounts, and survivor benefits.
Eligibility for these benefits is typically determined based on criteria such as deficiencies in performing Activities of Daily Living (ADLs) and cognitive impairment. Long-term care plans offer guaranteed renewability, a 30-day "free look" period, coverage for Alzheimer’s disease, provisions for waiving premiums, and unlimited/lifetime nursing home periods. Additionally, these plans incorporate features like inflation protection and nonforfeiture benefits, emphasizing a holistic approach to long-term care coverage.
Improved Cost Explanation:
Long-Term Care Insurance:
Employees are responsible for covering the costs of long-term care insurance, with premiums structured in five-year increments. The premium rates are age-dependent, with individuals aged 40 to 44 paying approximately one-third to half of what those aged 60 to 64 would pay. Once a coverage is chosen, premiums remain fixed until the employee enters a new age bracket. Premiums are typically payable for life. The insurance policies operate in one of two ways:
Reimbursement Basis: This model reimburses the insured for actual expenses, up to a specified daily limit (e.g., up to $200 per day), with coordination required with Medicare, except when Medicare acts as the secondary payer.
Per-Diem Basis: Benefits are paid irrespective of actual costs, with the daily limit honored even if actual expenses are lower.
Group Business Travel Insurance Benefit:
Business travel accident insurance offers Accidental Death and Dismemberment (AD&D) benefits to employees involved in accidents during business-related travel. For instance, a group of employees flying for a business conference is covered under this policy.
AD&D benefits are extended to groups of ten or more employees traveling for business, typically fully funded by the employer. Companies commonly provide Business Travel Accident (BTA) insurance at no cost to eligible employees, who are automatically covered without enrollment. Benefit structures may be influenced by job classification, annual earnings, a salary multiple, or a standardized flat amount.
A typical benefit schedule may equate to five times the annual base salary, with a maximum amount up to twice this figure, not exceeding $5 million, contingent on the group's size and benefits. BTA insurance disburses a percentage of coverage based on the nature of the loss. Coverage options may encompass 24-hour protection for business purposes only or both business and pleasure. Optional services can be incorporated into this plan.
Enhanced BTA Insurance Benefit Program Details:
The specifics of a standard Business Travel Accident (BTA) insurance benefit program are outlined as follows, providing comprehensive coverage and financial protection for employees. The benefit amount is set at ten times the employee's annual salary, capped at a maximum of $150,000, with an aggregate limit of $3 million. The plan encompasses a range of standard benefits, including:
• Loss of life
• Loss of speech
• Loss of hearing
• Loss of hand, foot, or eye
• Loss of thumb and index finger on either hand
• Paralysis benefits
Additionally, the policy offers the following payout structure:
• 100% of the coverage amount for the accidental loss of life; loss of two limbs; complete loss of eyesight (both eyes); loss of one limb and the sight of one eye; loss of speech and hearing; or complete loss of movement in both upper and lower limbs (quadriplegia).
• 75% of the coverage amount for the accidental loss of movement in both lower limbs (paraplegia).
• 50% of the coverage amount for the accidental loss of one limb; loss of sight in one eye; loss of speech or hearing; or loss of movement in both upper and lower limbs on one side of the body (hemiplegia).
• 25% of the coverage amount for the accidental loss of the thumb and index finger of the same hand.
The full coverage amount is disbursed under the following conditions, ensuring comprehensive protection for employees: [Include specific conditions and circumstances under which the full coverage amount is paid, such as detailed in the policy terms and conditions].
Enhanced Benefit Provisions in BTA Insurance:
This BTA insurance plan goes beyond the ordinary to provide comprehensive coverage, acknowledging various circumstances that may arise. The detailed provisions are as follows:
Extraordinary Commutation:
Benefits are extended if an employee is injured in a covered accident while commuting between home and work, using unconventional transportation during exceptional circumstances like transportation strikes, power failures, major civic breakdowns, and the like.
Personal Deviation (Sojourn):
Benefits cover injuries resulting from accidents worldwide during personal business or travel while on a covered business trip.
Paralysis Benefit:
Compensation is provided for injuries leading to complete and irreversible loss of movement in one or more limbs, including paraplegia and quadriplegia.
Permanent Total Disability:
Benefits are paid if the employee or their spouse becomes permanently disabled within 365 days of the accident.
Accidental Total Disability:
Weekly benefits are disbursed in the event of total disability resulting from a covered accident.
Additional Provisions:
Criminal Acts Coverage:
Benefits are granted if the employee is injured due to a violent crime such as kidnapping, robbery, or hold-up.
Specified Aircraft:
Compensation is provided if an employee is injured while a passenger on an aircraft owned, leased, or operated by the policyholder.
Spouse/Child (Children) on a Business Trip:
Additional benefits are paid if a spouse/child accompanies the employee on a business trip. Spouse coverage is set at $50,000, and each child at $25,000.
Relocation of Spouse/Child (Children):
Coverage is extended for injuries during a relocation trip, with a spouse covered at $50,000 and each child at $25,000.
Rehabilitation Benefit:
If benefits are payable for an injury other than loss of life, expenses for rehabilitative training are covered.
Spouse Education Benefit:
In the event of the death of the employee or their spouse, expenses for occupational training for the surviving spouse are covered.
Child Education Benefit:
Upon the death of the employee or their spouse, this provision covers expenses for each dependent child qualifying as a student.
Coma Benefit:
A portion of benefits is paid if the employee or a family member becomes comatose within a specified time after an injury and remains in a coma for a defined period.
Seatbelt Benefit:
Additional benefits are provided for death caused by injuries sustained in a motor vehicle while wearing a seatbelt.
Daycare Benefit:
In case of the death of the employee or their spouse, the provision covers each dependent child under a certain age enrolled or to be enrolled in a daycare program.
Therapeutic Counseling Benefit:
Occasionally, benefits cover necessary therapeutic counseling expenses.
Enhanced Explanation of Tax Implications for Group Life Insurance:
The tax implications associated with the earlier described risk benefit plans are intricately woven into federal income tax, estate tax, federal gift taxation, and state taxes. The substantial growth of these plans can be attributed to the favorable federal tax treatment they receive. Notably, the tax considerations are different for employer contributions and employee contributions to group life insurance policies.
Employer Contributions:
All contributions made by employers to group life insurance policies are fully tax-deductible under Code Section 162. This deduction is grounded in the recognition that providing such coverage is an ordinary and necessary business expense for the employer. However, adherence to Code Section 264 is essential, as it precludes any deduction if the employer is named as the beneficiary of the plan.
Employee Contributions:
Contrastingly, contributions made by employees are not tax-deductible, given that they are viewed as personal expenses for life insurance. Payroll deductions, as authorized by employees for the policy, are incorporated into the employee's gross income and duly reported in W-2s by employers.
Code Section 79 and Group Term Life Insurance:
A notable exception to the general tax treatment is found in Code Section 79, which offers favorable tax treatment for employer contributions categorized as group term life insurance. To qualify for this treatment, the policy must meet specific criteria:
Excludable Death Benefits: Death benefits must be eligible for exclusion from federal income taxes.
Inclusive Employee Coverage: The plan should extend coverage to all employees, with any deviations based on factors such as age, marital status, and other employment-related considerations.
Employer-Carried Policy: The employer must carry the policy, even if costs are shared with employees.
Master Contract or Group of Individual Policies: The policy must be covered by a master contract or a group of individual policies. This includes scenarios where the employee is not the policyholder, but the employer extends coverage from the master contract to employees, either through negotiated trusteeships or as part of multi-employer welfare arrangements.
Enhanced Explanation of Group Term Life Insurance Tax Implications:
Plan Structure and Supplemental Coverage:
The group term life insurance plan should disallow individual coverage selection. However, flexibility can be introduced through supplemental plans. These supplemental plans empower employees to tailor coverage amounts to their preferences, offering alternative benefit schedules based on their contribution levels.
Employee Count and Participation Criteria:
Coverage must be extended to a minimum of ten full-time employees, including those yet to fulfill the stipulated waiting period. Even non-participating employees, who have opted not to join the plan, are considered participants, provided they aren't obligated to contribute to benefits outside the group term life insurance policy.
Exceptions and Tax Code Guidance:
Certain scenarios exempt Section 79's application. For instance, when group term life insurance is issued to trustees of a qualified pension plan for death benefits, the full amount paid by the employer becomes taxable income for the employee. In such cases, alternative sections of the tax code guide the administration of the plan.
Non-Taxable Employer Contributions:
Employer contributions do not result in taxable compensation in three specific situations:
Disability Loss of Coverage: When an employee loses coverage due to disability.
Charitable Beneficiary: When a qualified charity is designated as the plan beneficiary.
Employer as Beneficiary: If the employer has been named as a plan beneficiary for an entire year.
Retired Employee Coverage:
Retired employee coverage falls under Section 79, treated similarly to active employees. Amounts exceeding $50,000 are considered taxable income for retirees. The initial $50,000 is non-taxable, except for the excess amount minus any employee contributions for comprehensive coverage, which becomes taxable.
Exclusion and Calculation Under Section 79:
Up to $50,000 of employer-provided group term life insurance is excluded from the employee's income, given compliance with Section 79 requirements. This section mandates that group life insurance policies adhere to a formula preventing individual selection. Taxable income, following this outline, is determined using the Uniform Premium Table.
Optimized Explanation of Group Term Life Insurance Taxation:
To exempt the initial $50,000 of group term life insurance policies from taxation, employers should structure coverage as a fixed amount or as a multiple of an employee's earnings. Referring to Table 4.3, any coverage surpassing $50,000 becomes taxable, and these excess costs should be detailed on the employee's W-2 form. Additionally, any value exceeding $2,000 for dependent group term life insurance, covering the spouse or dependents of the employee, must also be reported on the W-2.
Calculation of taxable compensation in this policy involves taking the cost from the table corresponding to the employee's age group, determined by their age at the year's end. This cost is then multiplied by an appropriate thousand-dollar increment above the $50,000 threshold. Monthly costs are subsequently converted into an annual figure for accurate reporting.
All group term life insurance plans undergo nondiscrimination tests, as detailed later in this chapter. Failure to pass these tests renders the $50,000 exclusion unavailable to key employees (as defined in the next section) under the plan. In such cases, the full coverage value minus employee contributions becomes taxable income. The benchmark for taxation is the higher of the actual costs or the costs outlined in Table 4.3, as discussed earlier. This ensures equitable treatment and compliance with nondiscrimination standards.
Improved Explanation of Nondiscrimination Rules:
Nondiscrimination Rules for Qualified Group Term Insurance Plans:
Any group term insurance plan that qualifies under Section 79 is subject to stringent nondiscrimination rules. Failing these essential tests renders the plan inaccessible to key employees, as previously defined. For key employees, the value of full coverage, excluding their contributions, becomes taxable income, determined by the higher of actual costs or Table 4.3 costs.
Definition of Key Employees:
A key employee falls into one of the following categories:
An officer earning over $160,000 annually (Officers defined as the greater of three employees or 10% of all employees in the company.)
A 5% owner of the company, holding 5% or more of its outstanding stock.
An employee owning 1% of the company's outstanding stock, earning over $160,000 annually.
Eligibility Requirements and Non-Discrimination Criteria:
Eligibility requirements are not considered discriminatory under the following conditions:
At least 70% of all employees are eligible to participate in the plan.
At least 85% of all employees are not categorized as key employees.
The IRS determines that employees belong to a nondiscriminatory classification.
Employees with less than three years of service, part-time, and seasonal employees may be excluded from the first 70% eligibility test. The plan achieves nondiscrimination status if benefits, either in type or amount, do not disproportionately favor key employees. Benefits can be based on a uniform percentage of an employee's salary.
Tax Treatment of Life Insurance Proceeds:
Under Code Section 101, life insurance proceeds are not taxable income if distributed as a lump sum upon the death of the employee. If distributed in installments, only the interest earned is considered taxable income for the beneficiary.
Estate Tax Considerations (Code Section 2042):
Proceeds from an employee's contract, even if paid to a beneficiary, become part of the employee's estate for federal tax purposes if the coverage was owned at the time of death. However, no estate taxes apply to amounts paid to the surviving spouse. To mitigate estate taxes, life insurance proceeds are often assigned to another person, typically the named beneficiary, provided it aligns with contract terms and relevant state laws.
The tax implications of supplementary life insurance policies hinge on whether the policy is a distinct contract or an integral part of the basic policy. When structured as a separate policy and meeting the criteria for a Section 79 group life insurance program, the coverage amount from a supplementary policy is aggregated with all other coverage for calculation purposes under Table 4.3. Employee-paid premiums for this supplemental coverage are added to deductions, influencing the calculation of final taxable income. It's noteworthy that not all supplemental plans qualify under these provisions; eligibility is contingent on employee rates aligning with or exceeding Table 4.3.
AD&D (Accidental Death and Dismemberment) plans have a distinct tax treatment. The premiums paid for AD&D plans are classified as health insurance premiums rather than group life insurance premiums. Nevertheless, these costs remain deductible for employers as ordinary and customary business expenses. Dependent life insurance premiums covered by the employer are fully deductible, with employer contributions not incurring tax for employees, provided the benefits remain modest. Notably, death benefits under such programs are exempt from taxation, providing an additional layer of financial security for beneficiaries.
Enhanced Explanation of Tax Implications for Group Disability Programs:
Deductibility of Employer Contributions:
Similar to group life insurance, employer contributions to group disability insurance programs are fully deductible as normal and customary business expenses under Code Section 162, provided the employee's compensation is reasonable.
Tax Implications for Employees (Section 106):
Contributions made for disability insurance under Section 106 usually do not have tax implications for employees. However, the taxation of benefits under a disability or sick-leave plan depends on whether the plan is fully contributory, partially contributory, or noncontributory. Most disability insurance programs fall into the noncontributory category, where the employer bears the full cost, and the benefits are included in the employee's gross income.
Tax Credits for Permanent Disability (IRS Criteria):
For employees who are permanently or totally disabled, the IRS provides tax credits. The IRS utilizes the Social Security Administration's definition of disability, considering activities related to consistent employment but excluding ordinary personal and household maintenance. The ability to manage household activities does not negate a claim for permanent and total disability, though it is a factor considered in the evaluation.
Claiming the credit involves obtaining a physician's statement certifying the disability. Notably, disability income does not include payments from plans not specifically designed for such benefits, such as 401(k) accounts or cash payments for accrued personal or vacation days.
Taxation of Benefits in Partially Contributory Plans:
In partially contributory plans, benefits are taxable based on the proportion of employer premiums compared to total premiums. Social Security taxes apply to all taxable disability benefits for the last month worked by an employee plus the subsequent six months.
Tax Credits for Partially Contributory Plans:
Tax credits for such plans vary:
Maximum Credit:
$750 for a single person
$1,125 for married couples filing jointly
$562.50 for married individuals filing separately
Credit Limitation:
The credit is capped at the received disability benefits.
It is reduced by 7.5% for adjusted gross income, including disability income, exceeding:
$7,500 for single individuals
$10,000 for married couples filing jointly
$5,000 for married individuals filing separately
The credit is further reduced by 15% for tax-free income received as pension, annuity, or disability benefits from governmental programs like Social Security. This reduction is particularly relevant as disability payments are often coordinated with Social Security, impacting the tax credit available to individuals receiving these payments.
Enhanced Explanation of Tax Implications for Disability Insurance Programs:
Employer Contributions and Tax Treatment:
Employers commonly exclude their contributions to disability insurance programs as they are recognized as ordinary and necessary business expenses. However, since benefits paid to employees are treated akin to wages, a withholding tax concern arises. Payments to disabled employees or their beneficiaries are considered taxable wages for six months following the last date of service under the Federal Insurance Contributions Act (FICA) and the Federal Unemployment Tax Act (FUTA) withholding rules.
Tax Responsibility and Withholding:
A critical taxation consideration revolves around determining the entity responsible for withholding FICA and FUTA taxes and remitting payments to the federal government. Typically, employers bear this responsibility. However, in certain scenarios, third-party payers or agents may assume this role based on their liability for losses. The differentiation between third-party payers and agents hinges on who assumes the risk of losses. Independent insurance companies fall under the category of third-party payers and are regarded as employers for taxation purposes since they are accountable for making payments to disabled employees and their dependents. Consequently, these companies are obligated to withhold and remit both FICA and FUTA taxes.
Other Agents and Taxation Responsibility:
Various entities, such as payroll services, accounting firms, or an employer's internal payroll department, may administer disability programs on behalf of an employer. From a technical standpoint, these entities do not assume a risk of loss because their role is strictly administrative. As a result, the employer remains responsible for FICA and FUTA taxes.
Exceptional Cases and Agreements:
An exception exists when an agreement between the employer and an external agency explicitly defines the party responsible for FICA taxes. In such cases, the terms of the agreement dictate the taxation responsibility, offering flexibility in the allocation of tax-related duties between parties involved in administering disability programs.
Enhanced Explanation of Tax Implications for Long-Term Care Insurance:
Employer Deductions and Employee Benefits:
The federal tax code extends favorable treatment to long-term care insurance, allowing employers to deduct both the setup costs of a long-term care plan for their employees and contributions made toward tax-qualified premiums. If an employer covers all or a portion of tax-qualified premiums for an employee, the entire contribution is deductible as a business expense, without age limitations. The contribution made by the employer is entirely excluded from the employee's adjusted gross income (AGI).
Employee Tax Benefits:
Long-term care insurance provides tax benefits to employees as well. Premiums for these benefits are classified as medical expenses and are deductible to the extent that, combined with other unreimbursed medical expenses, they surpass 7.5% of the worker's AGI. If the employer covers only a part of the premium, employees can apply the remainder they pay toward their medical expenses, up to the eligible premium amount, qualifying for a similar deduction.
State-Specific Tax Incentives:
Certain states offer tax incentives to encourage the purchase of LTC insurance. However, taxpayers may need to meet state-specific requirements to qualify for deductions or credits related to this insurance. Tax-qualified LTC premiums are considered a medical expense for itemization purposes, deductible to the extent that they exceed the amount needed to meet the employee's AGI. The deductible portion is limited to eligible LTC insurance premiums, as defined by Internal Revenue Code 213(d), based on the age of the employee.
Individual Taxpayer Benefits:
For individual taxpayers, premiums for tax-qualified long-term care insurance covering themselves, their spouse, or any dependents (such as parents or children) can be treated as a personal medical expense. This provision provides individuals with the flexibility to leverage tax benefits associated with long-term care insurance, supporting the financial aspects of caring for themselves and their family members.
The annual maximum deductible amount for each employee is contingent on their attained age at the conclusion of the current taxable year, as detailed in Tables 4.4, 4.5, 4.6, and 4.7. These maximums are subject to indexing and experience annual increases to accommodate adjustments for inflation.
Employer-paid long-term care benefits remain non-taxable, providing a financial advantage; out-of-pocket expenses incurred for long-term care are deductible; and benefits from a tax-qualified long-term care insurance policy, as defined by the Health Insurance Portability and Accountability Act (HIPAA), are generally exempt from income taxation, with a notable exception: under per-diem contracts, proceeds are excludable up to a daily limit of $300.
HIPAA establishes a framework for favorable tax treatment of qualified long-term care insurance programs, but the insurance contract must meet specific criteria:
The insurance contract should exclusively provide coverage for long-term care services.
Services reimbursable under Medicare are not covered by the contract.
Guaranteed renewability for the contract is a prerequisite.
The contract must lack cash surrender value or any other form of funding that could be borrowed, paid, assigned, or pledged as collateral.
Premium refunds and plan dividends must contribute to reducing premiums or increasing future benefits.
The policy, as part of the contract, must comply with relevant consumer protection legislation, ensuring fair and ethical practices in providing long-term care coverage.
This chapter delves into various other risk benefits plans, covering aspects such as group term life insurance benefits, group dependent life insurance benefits, supplemental life insurance benefits for both employees and dependents, disability benefits, group accidental death and dismemberment plans, long-term care plans, and group travel accident insurance. It explores the accounting, tax, legal, actuarial, and financial dimensions associated with these plans.
Group term life insurance consolidates life coverage for a group of individuals, and tax implications for this type of insurance involve federal income taxes, estate taxes, federal gift taxes, and state taxes. The chapter underscores the growth of these plans due to their overall favorable federal tax treatment.
Similar to group term life insurance, employer contributions to group disability insurance programs are fully deductible as normal and customary business expenses under Code Section 162, contingent on the reasonableness of employee compensation.
The tax implications of supplementary life insurance policies hinge on whether they are written separately or as part of a basic term life insurance policy. Additionally, premiums for accidental death and dismemberment (AD&D) plans are treated as health insurance premiums, deductible by employers as part of regular business expenses.
In the realm of long-term care plans, the federal tax code allows employers to deduct both the setup costs and contributions made toward tax-qualified long-term care insurance premiums as business expenses.
Key Concepts in This Chapter:
Group term life insurance benefits
Group dependent life insurance benefits
Supplemental life insurance benefits for employees and their dependents
Disability benefits
Group accidental death and dismemberment plans
Long-term care plans
Group travel accident insurance
Nondiscrimination rules
Chapter 5: Retirement Plans
Aims and Objectives:
Introduction to Pension Plans: Provide a brief overview of pension plans and their significance in retirement planning.
Types of Pension Plans: Explore the distinctions between defined contribution plans and defined benefit pension plans.
Impact of ERISA: Discuss the influence of the Employee Retirement Income Security Act (ERISA) on pension plans.
Accounting Issues: Examine accounting considerations for both defined contribution plans and defined benefit pension plans.
Pension Benefit Obligations: Clarify the concept of pension benefit obligations.
Pension Plan Assets and Expenses: Explore the management of pension plan assets and associated expenses.
Financial Reporting: Discuss the financial reporting standards and practices for pension plans.
Accounting Recordkeeping: Address the essential accounting recordkeeping requirements for pension plans.
Pension plans play a pivotal role in the economy as the primary tool individuals use to save for retirement, either through employer-sponsored arrangements or personal initiatives. These plans, with substantial financial assets, serve as major sources of investment and equity capital, contributing to the sustainability and growth of the overall economy.
Employee Retirement Income Security Act (ERISA):
The chapter delves into the impact of the Employee Retirement Income Security Act (ERISA), a regulatory framework shaping the landscape of pension plans and safeguarding the interests of plan participants.
Types of Pension Plans:
Distinguish between defined contribution plans and defined benefit pension plans, elucidating their unique characteristics, advantages, and considerations.
Accounting and Financial Aspects:
Explore the accounting intricacies related to pension plans, encompassing pension benefit obligations, assets, expenses, and financial reporting standards. The chapter also delves into the meticulous accounting recordkeeping required for effective pension plan management.
By providing a comprehensive understanding of these crucial aspects, the chapter equips readers with the knowledge needed to navigate the complex terrain of retirement planning and pension management.
Chapter 5: Retirement Plans
Overview:
In this chapter, we explore the critical landscape of retirement plans, shedding light on their conceptual framework, types, regulatory influences, and the intricate financial and fiduciary responsibilities associated with managing substantial pension assets.
Pension Assets Landscape:
As of 2010, pension assets in the United States reached an astounding $6.2 trillion, with defined benefit plans comprising $2.4 trillion and defined contribution plans amounting to $3.8 trillion. These colossal figures underscore the significant role played by corporate pension investment managers, trustees, and retirement plan committees, predominantly composed of organizational leaders. Endowed with fiduciary responsibility, they navigate the complex task of investing these assets to optimize returns, ensuring financial security for employee retirement and fostering talent retention.
Multifaceted Challenges:
Managing pension plans involves grappling with multifaceted challenges encompassing financing, taxes, accounting, legal compliance, and auditing. The chapter explores these issues from diverse perspectives, considering political, societal, union relations, financial sustainability, and personal financial security.
Retirement Crisis Concerns:
An essential introduction delves into the pervasive concerns surrounding the retirement crisis, not only in the United States but also in several other countries. The narrative acknowledges the extensive coverage and discussions in the press regarding this pressing issue.
Insights from a Senate Report:
Highlighting the severity of the situation, a 2012 report from the U.S. Senate Committee on Health Education Labor and Pensions, titled “The Retirement Crisis and a Plan to Solve It,” is referenced. This report provides a comprehensive description of the pension crisis facing the United States, setting the stage for a detailed exploration of solutions and strategies.
This chapter aims to equip readers with a nuanced understanding of the intricacies surrounding retirement plans, enabling them to navigate the evolving landscape of pension management and contribute to addressing the challenges posed by the ongoing retirement crisis.
Chapter 5: Retirement Plans - Addressing the Crisis
The Retirement Income Deficit:
A staggering retirement income deficit of $6 trillion looms, reflecting the alarming gap between what individuals have saved for retirement and the actual amount required. A significant portion of Americans, half to be precise, have accumulated less than $10,000 in retirement savings, setting the stage for a dire situation as aging citizens exit the workforce.
Challenges of Extended Life Expectancy:
Compounded by the rising life expectancy, a byproduct of improved living conditions and advancements in healthcare, the crisis deepens. This places an immense strain on families, communities, and the societal safety net, as retirees grapple with financial inadequacy in their later years.
Breakdown of the Three-Legged Stool:
Many attribute the retirement crisis to the breakdown of the "three-legged stool" approach: personal savings, employer retirement benefit programs, and government-provided Social Security. Dwindling personal savings, the shift from defined benefit to defined contribution plans, and instability in the federal social security structure collectively weaken this foundation. Employees, uncertain about the reliability of employer-sponsored plans, increasingly contribute personally to ensure their financial security.
Importance of Retirement Plans for Employers:
For employers, pension/retirement plans represent a crucial strategic element within the broader benefits portfolio. Employees, in turn, prioritize retirement benefits as the second-most important aspect, following healthcare.
Bureau of Labor Statistics Insights:
The Bureau of Labor Statistics' March 2013 release provides a comprehensive view of retirement plans in the United States, offering valuable insights into the prevalence and significance of these plans.
Implications and Solutions:
This chapter aims to delve into the multifaceted implications of retirement planning, encompassing design, development, and technical aspects such as accounting, finance, legal considerations, and tax-related issues. By understanding these intricacies, employers and employees can collaboratively navigate the evolving landscape of retirement benefits, paving the way for informed decisions and strategic solutions to address the crisis at hand.
Retirement Benefits Landscape:
Disparity in Access:
The landscape of retirement benefits mirrors the trends observed in medical care benefits. In the private sector, a notable 74 percent of full-time workers enjoy access to retirement plans, a stark contrast to the 37 percent of part-time workers who have similar benefits. This discrepancy underscores the challenges faced by part-time employees in securing comprehensive retirement provisions.
Establishment Size Matters:
Access to retirement benefits varies significantly based on the size of the establishment. While 49 percent of workers in small establishments have access to retirement plans, a more substantial 82 percent of workers in medium and large establishments enjoy similar benefits. This suggests that the scale and resources of the employer play a pivotal role in determining the availability of retirement benefits for their workforce.
Defining Access:
It's important to note that a worker is considered to have access to a medical or retirement plan if their employer provides such plans, irrespective of the worker's decision to enroll or actively participate in these plans. The focus is on the availability of employer-provided plans rather than the employees' individual choices to engage with them.
Cost Considerations for Employers:
The relative importance of retirement savings, gauged from the employer's cost perspective, is outlined in Table 5.1. This sheds light on the varying degrees of emphasis placed on retirement benefits by employers, potentially influencing the overall compensation structure within organizations.
Retirement Benefit Landscape: A Shift in Trends
Survey Insights:
A comprehensive survey on employee benefits conducted by the Society of Human Resource Management in 2012 provides valuable insights into the prevailing trends in retirement plans. Of the companies surveyed, a substantial 92% indicated that they offer a defined contribution retirement savings plan. This signifies a predominant shift towards defined contribution plans in the contemporary employment landscape.
Defined Benefit Pension Plans: A Decline:
In contrast, the survey revealed a notable decline in the prevalence of defined benefit pension plans. Only 21% of the surveyed companies reported offering such plans. This decline underscores a broader shift away from traditional pension structures towards more contemporary retirement savings models.
Frozen Defined Benefit Plans: A Restricted Landscape:
Another noteworthy finding from the survey is that 12% of the organizations reported that their defined benefit pension plans were frozen. This indicates that these plans were no longer available to new employees, further substantiating the diminishing popularity of traditional pension plans. The freezing of these plans suggests a strategic reassessment by organizations in light of evolving employee benefit preferences and economic considerations.
These survey findings collectively reflect a dynamic shift in the retirement benefits landscape, with a clear preference for defined contribution plans and a decreasing reliance on traditional defined benefit pension structures.
This survey delved into another facet of defined benefit plans by examining their historical prevalence trends. Between 2008 and 2012, there was a noteworthy shift in the landscape, with defined contribution benefits plans experiencing a rise from 84% to 92%, while the prevalence of defined benefit pension plans declined from 33% to 21%. This chapter undertakes an exploration of the underlying reasons behind these trends, with a primary focus on the financial and accounting perspectives.
The insights provided in this chapter draw from the 11th annual retirement survey conducted by the Transamerica Center for Retirement Studies. This survey specifically delves into the perspectives of employees regarding retirement programs. Notable findings from this study are pertinent to our analysis of the technical dimensions of retirement programs, adding depth to our understanding.
The survey uncovered the following key insights:
Employers across the board, especially in small companies, increasingly recognize the significance of retirement packages for their employees.
There is a prevailing sense of confidence among employers regarding the retirement plan options they provide.
Employees in larger companies appear to be in a more favorable position for retirement compared to their counterparts in smaller companies.
Large companies are more inclined to offer defined benefit pension plans, contributing to the retirement landscape dynamics.
The majority of employers consistently assert that robust retirement benefits hold greater appeal to potential candidates than a higher salary.
Notably, a growing number of employers, particularly in small companies, now acknowledge the importance of retirement plans to their employees, reflecting an upward trend in this awareness.
Pension plans come in two main types, each offering distinct structures and benefits:
Defined Contribution Plans:
These plans commit to a fixed annual contribution to a pension fund, often a percentage of the employee's salary (e.g., 6%).
Employees have the flexibility to choose from a range of investment options, typically involving stocks or fixed-income securities.
Retirement benefits hinge on the fund's size at the time of retirement.
Unlike defined benefit plans, there's no assurance of a specific retirement benefit amount.
Both the employee and employer contribute to an individual account, with the employee managing investment decisions.
Employers may match a percentage of the employee's contributions.
Popular examples include the Traditional 401(k), Safe Harbor 401(k), Simple 401(k), and Automatic Enrollment 401(k).
Other variations encompass the Simple IRA plan, Simplified Employee Pension Plan (SEP), Employee Stock Ownership Plan (ESOP), and Profit-Sharing Plan.
Defined Benefit Plans:
These plans commit to fixed retirement benefits based on a predetermined formula.
The formula typically factors in the employee's years of service, annual compensation (often based on the final year or an average for the last few years), and age.
Employers bear the responsibility of ensuring adequate funds to fulfill the promised benefits.
Defined benefit plans are funded by the employer and guarantee a specific monthly payout upon retirement.
The payout may be a fixed amount per month (e.g., $1,000) or calculated using a formula based on factors like average income for the employee's last five years multiplied by total years of service (e.g., 1% of the average income for each year of service).
In summary, defined contribution plans offer flexibility and are dependent on contributions and investment performance, while defined benefit plans provide a predetermined, employer-funded retirement benefit based on a specified formula.
Employers bear the responsibility of ensuring ample financial resources to fulfill agreed-upon benefits for their employees. One prevalent mechanism for this is the defined benefit plan, where the employer commits to disbursing a specific monthly sum post-retirement. This sum can be a fixed amount, like $1,000 per month, or determined through a formula that factors in elements like a percentage of the employee's average income over the last five employment years multiplied by the total years of service.
It's crucial to acknowledge a significant shift in the pension landscape, particularly in the private sector. Over the last few decades, employers have increasingly moved away from traditional defined benefit plans, opting instead for defined contribution plans, exemplified by the popular 401(k). In 1979, 64% of employees with retirement plans relied solely on defined benefit pensions. Fast forward to 2005, and 63% exclusively utilized a 401(k). Regulatory and financial pressures have been instrumental in steering this decline in defined benefit plans, reflecting a clear and consistent trend of diminished importance attributed to these plans by employees.
Studies indicate a noticeable decline in the significance employees place on defined benefit plans. Surveys reveal that a third of employers no longer consider them important, marking a notable increase from a quarter in previous years. Since 2006, there has been a continuous shift from defined benefit to defined contribution plans.
Defined benefit plans are undergoing a phase-out, with changes typically taking a negative turn, such as reductions, freezes, or outright termination. Despite these trends, many public employers still uphold defined benefit plans, often complementing them with defined contribution strategies. This nuanced landscape underscores the evolving nature of retirement benefits in the contemporary employment arena.
The Employee Retirement Income Security Act
The impact of the Employee Retirement Income Security Act (ERISA) on the framework of retirement plans is pivotal. Enacted in 1974, ERISA safeguards the assets of millions of Americans, ensuring that funds invested in retirement plans throughout employees' careers remain accessible post-transition. This federal law establishes minimum standards for retirement plans in private industries, dictating crucial aspects such as the eligibility criteria for employee participation, the timeline for acquiring nonforfeitable interest in plan benefits, and the implications for benefits during an employee's absence from their job. ERISA also delineates the rights of spouses to a portion of an employee's benefits in the event of the employee's death. The majority of ERISA provisions became effective for plan years starting on or after January 1, 1975.
It's important to note that ERISA doesn't mandate employers to establish a retirement plan; rather, it sets forth the minimum standards a plan must meet if established. While ERISA doesn't prescribe specific employee compensation, it does mandate the provision of comprehensive information about retirement plan features and funding to employees. Some information must be regularly and automatically provided, with certain aspects available at no cost and others incurring charges.
ERISA establishes minimum standards for various facets, including participation, vesting, benefit accrual, and funding. It imposes funding rules, compelling plan sponsors to ensure adequate financial support for the plan.
A crucial aspect of ERISA is the accountability it demands from plan fiduciaries. Fiduciaries, defined as individuals exercising discretionary authority or control over a plan's management or assets, bear the responsibility of adhering to established principles of conduct. Failure to do so may render fiduciaries liable for restoring plan losses. ERISA also empowers plan participants with the right to legal recourse, allowing them to sue for benefits and breaches of fiduciary duty. This comprehensive framework underscores ERISA's role in safeguarding the interests and financial security of employees enrolled in retirement plans.
The Retirement Equity Act of 1984
On August 23, 1984, Congress enacted the Retirement Equity Act (REA), a landmark legislation that brought about significant amendments to both the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code. The REA introduced a range of pivotal rules with the following key provisions:
Reduction in Minimum Age Requirement: The REA lowered the minimum age for participation in pension plans, expanding access for individuals seeking to engage in retirement programs.
Extension of Vesting Years: The legislation increased the years of service considered for vesting purposes, enhancing the rights of employees in securing their entitled benefits over an extended service period.
Revised Break-in-Service Rules: The REA liberalized the break-in-service rules for vesting purposes, providing greater flexibility and fairness in recognizing continuous service.
Inclusion of Maternity and Paternity Leave: Plans were barred from counting maternity and paternity leave as a break in service for both participation and vesting considerations, acknowledging the importance of family-related leaves.
Mandatory Survivor Benefits: Qualified pension plans were mandated to offer automatic survivor benefits, allowing the waiver of such benefits only with the explicit consent of the employee and their spouse.
Compliance with Domestic Relations Court Orders: The REA clarified that pension plans could adhere to specific domestic relations court orders, enabling them to make payments to an employee's former spouse (or an alternate payee) without violating ERISA's restrictions against the assignment or alienation of benefits.
Expanded Protection of Accrued Benefits: The legislation broadened the definition of accrued benefits safeguarded against reduction, fortifying the security of employees' accumulated retirement assets.
Additionally, the REA introduced minimum participation standards aimed at facilitating swift involvement of eligible employees in retirement plans, curbing age-based exclusions from policy coverage, and safeguarding rehired employees from prolonged periods of nonparticipation resulting from short interruptions.
Moreover, the REA set the minimum age for mandatory participation at 21 years, requiring one full year of credited service. This provision aimed to streamline and enhance the inclusivity of retirement plan eligibility, ensuring a more comprehensive and equitable approach to employee participation.
The calculation of credited service plays a crucial role in determining various aspects related to employee benefits within a qualified retirement plan. Specifically, it is instrumental in assessing:
Participation Eligibility: Credited service is a key factor in determining whether an employee meets the eligibility criteria to participate in a qualified benefits plan.
Vesting Status: It is pivotal in evaluating the vested (nonforfeitable) portion of an employee's benefits, ensuring that accrued benefits are protected and accessible.
Accrued Benefits: Credited service is utilized to compute the benefits accrued by a plan participant over the course of their service.
For the purposes of participation eligibility and vesting, a year of service is defined as the completion of 1,000 or more hours of service during a specific period.
Credited Service
The vested rights of an employee are contingent upon the source of contributions:
Employee Contributions: Rights stemming from an employee's own contributions under a qualified retirement plan must be vested at all times.
Employer Contributions: Benefits attributable to employer contributions must be fully vested when the employee reaches normal retirement age. The acquisition of vested interest in these benefits before normal retirement age follows specific alternative vesting schedules:
10-Year (Cliff-Vesting) Rule: Requires 100% vesting of an employee's accrued benefits, derived from employer contributions, after ten years of service.
5- to 15-Year Graded Vesting Schedule: Mandates that after completing five years of service, the employee earns at least 25% vested interest in the employer's contributions. Vesting increases by 5% each year for the subsequent five years and an additional 10% each year for the subsequent five years, resulting in full vesting within 15 years.
Rule of 45: If an employee has five or more years of service, they must acquire a minimum of 50% vested interest in the accrued benefit derived from employer contributions when the sum of age and service equals or exceeds 45. Additional vesting of 10% occurs for each subsequent year until full vesting is achieved. After ten years of service, benefits must be vested by 50%, irrespective of age, with an additional 10% of vesting for each subsequent year. This comprehensive framework ensures a gradual and equitable vesting progression for employees in alignment with their years of service and age.
Pension Benefit Guaranty Corporation
ERISA, the federal legislation that oversees employee benefit plans, establishes a safety net for participants through the creation of the Pension Benefit Guarantee Corporation (PBGC). Instituted in 1974, the PBGC serves as a safeguard for pension benefits within the realm of private-sector defined benefit plans—those plans that traditionally provide a predetermined monthly payout upon an employee's retirement.
In the event of a defined benefit plan termination lacking adequate funding to cover all stipulated benefits, the PBGC steps in with its insurance program. This program bridges the financial gap, compensating individuals up to the legally defined limits. Consequently, most recipients receive the entirety of the benefits they would have accrued before the plan's termination.
The PBGC's financial foundation is multifaceted. It draws from insurance premiums contributed by companies whose plans fall under its protective umbrella, assets of pension plans assumed by the PBGC as a trustee, and recoveries obtained from companies previously responsible for the benefits plans. Notably, the PBGC sustains itself without reliance on taxpayer funding.
An interesting facet of the PBGC's operations lies in its ability to insure plans, even if an employer neglects to fulfill the requisite premium payments. Annual premiums are a key component of this financial structure, with rates determined by factors such as plan type and funding status.
For the year 2014, single-employer plans are subject to a per-participant flat premium rate of $49, a slight increase from the previous year. The variable-rate premium for these plans, dependent on the level of unfunded vested benefits (UVBs), is set at $14 per $1,000 of UVBs—a notable rise from the 2013 rate. This increase is attributed to indexing and a scheduled adjustment. Importantly, the variable-rate premium is capped at $412 times the number of participants.
Conversely, multiemployer plans do not bear the burden of a variable-rate premium. Instead, they adhere to a flat premium rate of $12 per participant, unchanged from the previous year. The intricacies of premium calculations, coupled with the PBGC's role in safeguarding pension benefits, underscore its significance within the framework of ERISA.
The PBGC functions as a governmental insurance entity, with qualified plans remitting premiums for each participant, as detailed in the preceding paragraph. Primarily serving as a last-resort payer for retirement plans, the PBGC steps in when defaults occur due to bankruptcy. Its role mirrors that of the Federal Deposit Insurance Corporation (FDIC) in the banking sector.
The maximum pension benefit guaranteed by the PBGC, mandated by law and subject to annual adjustments, is akin to a safety net for retirees. The PBGC's insurance program for single-employer plans, as reflected in the maximum monthly guarantee tables, illustrates this. For instance, in 2011, individuals retiring at 65 could receive up to $4,653.41 per month, totaling $55,840.92 annually. Actuarial adjustments apply for those retiring at different ages, with lower maximum guarantees for early retirees and higher ones for those retiring later. Notably, benefits adopted within five years before a plan's termination and those not payable throughout a retiree's lifetime do not receive full PBGC guarantees.
In the realm of multi-employer plans, the PBGC's guarantee is based on years of service. For plans concluding after December 21, 2000, it covers 100% of the first $11 monthly payment per year of service and 75% of the subsequent $33. For plans terminating between 1980 and December 21, 2000, the maximum guarantee encompasses 100% of the initial $5 in the monthly benefit accrual rate and 75% of the subsequent $15.
During the fiscal year of 2010, the PBGC disbursed a total of $5.6 billion in benefits to employees affected by failed pension plans. In that period, 147 pension plans faltered, resulting in a 4.5% increase in the PBGC's deficit to a total of $23 billion. The PBGC faces obligations amounting to $102.5 billion, while possessing $79.5 billion in assets. These financial dynamics underscore the critical role played by the PBGC in mitigating the impact of pension plan failures on retirees.
The Nature of Pension Plans
When meticulously crafted in adherence to the stringent regulations outlined earlier, employers stand to gain tax advantages by sponsoring a benefit plan classified as a qualified plan. These plans offer the company an immediate tax deduction for its contributions, subject to certain limits. Importantly, employees do not incur taxes at the time of the employer's contributions; instead, taxation occurs when retirement benefits are disbursed, and the earnings within pension funds grow on a tax-free basis.
For a pension plan to secure the coveted special tax treatment, it must satisfy distinct criteria:
Broad Coverage: The plan must extend to at least 70% of the company's workforce, ensuring a comprehensive reach among employees.
Non-discrimination: There should be no preferential treatment towards highly compensated employees, ensuring fairness and equality in benefit distribution.
Pre-Retirement Funding: An irrevocable trust fund must be established and funded before an employee's retirement, guaranteeing financial preparedness for future benefit payouts.
Vesting Period: The plan must specify a vesting period, after which employees gain a non-forfeitable right to their accrued benefits, promoting long-term commitment and loyalty.
Compliance with Restrictions: The plan must adhere to specific regulations governing the timing and amounts of both contributions and benefits, ensuring consistency with legal guidelines.
In essence, meeting these stringent requirements not only secures the tax advantages for the employer but also ensures that the benefit plan operates in a fair, transparent, and financially responsible manner, benefiting both the company and its employees.
Plan Accounting
Defined Contribution Plans
In a defined contribution plan, both employer and employee contributions are predetermined through a contractual agreement. The employer specifies a percentage of the employee's base salary for contribution, typically up to a specified limit, constituting matching contributions. Should the employee choose to contribute a certain percentage of their salary, the employer matches these contributions on a dollar-for-dollar basis, typically up to a predetermined percentage limit, commonly set between 4% to 6%.
It's important to note that there is no binding commitment on the part of the employer to maintain continuous contributions; changes in company conditions may prompt a reduction or elimination of the employer's contribution percentage. However, eliminating the matching contribution in a defined contribution or 401(k) plan could make the company less competitive compared to its industry peers.
Conversely, employees have the flexibility to determine the percentage of their salary they wish to contribute to the plan, up to the annual limit established and updated by the IRS each year, factoring in inflation. For example, in 2013, employees were allowed to contribute up to $17,500 as an elective deferral to their employer's 401(k) plan. Individuals aged 50 or older could make an additional catch-up contribution of up to $5,500 to this limit.
Table 5.2 provides a comprehensive list of statutory limits set by the IRS for 401(k) plans in various years, offering a clear reference for plan participants and administrators.
Table 5.2:
This annual limit is applicable to the total sum of contributions across all 401(k) accounts held by an employee for the respective year. In cases where an employee holds multiple jobs concurrently or transitions between jobs within the year, it becomes imperative for the individual to meticulously monitor their 401(k) contributions. This vigilance is necessary to prevent inadvertently surpassing the established limit.
General Distribution Rules for Defined Contribution (401(k)) Plans
Distributions of elective deferrals from a 401(k) plan are contingent on specific triggering events, including:
The employee's death, disability, or receipt of severance from employment.
Termination of the plan without the establishment of a successor plan by the employer.
The employee reaching the age of 59.5 or experiencing a financial hardship.
The nature of these distributions, whether nonperiodic (such as lump-sum payments) or periodic (such as annuities or installments), is subject to the terms outlined in the plan.
Under certain circumstances, the plan administrator may need the employee's consent before making a distribution, especially if the account balance exceeds $5,000. Additionally, depending on the 401(k) plan's provisions, spousal consent may be required for certain types of distributions. It's essential to note that rollovers from other plans might not count toward the $5,000 limit as specified by the plan.
In cases where a single distribution surpasses $1,000 and the employee (or designated beneficiary) doesn't opt for direct receipt or rollover, the plan administrator is mandated to transfer the distribution to an individual retirement plan held by a designated trustee or issuer. Written notification must be provided to the employee or beneficiary, informing them of this potential transfer.
It's important to recognize that distributions from 401(k) plans are typically taxable unless they are rolled over. For individuals born before 1936 receiving a lump-sum distribution, optional methods for calculating taxes on the distribution may be available, providing additional flexibility in managing tax implications.
A 401(k) plan is obligated to stipulate that an employee will either receive the complete interest or benefits from the plan by the required beginning date or commence receiving regular distributions from that date onward. These distributions should be calculated to disburse the entire interest either over the employee's life expectancy, the joint life expectancy of the employee and the designated beneficiary, or a shorter designated period.
It's crucial to note that these mandatory rules apply on an individual basis to each qualified plan. Compliance with the requirements for one plan cannot be achieved by utilizing distributions from another. The plan's documentation must explicitly state that these rules take precedence over any conflicting distribution options previously presented.
In cases where the account balance is slated for distribution, the plan administrator is tasked with determining the minimum amount required to be distributed to the employee annually. The required beginning date, falling on April 1 of the first year after the later of the following events, marks the point at which these distributions must commence.
Distribution rules for 401(k) plans hinge on specific events, notably:
The calendar year in which the employee turns 70.5 years old.
The calendar year in which the employee officially retires.
A plan has the authority to mandate distributions by April 1 of the year following an employee reaching 70.5, even if retirement has not yet occurred.
Post the initial year of distribution, treated as the starting year, subsequent mandatory distributions must occur annually by December 31. If no distribution is made in the starting year, the subsequent year necessitates two distributions—one by April 1 and another by December 31.
In instances of hardship, a 401(k) plan may allow for hardship distributions due to immediate and substantial financial needs. These distributions are typically limited to the employee's elective deferrals and may include certain employer-matching and discretionary contributions if permitted by the plan. Notably, hardship distributions are non-rollable and cannot be transferred to another plan or an Individual Retirement Account (IRA).
For a distribution to qualify as a hardship distribution, it must be explicitly made due to hardship. In this context, hardship distributions are defined as those made to address an immediate and substantial financial need of the employee, essential to meet that need. The determination of both the existence of the financial need and the required amount must adhere to the standards established within the plan.
A distribution authorized on the grounds of hardship must adhere to the policy's defined parameters. This distributable amount is computed as the total elective deferrals up to the distribution date, with reductions made for any prior distributions of elective contributions.
Determining whether an employee faces an immediate and substantial financial need involves a comprehensive assessment of all relevant facts and circumstances. Notably, a financial need may be deemed immediate and substantial even if it was foreseeable or voluntarily incurred by the employee. A distribution is categorized as addressing an immediate and substantial financial need if utilized for the following purposes:
Covering medical care expenses incurred by the employee, the employee’s spouse, or dependents, or expenses essential for these individuals to access medical care.
Financing the acquisition of a principal residence for the employee, excluding mortgage payments.
Settling tuition, related educational fees, and room-and-board expenses for the next 12 months of postsecondary education for the employee, the employee’s spouse, children, or other dependents.
Making payments to prevent the employee's eviction from their principal residence or foreclosure on the mortgage for that residence.
Covering funeral expenses.
Addressing specific expenses associated with repairing damage to the employee’s principal residence.
A distribution, deemed necessary to alleviate an immediate and substantial financial need for an employee, is subject to stringent criteria. This determination, generally informed by all pertinent facts and circumstances, mandates that the distribution amount must not exceed what is required to address the financial need. Additionally, the need must be such that it cannot be reasonably satisfied from other resources available to the employee.
In evaluating available resources, the employee's assets encompass those of their spouse and minor children that are reasonably accessible to the employee. Notably, properties like a vacation home jointly owned by the employee and their spouse are typically regarded as resources of the employee. The immediate and substantial financial need may encompass anticipated federal, state, or local income taxes or penalties resulting from the distribution.
The inability to relieve the financial need through other reasonably available resources may be assumed, unless the employer possesses specific knowledge to the contrary. This includes situations where the need cannot reasonably be relieved through reimbursement, compensation by insurance, liquidation of assets, cessation of contributions under the plan, other distributions or nontaxable loans from plans maintained by the employer or any other employer, or borrowing from commercial sources on reasonable terms sufficient to meet the need.
Importantly, a need cannot be considered relieved if the action taken would increase the need. For example, a plan loan would not reasonably address the need for funds to purchase a principal residence if it disqualifies the employee from obtaining other necessary funding.
A distribution is deemed necessary to satisfy an immediate and substantial financial need if the following conditions are met:
The distribution does not exceed the employee's financial need.
The employee has accessed all available distributions, excluding hardship distributions, and all nontaxable loans under all plans maintained by the employer.
The employee is prohibited, as per the plan terms or a legally enforceable agreement, from making contributions and employee contributions to the plan and all other plans maintained by the employer for a minimum of six months following the receipt of the hardship distribution.
Rollovers from a 401(k) plan involve the tax-efficient transfer of cash or other assets from one qualified retirement plan to another or to a traditional IRA within a 60-day window. While this transaction is not subject to taxation, it is a reportable event on Form 1099-R, Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, for federal tax reporting purposes. Generally, most distributions are eligible for rollovers, with certain exceptions, including:
Series of payments based on life expectancy or spanning ten years or more.
Required minimum distributions.
Corrective distributions.
Hardship distributions.
Dividends on employer securities.
Any portion of the distribution not rolled over is treated as taxable income for the employee. It's essential to complete the rollover within 60 days of receiving the distribution, and a taxable distribution is subject to a mandatory 20% withholding, even if the intention is to roll it over later. If the employee chooses a direct transfer to another eligible plan or IRA, no taxes are withheld.
In the case of early distributions before the employee turns 59.5 years old, a 10% additional tax on the distribution may apply. However, certain exceptions exist, such as:
Distributions to a beneficiary or the estate of the employee upon their death.
Distributions due to a qualifying disability.
Distributions as part of a series of substantially equal periodic payments, initiated after a separation from service, and made at least annually for the life or life expectancies of the employee and their designated beneficiary. Payments under this exception must continue for at least five years or until the employee reaches age 59.5, whichever is longer, except in cases of death or disability.
Exceptions to the 10% additional tax on early distributions from a 401(k) plan include:
If the distribution is made to an employee after separation from service, provided the separation occurred during or after the calendar year in which the employee reached the age of 55.
If the distribution is made to an alternate payee under a qualified domestic relations order.
If the distribution is made to an employee for medical care, up to the amount allowable as a medical expense deduction, irrespective of whether the employee itemizes deductions.
If the distribution is timely made to reduce excess contributions.
If the distribution is timely made to reduce excess employee or matching employer contributions.
If the distribution is timely made to reduce excess elective deferrals.
If the distribution is made because of an IRS levy on the plan.
If the distribution is made on account of certain disasters for which IRS relief has been granted.
These exceptions provide flexibility and relief under specific circumstances, acknowledging the diverse situations that may warrant early distributions without incurring the additional 10% tax penalty.
Loans from 401(k) Plans
Some 401(k) plans offer employees the option to borrow funds from the plan, contingent upon explicit provisions outlined in the plan's documentation. The tax implications of such loans are contingent upon adherence to specified criteria, as detailed below.
In general, if permitted by the plan, employees can borrow up to 50% of the vested account balance, with a maximum limit of $50,000. The repayment period is typically five years, unless the loan is utilized for the acquisition of a primary residence. Repayments must occur in substantially level installments, at least quarterly, over the loan's duration.
In cases where there is an existing loan approaching the $50,000 limit, a mandatory reduction is required within a one-year timeframe, concluding the day preceding the new loan. The reduction amount equals the highest outstanding loan balance within that period minus the outstanding balance on the new loan's date. It's essential to note that certain employee loans may be categorized as taxable distributions.
Notably, in September 2010, the Financial Accounting Standards Board (FASB) introduced Accounting Standards Update (ASU) 2010-25, altering the reporting framework for employee loans. Previously classified as investments, employee loans posed challenges as they were obligated to be reported at fair value, a metric reliant on market dynamics. Given the absence of an open market for employee loans within a 401(k) plan, administrators were compelled to estimate fair value, incorporating market interest rates, credit risks, and other assumptions. This adjustment aimed to align reporting practices with FASB ASC 850, which mandates fair value reporting based on open market transactions.
By transitioning the reporting classification of employee loans from investments to receivables, the reporting methodology now revolves around the outstanding principal amounts, coupled with accrued unpaid interest. Unlike other receivables, there is no need for considerations regarding valuation reserves. While, in practical terms, this shift is unlikely to alter the reported value of employee loans on financial statements due to the standard assumption of "fair value approximated amortized cost," it markedly streamlines the financial statement preparation process.
In essence, this adjustment minimizes the intricacies involved for the individual responsible for preparing financial statements. The simplified approach underscores the efficiency gained by removing additional steps, offering a more straightforward path to ensuring the accuracy of the reported amounts.
Accounting for Defined Benefits Plans
Defined benefit plans exhibit three key characteristics:
Commitment to Specific Benefits: Employers undertake a commitment to deliver precise retirement benefits to employees. This assurance signifies a pledged obligation that, upon reaching retirement, employees will receive predetermined retirement payments.
Formula-Based Calculation: The commitment to retirement benefits is underpinned by a specific formula for calculating retirement income. Variables such as years of service, compensation levels, and the employee's age intricately contribute to determining the retirement benefits.
Employer Assumes Fund Performance Risks: The employer bears the entirety of the risks associated with the plan's fund performance. At the contract's inception, the company must define the contributions into the plan, accounting for the time value of money. Strategic funding approaches are imperative to ensure ample funds are accessible to honor the agreed-upon benefits when they become due.
Funds earmarked for a defined benefit plan are allocated to a trust, designating participants as beneficiaries. Post-retirement, individuals receive their entitled benefits from this trust. The primary purpose of the trust is to safeguard and judiciously invest the funds, ensuring their adequacy to meet the intended obligations. While the pension trust operates independently of the employer, the trust assets technically belong to the employer. Consequently, the employer bears the responsibility of fulfilling the plan-defined benefits, irrespective of the trust's financial health when these benefits mature.
In essence, the employer is obligated to rectify any shortfalls in the trust, if necessary. Conversely, should the trust exhibit an excess of funds, the employer has the latitude to reclaim these surplus funds, either by reducing future contributions or redirecting the excess for other purposes. The defined benefit plan places the onus of responsibility squarely on the employer, encapsulating the risks inherent in this pension arrangement.
These characteristics introduce a myriad of complexities spanning accounting, taxation, financial, and compliance domains. Let's delve into the nuanced technical aspects and perspectives inherent in these dimensions.
The annual benefit pension formula encapsulates a spectrum of variables. An average employee's salary, whether derived from the final year, a career average, or the final five- or ten-year period, becomes a pivotal component. Credited service years, combined with a predetermined percentage (e.g., 1.0%, 1.5%, or 2.5%), further shape the formula. Additional nuanced factors, such as mortality estimates or the anticipated number of retirement years contingent on the employee's life expectancy, can further refine this intricate calculation.
For instance, a pension formula might articulate annual retirement benefits through the expression:
(Years of service)
×
(Final year’s salary)
×
2.0%
(Years of service)×(Final year’s salary)×2.0%
Consider an illustrative scenario where an employee retires after 35 years of service, culminating in a final salary of $160,000. The computation unfolds as follows:
35 \times 160,000 \times 2.0\% = $112,000
Critical components of this specific formula warrant closer examination, notably the percentage factor and the final year's salary. In the subsequent discussion, we will dissect and elucidate these pivotal elements in finer detail.
The Income-Replacement Ratio
The computation of these benefits initiates with an established income-replacement ratio, representing the percentage of pre-retirement income that will be substituted post-retirement. This ratio is rooted in the notion that employees require a portion of their pre-retirement income to uphold their accustomed standard of living. Logically, this percentage is anticipated to be less than 100%, as certain expenses—such as work-related costs, commuting, child-rearing, and additional family-related expenditures—are eliminated in retirement. Typically, this determination rests within the domain of policy decisions, with unionized organizations involving bargaining negotiations in the process.
Illustratively, the formula for calculating retirement benefits, as demonstrated in the preceding example, is expressed as follows:
Final year average salary
×
Years of credited service
=
The retirement benefit formula amount
Final year average salary×Years of credited service=The retirement benefit formula amount
For instance, an employee with 35 years of credited service and a final year's salary of $160,000 would receive an annual retirement amount of $112,000, resulting in an income replacement ratio of 70%, which is deemed acceptable.
It's noteworthy that, influenced by union negotiations, the income-replacement percentage may undergo distortions, labeled as a retirement factor or age factor by some organizations. Despite nomenclature differences, the conceptual essence of this factor in the defined benefit pension formula aligns with the proposed concept—an income replacement percentage enabling retirees to uphold a standard of living akin to their working years.
The significance of an adequate income-replacement ratio is underscored in a study titled "Income Replacement Ratios in the Health Retirement Study," presented in a 2012 paper for the Social Security Bulletin. This research highlights the imperative nature of determining retirement income levels relative to pre-retirement income. Inadequate incomes from sources like Social Security, private pensions, and personal savings may pose challenges for retirees in maintaining their pre-retirement lifestyle. Hence, establishing a robust link between retirement income and pre-retirement income becomes pivotal in ensuring financial stability during retirement.
The income-replacement ratio, delineating retirement income as a percentage of pre-retirement earnings, has evolved into a pivotal metric for financial planners and economists gauging the sufficiency of retirement income. The precision of these ratios and the components encompassed within them remain subjects of fervent debate. Notably, individuals with lower incomes allocate a greater proportion of their earnings to essential expenditures such as food, housing, clothing, transportation, and medical care. This prompts the crucial inquiry: What constitutes an adequate income-replacement ratio?
Diverse perspectives exist regarding the requisite magnitude of a replacement ratio to afford retirees a proper standard of living. While opinions differ, a consensus emerges: the majority concur that sustaining an adequate lifestyle in retirement generally necessitates less than the entirety of one's pre-retirement income. The previously cited study contributes valuable insights by furnishing data on replacement targets for distinct demographic groups, as detailed in Table 5.3. This empirical evidence serves as a foundation for understanding the nuanced dynamics of income-replacement ratios across various segments of the population.
Table 5.3:
Note: Ratios are based on CPI-U 2007 dollars.
Table 5.3: Replacement Ratios by Percentile and Year in Retirement – Four Measures of Retirement Income
In the computation of retirement benefits, the third pivotal factor is the compensation component within the equation. The determination of pay involves two critical considerations: the duration of years taken into account and the elements encompassed in the definition of pay. Pay definitions may encompass the following:
Career average pay
Average pay from the last five years before retirement
Pay for the final year preceding retirement
Contemporary trends indicate a departure from final-year pay plans, with an inclination toward career-average pay plans. Across all defined benefit plans, base pay is universally incorporated, with 60% including overtime and 65% factoring in bonuses. Notably, commissions find inclusion with less frequency in these calculations.
Recent trends indicate a shift away from final-year pay plans towards career-average pay plans in the realm of defined benefit pension plans. While all such plans encompass base pay, overtime is included in 60%, and bonuses in 65% of cases, with commissions being less commonly factored in.
It's crucial to note that in final-average pay systems, there's a potential for artificially inflating the final average, leading to a retirement income surpassing pre-retirement earnings. This can be achieved by incorporating overtime pay, vacation pay, expense reimbursements, and other elements into the calculation, resulting in retirees receiving higher income levels for not actively working.
Moreover, the accumulation of sufficient funds to fulfill the predetermined benefits involves numerous assumptions and uncertainties. Defined benefits, being contractual promises to retiring employees, hinge on assumptions regarding the rate of return on plan assets, employee turnover, retirement age, inflation rates, salary-increase trends, and interest rates.
The intricate interplay of these unknown factors, essential assumptions, complex calculations, and the utilization of a somewhat arbitrary defined benefit formula contribute to the opaqueness of such plans, rendering them complicated, uncertain, and financially burdensome—akin to a "black box."
Structurally, defined benefit pension plans grapple with issues due to the reliance on assumptions, necessitating continuous adjustments based on evolving financial conditions. Additionally, meeting investment targets for pension funds proves challenging, resulting in an increase in pension liabilities that pension assets struggle to match. These and other factors have led to a decline in the prevalence of defined benefit pension plans, particularly in the private sector. Despite this decline, a comprehensive examination of the financial and accounting aspects of such plans remains essential for those still involved in them.
The intricate tasks of calculating expenses, obligations, and liabilities, as well as formulating the framework for retirement benefits, fall under the purview of an actuary. An actuary is a certified professional well-versed in a specialized branch of mathematics and statistics. Renowned for their expertise in quantifying contingent risks, actuaries play a crucial role in advising management and other stakeholders, offering insights to help comprehend and navigate the risks and responsibilities inherent in various corporate endeavors.
In addition to their broader expertise, actuaries often serve as architects of retirement systems. Their primary focus lies in the design and administration of pension plans. In the context of defined benefit retirement plans, actuaries shoulder the responsibility of estimating the cost of providing benefits in alignment with the plan’s rules and regulations. They also provide guidance on the diverse methods available to finance these liabilities. While benefits are typically financed on a pay-as-you-go basis, actuarial projections assume a pivotal role in the decision-making process. This is because the commitment to a specific level of benefits implies a future obligation that is, to a large extent, unavoidable. While actuaries cannot predict the future with certainty, they excel at modeling plausible scenarios based on reasonable assumptions, thereby illuminating the challenges inherent in retirement planning.
The inevitability of future obligations does not necessarily translate to the foreseeability of the liabilities tied to these commitments. Such liabilities often hinge on economic factors like wage or price inflations and the unique circumstances of individual beneficiaries. These individual circumstances encompass factors such as an employee's tenure in the workforce, personal salary level, potential contingent events leading to workforce departure, life expectancy, familial considerations, and more. Actuarial models come into play to estimate the collective impact of these factors, not on an individual basis, but rather by employing various assumptions about the likelihood of specific contingencies and distributions of relevant factors. To streamline these calculations, average values may be employed, representing either a best estimate or an estimate with an appropriate margin, tailored to the specific purpose of the estimate.
Operating in a challenging milieu, actuaries are tasked with crafting accounting estimates of liabilities and expenses, projecting future cash payments. This forecasting endeavor is fraught with risks, particularly the peril of the obligated amount in a pension surpassing previously calculated sums. In a defined benefit plan, where a fixed, predetermined formula is employed, any escalation in the obligated amount falls squarely on the shoulders of the employer.
The dynamic economic environment, coupled with the volatility in financial markets over the years, has induced fluctuations in pension asset balances. The performance of pension investments has often fallen short of initial expectations. Employers' financial constraints have impeded efforts to rectify deficiencies in later funds, resulting in shareholders grappling with substantial unfunded pension liabilities that erode balance sheets.
Moreover, the confluence of falling interest rates and bear markets has precipitated a pension crisis. Numerous companies find themselves with severely underfunded plans, leading some to file for bankruptcy, such as the case of American Airlines (AMR), citing an inability to meet pension obligations. In response to such challenges, the Financial Accounting Standards Board (FASB) intervened, introducing a new standard in 2006 (SFAS 158) to address issues with pension accounting. Later in the chapter, the FASB standards pertaining to defined benefit pension plans are expounded upon.
As elucidated earlier, a defined benefit plan precisely outlines the retirement benefits an employee will receive. The employer commits to these specific benefits, with the trust accumulating assets, and the employer serving as the trust beneficiary on behalf of the employee. This implies that the employer bears the investment risks. Throughout the plan's existence, the employer bears the responsibility for disbursing the defined benefits, irrespective of the trust's financial state. Retiree benefits remain fixed, and any shortfall in trust assets must be replenished by the employer. Conversely, the employer has the ability to reclaim any excess accumulated in the trust.
At the outset, the employer faces the critical task of determining the initial contribution required to fulfill the commitments of pension benefits due at retirement. The absence of sufficient contributions puts the employer at risk, a liability often surrounded by controversy due to its reliance on measurements and recognition tied to unknown future variables.
The overarching objective of the pension plan is to meet the actuarial rate of return, serving as the discount rate utilized to ascertain the present value of the plan's future obligations. This, in turn, determines the annual contribution size from the company to the pension plan. Actuaries play a pivotal role in setting this rate by estimating the future obligations of the pension based on assumptions regarding future salaries (and increases), retirement patterns, employee age and life expectancy, and the company's benefit formula.
The key components of a defined benefit plan encompass the obligation for benefits destined for retirees, the plan's assets earmarked to fulfill these obligations, and the recurring expense associated with offering and maintaining the pension plan.
The funded status of a plan is commonly referred to as the plan's economic position. An underfunded plan, lacking adequate funds, is a cause for concern. Analysts closely monitor the liability of large companies, assessing the extent to which their retirement accounts may be inadequately funded. Conversely, overfunded plans, where the present value of liabilities falls short of assets, empower fund portfolio managers to adopt a more aggressive investment strategy.
With this context, the focus now shifts to a closer examination of pension obligations and assets, paving the way for a subsequent exploration of the components integral to pension expenses.
What Are Pension Benefit Obligations?
The pensions' obligation encapsulates the actuarial present value of anticipated benefits earmarked for retirees.
Accumulated Benefit Obligation (ABO):
The ABO represents the present value of pension benefits earned up to the balance sheet date, derived from compensation up to the current date, and is based on prevailing salary levels. Particularly useful when there's an expectation of settling the liability promptly, such as through a plan settlement, the ABO serves as the actuary's estimate of the total retirement benefits, discounted to their present value, earned by employees before the application of the pension formula.
Vested Benefit Obligation (VBO):
The VBO is the portion of benefit obligation not contingent on future employee service, rooted in vested benefits. It reflects the share of the accumulated benefit obligation that employees are entitled to receive irrespective of their ongoing employment. Commonly aligned with vesting requirements, where employees must fulfill a specified period of service before qualifying for full pension benefits, the VBO is expressed as a percentage of the ABO.
Projected Benefit Obligation (PBO):
The PBO signifies the actuarial present value of benefits attributed to employee service up to the present, gauged by the benefit formula. Its calculation encompasses projected salary increases. Similar to the ABO, the PBO is the actuary's estimation of the total retirement benefits, discounted to their present value, presently earned by employees, before the application of the pension formula. If the pension formula excludes future compensation levels, the PBO aligns with the ABO. In Generally Accepted Accounting Principles (GAAP) calculations, emphasis is typically placed on the PBO, representing the actuarial present value of benefits expected to be disbursed by the employer to retired employees. This assumption operates under the premise that employees will remain with the employer until retirement, and the company is a going concern.
In essence, the Accumulated Benefit Obligation (ABO) serves as a recalibration of the Projected Benefit Obligation (PBO), excluding considerations for any anticipated salary increases.
The dynamics among these terms unfold as follows:
Projected Benefit Obligation (PBO):
The PBO is a forward-looking estimation of pension obligations based solely on years of service presently accrued.
Accumulated Benefit Obligation (ABO):
The ABO, conversely, reevaluates the PBO under the assumption that the employee will depart the company at the year's end. In practical terms, this means that future salary and pension increases from additional years of service are not factored into the ABO.
Vested Benefit Obligation (VBO):
Notably, neither the ABO nor the VBO incorporates potential compensation increases in their calculations.
Critical assumptions underpinning the estimation of future benefits include:
Discount Rate:
The discount rate holds significance in computing the actuarial present value of benefits, pension expenses, and employer obligations under the plan. It delineates the amounts payable to employees, assuming all employee obligations were hypothetically settled at the current date. Crucially, the discount rate should closely mirror the market interest rate. A higher discount rate translates to lower values for PBO, ABO, and VBO (and vice versa). Importantly, the discount rates impact doesn't extend to plan assets; thus, a higher discount rate results in a lower net pension liability.
• Rate of Compensation Increase:
The economic consistency of the rate of compensation increase is pivotal in maintaining coherence with other calculation assumptions. A higher expected rate in this context correlates to a higher Projected Benefit Obligation (PBO), with no impact on the Accumulated Benefit Obligation (ABO) and Vested Benefit Obligation (VBO).
The pension benefit obligation assumes paramount significance in pension plan accounting. Delving deeper into this factor, the PBO holds significance as it encompasses a projection of the potential salary for an employee at the time of retirement.
To illustrate, consider the hypothetical scenario of an employee, John Peters, hired by the Trenton Corporation in 1996. He qualifies for the company's defined benefit pension plan, and the benefit formula is expressed as follows:
Annual salary for the year of retirement
Annual salary for the year of retirement×Number of years in service×2.5%=Annual retirement benefits
Assuming John plans to retire in 2036 after 40 years of service, with a projected retirement period of 20 years, and his salary at the end of 2006, after 10 years of service, is $90,000. The interest rate used is 4%, and the actuary foresees his salary reaching $300,000 upon retirement.
For the calculation of the PBO in this scenario, the following steps are undertaken:
Use the pension formula to determine retirement benefits earned to date:
$300,000×10×2.5%=$75,000 per year
Calculate the present value of retirement benefits as of the retirement date
In the given scenario with a projected retirement period of 20 years and an interest rate of 4%:
The calculation of the present value of retirement benefits as of the retirement date is as follows:
$75,000 \times 13.59033 = $1,019,275
Next, the present value of retirement benefits as of the current date is determined with remaining years of service equal to 30 and an interest rate of 4%:
$1,019,275 \times 0.30832 = $314,263
Consequently, the Projected Benefit Obligation (PBO) in this case amounts to $314,263.
The PBO undergoes changes over time due to various factors, including:
For Each Year’s Service Cost:
As each year elapses, an additional year's service cost contributes to the pension benefit obligation. Assuming no change in the actuary’s estimate of the final salary, the PBO for the example would be $359,513 at the end of 2007. The breakdown is as follows:
$300,000 \times 11 \times 2.5\% = $82,500
$82,500 \times 13.59033 = $1,121,202
$1,121,202 \times 0.32065 = $359,513
Therefore, the additional PBO at the end of 2007 is $45,250 ($359,513 − $314,263).
• Cost-of-Money Factor (Interest Costs):
Given that the PBO is a liability, interest on this liability changes each year, contributing to the PBO during each period, except the first. In this example, the additional interest cost is calculated as follows:
$314,263 \times 4\% = $12,571
In the event of an amendment to the plan's terms, resulting in a change to the plan's formula, an additional cost known as prior service cost is incurred. This cost is typically applied retroactively to accumulated years of prior service. Using the hypothetical scenario of John Peters, assuming a change in the benefit formula to 2.75% instead of 2.5%, effective from January 2, 2007:
2.75%×$300,000×10=$82,500
$82,500×13.59033=$1,121,202
$1,121,202×0.30832=$345,689
The prior service cost is then calculated as
$345,689−$314,263=$31,426.
• Plus or Minus Effect on the PBO:
The plus or minus effect on the PBO stems from gains or losses resulting from actuarial revisions made during the current year. The actuary might alter assumptions such as life expectancy, retirement timing, or the assumed discount rate. This adjustment directly influences the PBO for the ongoing calculation period.
In the context of adjustments to assumptions, alterations can lead to gains or losses in the Pension Benefit Obligation (PBO). Consider the scenario where a change is implemented for the final year's salary, increasing it from $300,000 to $320,000 in the year 2008. The ensuing alterations in the formula are outlined as follows:
2.75%×12×$320,000=$105,600
$105,600×13.59033=$1,435,138
$1,435,138×0.33348 (Remaining years=28, Interest=4%)=$478,590
The resulting increase in the PBO, solely attributed to this revised assumption, is calculated as:
$478,590−$359,513=$119,077
• Payment of Retirement Benefits:
The aforementioned example illustrates the PBO's adjustment when an employee retires during the current period, leading to the disbursement of retirement benefits. This, in turn, results in a reduction to the PBO.
In summary, the PBO can undergo changes due to the following factors:
In this example, the calculations have been concentrated on a single employee. In typical situations, however, the actuary extends estimates and projections to encompass an entire company's employee population covered by the defined benefit pension plan.
The cumulative changes in the Pension Benefit Obligation (PBO) for our Trenton Corporation over the year 2007 are presented here. All amounts are assumed.
Note: that the aggregates shown in this example are not merely made through calculating for a single employee and then multiplying by the actual number of employees. Instead, the actuary will model costs for each employee with their individual variable values and then add the totals for each employee.
Pension Plan Assets
Determining the pension obligations is one aspect; however, the formidable challenge lies in securing the necessary funds to fulfill these commitments when they mature.
For a defined benefit plan to meet its obligations, it must amass a sufficient pool of assets, which are detailed in the financial statement footnotes.
A trustee is entrusted with managing the identified assets of the pension plan. This entity receives contributions from the employer, invests the accumulated funds, and disburses pension benefits to retired employees. Typically, a bank or specialized service-providing company assumes the role of the trustee. Guided by the insights of a pension plan advisor, the trustee strategically invests these assets in stocks, bonds, and other income-generating instruments. The investment advisor, or manager, oversees these investments by providing direction to the trustee.
The investment advisor operates within a framework established by a retirement committee. This committee formulates a suitable investment policy for retirement funds and defines an ongoing funding strategy for the pension plan. The overarching objective is to ensure that the assets remain adequate to meet the scheduled benefit payouts. Fluctuations in these assets are contingent upon factors such as dividends earned, interest, and market price appreciation.
Annually, the actuary assesses whether the company needs to augment its contributions to earmarked funds for employee benefits. This involves computing the anticipated rate of return that the accrued funds are expected to generate. A higher projected return rate translates to more available funds, potentially necessitating fewer contributions from the company. If the anticipated return falls short, the company may be obligated to make additional contributions from its general funds to guarantee sufficient assets for meeting obligations. The actuary bases these calculations on the following estimates.
Throughout each assessment period, if the actuary determines that the assets are insufficient to cover projected obligations, the pension plan is deemed underfunded. In recent years, a prevalent trend has seen many defined benefit plans consistently operating in an underfunded state. Multiple factors contribute to this circumstance, with the key reasons being:
Limited Cash Availability: Many companies, constrained by a lack of available cash, have been unable to sustain contributions to pension plans. The failure to inject additional funds into the plan has prompted some companies to convert from defined benefit plans to defined contribution plans or, in extreme cases, to entirely dissolve such plans.
Assumption Revisions: Actuaries regularly find the need to adjust their assumptions, particularly regarding the rate-of-return assumption. Market volatility has impacted investments, prompting revisions that, in turn, elevate the projected Pension Benefit Obligation (PBO) and exacerbate the underfunding challenge.
Market Volatility Impact: Fluctuations in the stock market have resulted in both overfunding and underfunding of PBO. Additionally, companies have redirected pension funds during periods of overfunding, further contributing to the underfunding dilemma.
Due to the intricate dynamics affecting pension plans, ERISA's minimum funding standards were instituted to safeguard employees, particularly under the revised regulations of Code Section 430 introduced in 2008. A crucial element of these standards is the establishment of a funding target, representing the present value of all accrued and earned benefits under the plan at the commencement of the current year. If a plan's assets fall short of this funding target, the minimum required contribution comprises:
The normal target cost for the current plan year
Any shortfall in the amortization charge
Any waiver amortization charge
Amortization charges serve to cover shortfalls in funding from previous years, typically over a seven-year period.
In the realm of accounting, there is still no formal mandate to separately disclose pension plan obligations or accumulated pension assets in financial statements. Organizations are obligated to report only the net difference between these two amounts, presenting it as either a net liability or a net asset.
Now, let's delve into aggregate calculations using the hypothetical case of Trenton Corporation.
The company has decided to allocate funds for a portion of each year's service cost, determining a total funding commitment of $8 million for the current year as decided by the retirement committee.
As of the beginning of 2007, plan assets stood at $390 million, with an expected return of 6%. However, the actual return for 2007 outperformed expectations, reaching 7%. Further, let's assume the company disbursed a total of $4 million in retirement benefits during 2007.
The plan assets at the end of 2007 would be as follows: [Include calculations or details for plan assets at the end of 2007 here]
As of the close of 2007, the Projected Benefit Obligation (PBO) for the entire employee population amounted to $448 million, signifying that the plan is presently underfunded. In such circumstances, regulatory guidelines mandate that a company acknowledges the underfunded or overfunded status of defined benefit plans on its balance sheets. This recognition is articulated in the balance sheet as the netted sum of the fair values of plan assets and the projected benefit obligation.
The Pension Expense
The pension expense, as reflected in the income statement, is intricately tied to the annual increase in pension liability, juxtaposed with the return on the plan's assets. This expense is a direct outcome of the fluctuations in the Projected Benefit Obligation (PBO) and the changes in plan assets, as detailed in preceding sections. Once computed, this expense is duly recorded in the income statement and is categorized as a compensation expense, aligning with other components of total compensation such as wages, salaries, sales commissions, incentives, bonuses, and various other forms of remuneration. The accounting process ensures the harmonious matching of all forms of total compensation with the services rendered by employees during the specified period.
In the current reporting framework, individual expenses are not itemized in financial statements. Instead, pension obligations are netted against assets, and the resultant net amount is presented as a distinct line item in the company's balance sheet. Specific balances are delineated separately in footnote disclosures, while the calculated pension expense finds its place as an operating expense in the income statement. This comprehensive expense encapsulates periodic changes in both plan obligations and assets, encompassing the following components:
Service Costs: Directly tied to an employee's services rendered during a defined period.
Accrued Interest: Reflects the interest accrued on the pension liability over a specific period.
Impact of Returns on Plan Assets: Carries a negative connotation as it diminishes the pension expense; conversely, a positive impact occurs in the case of favorable returns.
Amortization of Prior Service Costs: The increased impact of amortization linked to service before any alterations are made to the plan's calculation elements.
Gains or Losses Impact: Signifies the positive or negative impact resulting from changes in the pension liability or gains/losses from the investment of plan assets.
Figure 5.1 shows from where the pensions expense derives.
Figure 5.1 illustrates the breakdown of the pensions expense, delineating each component:
Service Cost: This pertains to the actuarial present value of benefits ascribed by the pension's formula to the service rendered by employees in the current period. It encompasses any increase in the Projected Benefit Obligation (PBO) arising from the employee's service during this timeframe. Notably, the calculation of service cost, or present obligation, must consider projected future compensation levels. The method endorsed by the Financial Accounting Standards Board (FASB) involves assessing benefits per year of service.
Interest Cost: Calculated by multiplying the actuary's discount (interest rate) by the beginning-year projected benefit obligation, interest cost represents the interest accrued during the year on the outstanding projected benefit obligation. It reflects the increase in the projected benefit obligation over time, essentially the interest accrued on the pensions liability. The interest rate is determined based on the returns from high-quality, fixed-income investments that align with the timing and amounts of expected benefit payments. According to FASB guidelines, the assumed discount rate should mirror the rates at which companies can effectively settle pension benefits. It's important to note that interest cost is amalgamated with other components of the pensions expenses and is reported as part of the pensions expense, rather than being presented separately in the income statement as an interest expense.
• Return on Plan Assets: The actual return on plan assets encompasses the growth in pension funds resulting from interest, dividends, and changes in the fair value of the plan's assets. It represents the returns derived from the strategic investment of pension plan assets in diverse vehicles such as stocks, bonds, and other securities. While the first two components contribute to an increase in the pension's liability and expense, this particular component works in the opposite direction, mitigating them. Nevertheless, an annual reconciliation is imperative between the expected rate of return and the actual rate of return. This necessity arises from the fact that employer contributions and actual returns on accumulated assets collectively augment the pension plan's assets. Wise investment decisions leading to positive returns alleviate the need for additional employer contributions, thereby reducing the overall cost of the plan. The actual returns earned on the plan's assets not only bolster the fund balance but also diminish the employer's overall cost. However, reconciling differences between the actual and expected rates of return presents a nuanced challenge. The Financial Accounting Standards Board (FASB) mandates the use of the expected rate of return in calculating the pension expense, despite the seeming counter-logic that the actual return reduces the expense. According to FASB guidance, the variance between the actual and expected rates of return is designated as either a gain or a loss on plan assets.
In the context of the Trenton Corporation example, this amount is determined as $390 million multiplied by 6%, resulting in $23.4 million.
• Amortization of Prior Service Cost: Plan amendments often result in increased benefits for services provided in prior years, leading to additional costs referred to as prior service costs within the Projected Benefit Obligation (PBO). Under Generally Accepted Accounting Principles (GAAP), these costs must be systematically amortized over the expected service years of all participating employees. Consequently, the company allocates the prior service costs, arising from the adoption of a new plan or an amendment to an existing plan, to the pension expense over the remaining service years of all affected employees. GAAP discourages recognizing these retroactive benefits as pension expenses entirely in the year of amendment, favoring the spread of expenses over the anticipated service lives of employees expected to benefit from the plan changes. The Financial Accounting Standards Board (FASB) generally prefers a years-of-service amortization method for prior service costs. However, Statement of Financial Accounting Standards (SFAS) No. 158 permits the alternative use of the straight-line method.
In terms of the straight-line method, the average remaining service life for employees expected to receive benefits is calculated by dividing the total future service years by the number of employees. This average is then utilized to determine the amortization expense each year.
Average Remaining Service Life=Total Future Service Years
Number of Employees Expected to Receive Benefits
Average Remaining Service Life= Number of Employees Expected to Receive Benefits
Total Future Service Years
As previously mentioned, the FASB leans towards the years-of-service amortization method. Here, the prior service cost is divided by the number of future service years the employee is projected to work, determining the cost per service year. This cost is then multiplied by the number of service years, applied at the end of each year.
In instances where a plan sponsor changes the benefit formula during a year, retroactive crediting of prior service years might occur, adhering to the terms of a union contract or employee relations policies. However, the expedient path, particularly if the employer negatively impacts the formula, would involve the reduced formula taking effect only moving forward. Importantly, under FASB guidance, the unamortized balance of prior service cost is not recognized as an asset; instead, it is carried as a shareholder equity account under accumulated other comprehensive income (AOCI).
• Amortization of Net Loss or Net Gain: The volatility in pension expenses can stem from abrupt and substantial changes in the fair value of a plan's assets and alterations to the Projected Benefit Obligation (PBO). Such fluctuations often arise in the context of the anticipated return on a plan's assets, where the expected return, used in computing pension expenses, may diverge from the actual return. Additionally, discrepancies might arise due to inaccuracies in actuarial assumptions used in estimating the PBO. These unexpected shifts in pension expenses can be attributed to:
**Sudden and Large Changes in the Fair Value of Plan Assets
Changes in Actuarial Assumptions Affecting the PBO**
These unanticipated changes to pension expenses are aggregated in a memo account, akin to prior service costs, and are amortized using a method known as the corridor approach. The Financial Accounting Standards Board (FASB) introduced this approach to manage the amortization of the accumulated net gain or loss balance when it reaches a certain magnitude. SFAS 87 designates a 10% threshold for excessive evaluations. In this context, 'large' is defined by the FASB as 10% of the larger beginning balance of the PBO or the market-related fair value of the plan's assets. Any accumulated gains or losses surpassing this 10% level are subject to amortization.
Specifically, the amortization is calculated by comparing the gain or loss account to the beginning PBO balance and the fair market value (FMV) of the plan's assets. Amounts exceeding 10% of the larger of these two values are then amortized over the remaining service lives of the employees in question. The amount subject to amortization is the excess of 10% of the greater of the beginning balances of the projected benefit obligation and the fair value of the assets.
The amortization of any unrecognized net loss from previous periods is added to compute pension expenses, while any unrecognized gain is deducted to calculate the pension expense. Accounting conventions, such as those governing prior service costs, do not permit the entire gain or loss resulting from updating the pension obligation to be reported as pension expenses in the income statements in the year changes are made. Instead, it is reported as other comprehensive income in the statement of comprehensive income.
• Net Loss – Accumulated Other Comprehensive Income (AOCI) or Net Gain – AOCI: These figures find their place in the balance sheet within the shareholder’s equity section, specifically reported as part of Accumulated Other Comprehensive Income (AOCI). While a compelling argument can be made for presenting these gains or losses as part of the current year’s earnings, given their direct impact on the net cost of providing the defined benefit plan, the Financial Accounting Standards Board (FASB) stipulates a deferred recognition. The FASB's decision to delay the recognition of gains and losses in the income statement aims to achieve income smoothing, although this stance diverges from the matching principle, a fundamental accounting principle.
Practically, the delay in recognizing gains or losses is justified by the fact that, over time, these fluctuations tend to offset each other. If gains and losses neutralize one another, the question arises: why subject corporate income statements to nonoperational fluctuations via changes in the pension benefit account?
The calculation for the amortized amount in the case of a net loss or net gain involves a nuanced process. For instance, let’s consider the hypothetical scenario where Trenton Corporation has a cumulative net loss.
In our illustration, the consolidated figures were as follows: $390 million in plan assets at the commencement of the year and a $400 million Projected Benefit Obligation (PBO) at the outset of the year.
In our specific scenario, the breakdown of pension expenses for the year 2007 is summarized as follows:
Given this information, the Net Loss – Accumulated Other Comprehensive Income (AOCI) account at the conclusion of 2007 will reflect the following:
Financial Reporting for Pension Plans involves the comprehensive disclosure of various accounts and pertinent details within both the financial statements and accompanying notes. Here is an enhanced breakdown:
Financial Statements:
Pension Expense: This account captures the annual cost associated with the pension plan.
Pension Asset Liability: Reflects the financial position of the pension plan, indicating whether it is overfunded or underfunded.
Components of Accumulated Other Comprehensive Income (AOCI): This account encapsulates the cumulative gains and losses from the pension plan that are not yet recognized in net income.
Notes to Financial Statements:
Major Components of the Pension: A detailed description of the primary elements constituting the pension plan.
Reconciliation of Projected Benefit Obligation (PBO) and Fair Value of Plan Assets: An explanatory breakdown illustrating the changes in the PBO and plan assets.
Disclosure of Measurement Rates: Provides information on the rates used in determining benefit amounts, including the discount rate, expected return on plan assets, and compensation rate.
Allocation of Pension Plan Assets by Category: A table delineating the distribution of plan assets across equity securities, debt securities, real estate, and other categories.
Percentage Distribution of Fair Value to Total Plan Assets: Indicates the proportional representation of each asset category relative to the overall plan assets.
Expected Benefits Payments: Projects anticipated benefit payments for current plan participants over the next five fiscal years and provides an aggregate figure for the subsequent five fiscal years.
Disclosure of Expected Contributions: Specifies the company's best estimate of anticipated contributions to the plan in the coming years.
Nature and Amount of Changes in Assets and Obligations: Describes the changes in assets and obligations recognized in both net income and other comprehensive income for each reporting period.
Accumulated Changes in Plan Assets and Benefit Obligations: Outlines the cumulative changes in plan assets and benefit obligations that have been recognized in other comprehensive income and will be integrated into net income in future periods.
Amortization of Actuarial Gains and Losses: Specifies the amount of estimated net actuarial gains and losses, along with prior service costs and credits, that will be gradually amortized from AOCI into net income over the next fiscal year.
Accounting Recordkeeping
This segment provides a concise overview of the requisite journal entries for pension accounting, particularly focusing on gains or losses resulting from the following scenarios:
Changing the PBO Assumption
Return on Assets Higher or Lower than Expected
The return on assets is integral to the Other Comprehensive Income (OCI) account within the statement of comprehensive income. If a loss arises from a change in assumption, an increase (or credit) is recorded in the Projected Benefit Obligation (PBO) account, accompanied by an associated decrease (debit) in the OCI account. Conversely, if a change in assumption results in a gain in the PBO account, a debit entry is made, while a credit entry is recorded in the OCI account.
When a gain is attributable to actual returns surpassing expectations, leading to an increase in the plan's assets, the difference between the expected and actual returns is captured. In this instance, a debit entry is made to the PBO account, and a credit entry is logged in the OCI account to reflect the gain. Conversely, if the actual return falls short of expectations, a debit entry is entered in the OCI account, and a credit is recorded to the plan's assets.
There is a necessity to update the prior service account whenever there is a new prior service cost. In such instances, a debit entry is made to the Prior Service Cost − OCI (increase due to plan revision), and a corresponding credit entry is recorded in the Projected Benefit Obligation (PBO) account.
As previously mentioned, service costs, gains, or losses are reported as they occur, categorized under other comprehensive income (OCI) in the statement of comprehensive income. OCI items accumulate as Prior Service Cost − Accumulated Other Comprehensive Income (AOCI) and as Net Loss/Gain − AOCI. When amortized, the resulting amounts are also reported in the statement of comprehensive income. Amortization reduces Prior Service Cost − OCI and Net Loss − AOCI. Given that these accounts carry debit balances, the amortization amounts are credited; however, Net Gain Amortization is debited as Net Gain holds a credit balance.
The funded status of the plan, representing the difference between the PBO and plan assets, finds a place on the balance sheet. When the company makes additional contributions to the plan, plan assets are debited, and cash is credited.
For the recording of pension expense, the following entries are essential:
• Pension expense (debit)
• Plan assets (expected return on assets) (debit)
• Amortization of Prior Service Cost − OCI (for a specific year) (credit)
• Amortization of Net Loss − OCI (for a specific year) (credit)
• Projected Benefit Obligation (PBO) (Service cost + Interest cost) (credit)
In a standard balance sheet, the net pension liability, as elucidated earlier, is reported in the liabilities section. In the shareholder’s equity section, the following accounts are reported under Accumulated Other Comprehensive Income (AOCI):
• Net Loss − Accumulated Other Comprehensive Income (AOCI)
• Prior Service Cost − Accumulated Other Comprehensive Income (AOCI)
ERISA, FASB, and AICPA have collectively set forth stringent requirements governing the issuance of financial statements for defined benefit pension plans, outlined comprehensively in the following section.
Statement of Accumulated Plan Benefits for Defined Benefit Pension Plans (ERISA)
In addition to fulfilling various reporting and disclosure obligations, defined benefit pension plans must provide detailed information regarding the actuarial present value of the plan’s accumulated benefits at both the commencement and conclusion of the plan year in question. Moreover, any alterations to the present value of accumulated benefits (PVAB) from one year to the next must be meticulously documented.
It is crucial to recognize that the PVAB does not represent the plan’s actual liability, which is ascertained through actuarial calculations. Instead, the PVAB solely reflects benefits that have accrued as of a specific date. This information can be presented on the same page as the Statement of Net Assets Available for Plan Benefits, in a distinct statement, or within a footnote.
The accompanying footnote must encompass the following numerical details:
• Vested benefits for employees currently receiving benefits.
• Other vested benefits.
• Nonvested benefits.
The methodology employed for calculating the PVAB, along with the significant assumptions underpinning this calculation, must be transparently disclosed in a footnote.
Any changes to the PVAB, spanning from prior reporting periods to the present, can be articulated either through a standalone financial statement or within the footnote. This information can be presented in a narrative or reconciliation format. Importantly, any modifications to accumulated plan benefits during a given plan year must be promptly reported within that same year; there is no retroactive reporting requirement. Furthermore, any significant factor, whether influencing independently or in tandem with other factors, must be clearly identified.
The minimum disclosure requirements for this statement encompass essential details such as:
• Plan Amendments: Any modifications or alterations to the pension plan.
• Changes in the Nature of the Plan: This involves shifts resulting from activities like spin-offs and mergers that impact the plan's structure.
• Changes in Actuarial Assumptions: Disclosure of adjustments made to actuarial assumptions, which play a crucial role in calculating pension-related values.
Additionally, any other changes in accumulated benefits and benefits paid, inclusive of actuarial gains or losses, stemming from alterations in discount rates must be transparently disclosed. This comprehensive reporting ensures stakeholders have a clear understanding of the dynamics influencing the pension plan's financial landscape.
ERISA Reporting Requirements for Defined Contribution Plans
In the realm of defined contribution pension plans, the plan balances are influenced by various factors, including contributions made by employees and the investment outcomes of the amassed funds and forfeitures.
To fulfill disclosure requirements comprehensively, the following details must be included:
• Amount of Unallocated Assets: Providing transparency about assets that have yet to be assigned.
• Basis Used for Asset Allocation: When the method used to allocate assets to employee accounts differs from the one employed for financial statement recording, it should be explicitly stated.
• Net Assets and Significant Changes: For non-employee-directed investment programs, disclosing net assets and key components of changes in net assets is imperative.
• Amounts Allocated to Withdrawn Employees: Clear reporting on amounts allocated to employees who have withdrawn from the plan.
• Non-Employee-Directed Investments: Any investments not directed by employees that represent more than 5% of total net assets should be highlighted.
Furthermore, it's noteworthy that an auditor’s report on employee benefit plan financial statements is typically incorporated as a section of annual reports in accordance with ERISA standards. These audit reports must adhere to the stipulations of SFAS No. 58 – Reports on Audited Financial Statements, ensuring the highest standards of financial reporting and accountability.
Accounting Standards Affecting Pension Plans
In September 2006, the issuance of SFAS 158 – Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans – An Amendment of FASB Statements No. 87, 88, 106, 132 (R) marked a significant transformation in the reporting of balance sheets for defined benefit pension plans. The dynamic nature of these plans prompted FASB to undertake reforms in pension accounting.
The initial framework for pension accounting under Generally Accepted Accounting Principles (GAAP) was established by SFAS 87, with a focus on achieving a stable and enduring measure of pension expenses. Pension expenses were previously included in net income under the term "net periodic pension cost."
SFAS 158 introduced two primary changes in financial reporting:
Recording Overfunded/Underfunded Status: The overfunded or underfunded status of a defined benefit plan must now be documented as an asset or liability on the company’s balance sheet.
Measuring Funded Status: The funded status of a plan is now measured as of a company’s reporting date.
The calculation of the overfunded/underfunded status involves assessing the disparity between the fair value of plan assets and the Projected Benefit Obligation (PBO). This variation from the old rules, which recognized a prepaid asset or accrued liability, is primarily attributed to the inclusion of the estimated impact of future salary increases. This crucial information is derived from an actuary’s report, adding a layer of transparency to the reporting of defined benefit pension plans.
The overfunded/underfunded amount must be reflected on the company’s balance sheet and recognized as other comprehensive income, net of tax. An underfunded amount is recorded as a long-term liability, with the exception of cases where the total assets of the plan are less than the benefits payable to employees in the next 12 months. An overfunded amount is consistently recognized as a noncurrent asset.
The measurement date for the overfunded/underfunded status must align with the reporting date for the company. For instance, for clients with a calendar-year plan and a September fiscal year, an actuarial evaluation must be conducted mid-year, precisely at the reporting date.
The pension expense, included in net income, retains SFAS 87’s net periodic pension cost structure. This cost is a composite of service cost, interest cost, expected return on pension plan assets, and amortization of unrecognized items. However, actuarial gains or losses and prior service costs occurring during a given period are acknowledged as part of comprehensive income amortization. Actuarial gains or losses require a reclassification adjustment to comprehensive income, emphasizing a holistic approach to reporting and recognizing the multifaceted nature of pension expenses.
This chapter provides a comprehensive exploration of pension plans, integral components of the broader economy. Individuals primarily utilize pension plans as a key mechanism for saving towards retirement, whether through employer-sponsored arrangements or individually initiated plans. From an employer's standpoint, pension or retirement plans play a crucial role in the overall employee benefits offered by a company. There are two primary types of pension plans discussed in this chapter: defined contribution plans, which commit to fixed annual contributions, and defined benefit plans, which promise fixed retirement benefits determined by a specified formula.
Various facets related to the financial, tax, accounting, legal, compliance, and auditing aspects of pension plans were explored. The Employee Retirement Income Security Act of 1974 (ERISA) emerged as a significant legal framework shaping retirement plans, safeguarding the assets of millions of Americans and ensuring that funds placed in retirement plans during their working lives will be available upon retirement.
This chapter also delves into the accounting and recordkeeping intricacies associated with pension plans. Defined contribution plans involve contributions from both the employer and the employee, determined by agreement. On the other hand, defined benefit plans commit the employer to provide specific retirement benefits based on a predefined formula, with the employer shouldering the risks associated with the pension fund's performance. The chapter guides readers through the formula for calculating defined benefit pension plans, and covers key concepts such as pension benefit obligations, pension plan assets, and expenses.
Key Concepts in This Chapter:
Defined contribution plans
Defined benefit pension plans
Employee Retirement Income Security Act (ERISA)
Pension Benefit Guarantee Corporation (PBGC)
401(k) plans
The income-replacement ratio
Accumulated benefit obligation (ABO)
Vested benefit obligation (VBO)
Projected benefit obligation (PBO)
Pension plan assets and expenses
Pension plan accounting recordkeeping
Unit 3 Discussion
How does the Employee Retirement Income Security Act (ERISA) affect you?
The ERISA or employee retirement income security act is in place to help protect retirement benefits for employees by making sure that companies provide qualified plans that meets the requirements of ERISA. It also needs to provide free information and sets minimum standards for benefits and budgets. The law also dictates how long a person is required to receive the benefits and also what requirements the individual needs to meet in order to be able to participate in the plan for benefits. The law also sets the requirement that funding requirements must be met by the plan sponsor. ERISA also has a requirement of providing accountability of the fiduciary plan and defines the fiduciary as the person who makes decisions or manages the assets of the plan. Any fiduciaries who don’t follow the required rules of the plan can be liable for the recovery of losses in the plan. ERISA also gives participants a recourse when there are violations of confidentiality and allows those individuals the right to sue for damages. ERISA also guarantees payment of certain benefits from federally employed corporation. All of these features of ERISA help protect retirement plans from any bad practices.
Unit 3 Assignment - Retirement Plans
Referring to Unit 3 Readings and Resources, write a 4-5 page paper explaining the differences between defined contribution and defined benefits plans, including benefits and shortfalls of each.
Your paper should include:
Cover page
4-5 pages of content
Reference page
Proper formatting per APA 7th edition
Retirement Plans
When we
think about retirement plans we are thinking about the future and planning for
the hope that one day we don’t have to work and can have a retirement plan that
we can save for the future. With those plans comes different retirement plans
some offered by our jobs, some we do ourselves without others input and some
are pensions or different benefits we get based on years of service. Regardless
of what type of plan we use its important to know what’s available to us and
about the different retirement plans and how they work. So we will talk about
different plans and how they are different.
Employee
Retirement income security act or ERISA protections cover to types of
retirement plans and they are either defined benefits plans or defined
contribution plans. The first promises a specific monthly benefit at retirement
and should specify the amount offered such as $150 per month at retirement for
example. It could also be a benefit which is calculated based on top highest
yearly salary for the last 3 years worked and a percentage such as 5% like some
government agencies do such as Transportation Security Administration. These
benefits are also protected by federal insurance from pension benefit guaranty
corporation.
A defined
contribution plan doesn’t promise a specific amount of benefits at retirement
and often includes the employee and employer both contributing to the plan such
as a 401k plan. For federal this is through www.tsp.gov
or the thrift savings plan in which your agency contributes up to 5% of what
you contribute to your 401k on a biweekly basis. Plans like this will fluctuate
based on the type of investments that they are tied to. The thrift savings plan
can either be in a basic savings plan or it can be different groupings of stock
options. But the option to pick your own stock isn’t included in that specific
plan you can only join one of the predefined plans they offer. Each 401k plan
for each company has different rules about how much can be contributed and what
rules are in place as well as what options the individual using can do.
Another
type of plan is simplified employee pension plan or SEP which is a plan that
isn’t complicated which allows retirement savings based on a tax favored basis
to IRA accounts which the employee owns. These type of plans have minimal
reporting and disclosure requirements but the employee must set up the IRA in
order to get contributions. Traditional IRAs offer substantial tax break
benefits while still allowing you to save for retirement. But withdrawing early
will subject the employee to additional taxes and penalties. On a positive note
it does allow the individual a limitless number of different investment
benefits that other 401k plans don’t offer. Such as stocks, CDs, mutual funds,
bonds, real estate, gold IRA and more. The negative is of course more penalties
if you need to take money out and it also requires you invest money yourself.
Also while you have the option to invest in all of those things someone who
doesn’t know what good investment options should seek an advisor. Another type
of IRA that’s newer is a Roth IRA are made with after tax money meaning you
paid taxes on the money that goes into the account meaning you won’t have to
pay on contributions and earnings that come out at the time of retirement. On
the negative side Roth IRA has contribution limits and you have to decide how
the money is invested or have someone who will do that for you.
Another
option for employee retirement is profit sharing or stock bonus plan that an
employer can set up and contribute to it can also be a 401k plan but some
companies like Siemens power generation for example offer share discounts on
the company stock or other options for profit sharing that the company
distributes to valid employees.
Cash
balance plan is a benefits plan which fits the defined contribution plan. A
cash balance plan defines the promised benefit in the terms of a stated account
balance this plan offers interest credit and a percentage of pay credit. But for
this plan increases and decreases to the value of the investment doesn’t affect
benefits amounts. The investment risks or rewards are the responsibility of the
company and when the employee is entitled to receive the benefits they receive
those benefits based on the defined terms.
Of course
companies aren’t required by law to offer 401k or retirement plans to the
individual however some states do have government sponsored retirement plans
that have mandatory participation but that depends on the state. Most companies
will offer some kind of retirement plan because it helps keep skilled talent
working for the company and helps compete in a human resources point of view as
well as overall happiness.
But what
should you do if you are employed by a company that doesn’t have an employee
retirement plan? It’s always a good idea to work for the future of retirement
or put money away so that you have it in case of an emergency. There are
self-401k plans that you can contribute to yourself and many other retirement
options but remember when picking any retirement plan or coming up with your
own plan you should always have a good understanding about benefits and any
fees before you make any decisions. Even a company 401k plan comes with fees
associated when it comes to purchasing and maintaining the account. And making
sure that the fees being charged aren’t hurting your overall profit is
important.
If you
don’t like the idea of potential fees and want full control many people go
after dividend stocks when it comes to managing their own retirement
money. Money in the bank makes very
little interest but often dividend stocks of good stable companies can make
more interest in a quarter then you could ever make in a year from having the
same money in the bank. For example, let’s take into account a famous company
everyone knows Ford. The stock as of currently is $11.91 per share. Let’s say
we decided to buy 10,000 dollars’ worth which would give us 839 shares. Ford
pays dividends on a quarterly basis of 5% of profit for the year. They pay a
total of $0.60 if we have 839 shares and $0.60 is paid per share that means we
would generate a profit of $503.40 some companies pay even higher rates then
Ford some pay 11% or higher not to mention if the stock is bought at a low point
you could also grow in the price per share on top of a dividend growth payout.
Of course picking the right companies to invest in is often up to the user but
picking some of your favorite most trusted companies can be very rewarding and
even could give you substantial yearly, quarterly or even monthly dividend
payouts to help manage retirement costs.
Other
potential investments can be anything from real-estate, precious metals or even
bonds or higher yield savings accounts. But regardless of what you pick the key
is always to do research in anything you invest in. Doing your homework and
save you a lot of heartache and frustration. And it’s important even if a
company manages your 401k you know the details of it so you can make the most
out of it. When I started for TSA I didn’t know that if I contributed 5% they
would match it cause that information wasn’t given to me also that the G fund
which everyone is standardly put into doesn’t grow the overall money since it's
more of a basic savings account. But by learning from people who have worked
for a long time I was able to learn more and find out the proper places to
learn all I needed to know to make my retirement plan a success. The most powerful thing we have is our mind
and knowledge.
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