Life Insurance in DB Plan

[ac]

In order for a death benefit under a DB plan to be "incidental", the maximum benefit is limited to 100 x "anticipated monthly retirement benefit". What exactly is the "anticipated monthly retirement benefit"?

I suppose it means the accrued benefit projected to the normal retirment date based on anticipated service at normal retirement and projected compensation at normal retirement. In the projection of compensation, can the current compensation be projected based on the valuation salary increase assumption or should the current average compensation be used?

[SoCalActuary]

You should also look up RR 74-307 with the additional rule for incidental benefits relating to the normal cost in the plan.

Generally, I calculate the projected benefit using the higher of the current pay or the average pay to date. Otherwise you have the method correct.

[Guest dsyrett]

I would calculate the projected benefit assuming continuation of pay at the current amount (without any salary increase assumption) and then compute average pay from that stream of pay data (retrospective and prospective).

[Blinky the 3-eyed Fish]

I have a related question regarding Rev. Rul. 74-307. When determining the maximum whole life insurance, I think it works like this, but more importantly, what do you think? (Ignore the 100x rule here.)

Amount needed to fund projected benefit annually (no insurance whatsoever): $200/yr.

Thus the maximum amount of contributions related to the life insurance is 2/3 or $133.33/yr.

Of course the whole life has a CSV, so the full $200 is not needing to be contributed, thus the contribution ends up being $200 + $133.33 - some value attributable to the CSV that reduces the $200.

Anyone differ?

P.S. No Andy, I have not turned to the dark side. I am just curious.

[Belgarath]

Blinky - the calculation of cost on a DB plan is a deep, dark mystery to my non-mathematical mind, (Oh, I understand the basic theory, but reality is another matter) so I posed your question to one who actually does DB valuations, and here's the response I received:

"There is more to it than that. First, what is your normal retirement age. The theoretical individual level premium calculation for life insurance is a separate calculation so you can't just say 2/3rds of the benefit is purchasing life insurance."

I pass that on for what it is worth, if anything, as I am an untutored rube in this arena. But maybe it will mean something to you!

[AndyH]

Whew, Blinky. I thought you were going to ask about how to fund a "Special UL" and get $150 in by year end.

Actually, I've seen more than my fair share of insurance. I though there were three options:

1. Not more than 100 x (I'm not sure if salary scale is allowed or not)

2. Premium not more than 50% (25% for term) of Normal Cost regardless of funding method

3. Premium not more than 2/3 (1/3 for term) of Normal Cost if ILP method were used (can be theoretical-don't have to use ILP).

We just took one over recently where the face amounts approached 400% of anticipated benefit. Report said that the ILP method was being utilized under whatever revenue ruling that was that allowed it. Can't wait to see the test. I suppose Hell will freeze over (or pigs will fly or the Red Sox will win) first.

[Blinky the 3-eyed Fish]

Andy, what promulgation describes your #3?

Belgarth, I am afraid I don't understand the remark as it related to my question. I don't think my question was clear to this person. I was saying that the $200 was the theoretical contribution to fund the retirement benefit at normal retirement age, and by retirement benefit I mean a beneifit not considering the life insurance.

[AndyH]

The ILP matter is Rev Ruling 74-307. The 1/3 to 2/3 is from the DB answer book but I don't see a cite, so I am presuming that it is in the same revenue ruling. I speak hearsay; I have never ventured to try this, nor do I intend to.

[Blinky the 3-eyed Fish]

And here is where the confusion starts. I thought 2 & 3 were the same and the mathematics just work out like this to develop the simple 2/3 rule:

$200 to fund the theoretical contribution using ILP.

Since we are talking about whole life, only 1/2 of that premium is being deemed to be for insurance, while the other 1/2 is for retirement.

Thus the formula would be to find the 50% figure is this:

whole life premium = ($200 + 1/2 of whole life premium) * 50%

whole life premium = $100 + 1/4 of whole life premium

whole life premium = $133.33

Thus the simple 2/3 rule is generated because $133.33 is 2/3 of $200.

[GBurns]

You cannot just deem an amount for the life insurance or calculate it in that manner. As Belgarath pointed out "you can't just say 2/3rds of the benefit is purchasing life insurance." There is much more to the calculation of the ILP and amount attributable to LI.

[Blinky the 3-eyed Fish]

The devil's in the details then, not vague statements. Care to elaborate?

[AndyH]

Maybe our old friend Dom would chip in if you email him if George does not elaborate. Could be a fun New Year's Eve.

[GBurns]

Why did you not ask Belgarath, he posted it and I only referred you back to his post since you seem to have either missed it or misunderstood it?

Anyhow, the elaboration would have to be fairly extensive and really has no place on the Thread. Suffice it to say that you cannot use the monthly Life insurance premium since it has costs, expense and retainage etc that are not part of the useable "cost of insurance". Cost of Insurance is not the premium. ILP is not the premium that you pay. Both are different and have to be calculated by the actuary for the individual subject to the plan design. Plan design varies even when using the same policy form because of age, riders, option selections (paid up adds, cash etc), dividend projection etc etc.

Now go drink some more Dom.

Happy New Year to you all and may next year be the best ever.

[Belgarath]

I'd just like to mention that asking me to explain it will be a grevious disappointment to you, since I only passed on an answer I didn't understand in the first place! But I'll try to get some additional clarification from my source - which won't be until next week, as apparently the champagne has started to flow in some households already.

I hope you all have a SAFE weekend, and a great 2005!

[Blinky the 3-eyed Fish]

Let me try again.

Georgie, look back, I did reference Belgarath's post and said I didn't understand it. Here is the LRM's from the IRS website related to this matter. I bolded the important part.

Statement of Requirement: Incidental insurance provisions

and definitely determinable retirement benefits, Rev. Rul. 60-83, Rev. Rul, 74-307, Rev. Rul. 83-53, and Rev. Rul. 85-15. (Note to reviewer: The following sample language is an example of an incidental pre-retirement death benefit which is definitely determinable. A pre-retirement death benefit paid in the form of a qualified preretirement survivor annuity is deemed incidental and is, therefore, always permitted; however, if death benefits are paid in a form other than or in addition to the qualified preretirement survivor annuity, such benefits must be incidental to the retirement purpose of the plan, See Rev. Rul. 85-15.)

Sample Plan Language:

The death benefit payable under this plan will be a qualified preretirement survivor annuity and, if applicable, any other additional incidental death benefit as selected by the employer in the adoption agreement.

- LRM 52, Incidental Insurance Provisions - 107

Sample Adoption Agreement Language:

The pre-retirement death benefit payable under this plan is

(select one of the following options):

( ) A. None, other than the qualified preretirement survivor annuity.

( ) B. The qualified preretirement survivor annuity plus the proceeds of insurance policies purchased on the participant's life; provided that any death benefit in addition to the qualified preretirement survivor annuity shall be reduced to the extent necessary so that the sum of such additional benefit and the present value of the qualified preretirement survivor annuity does not exceed 100 times the participant's anticipated monthly benefit. For purpose of this requirement, the total face amount of policies purchased will be ____ (fill in the amount but not in excess of 100) times the participant's anticipated monthly benefit.

( ) C. The qualified preretirement survivor annuity plus the excess, if any, of the present value of the participant's accrued benefit minus the present value of the qualified preretirement survivor annuity.

( ) D. The qualified preretirement survivor annuity plus, if a positive amount, the incidental reserve. The incidental reserve equals the proceeds of insurance policies purchased on a participant's life plus the theoretical ILP reserve minus the sum of the present value of the qualified preretirement survivor annuity and the cash value of the policies purchased. For purpose of this requirement, the face amount of the insurance policies will be that purchasable by _____ (fill in the amount but not greater than 66 if whole life and not greater than 33 if term and/or universal life) percent of the theoretical contribution. For purposes of D above, the following definitions apply: Theoretical ILP reserve is the reserve that would be available at the time of death if for each year of plan participation a contribution had been made on behalf of the participant in an amount equal to the theoretical contribution.

Theoretical contribution is the contribution that would be made on behalf of the participant, using the individual level premium funding method from the age at which participation commenced to normal retirement age, to fund the participant's entire retirement benefit without regard to pre-retirement ancillary benefits. The entire retirement benefit for this purpose is based upon a straight life

- LRM 52, Incidental Insurance Provisions -

108 annuity and assumes continuation of current salary (no salary scale) and the current defined benefit fraction under section 415(e) of the Internal Revenue Code.

For purposes of B, C, and D above, the calculations for resent value of any benefit hall be determined in accordance with section _____ of the plan. (Note to reviewer: The blank should be filled in with the plan section number corresponding to LRM #42.)

I am saying that the $200 is the annual theoretical contribution to fund the life annuity of the one and only participant in my example using the ILP funding method. My interpretation is that this theoretical contribution is purely for the retirement benefit, not the death benefit. I am then saying that the $133 is the allowable premium to fund the maximum life insurance. In other words the maximum whole life insurance is whatever $133 will buy annually. I am then saying that the total contribution is not $333 annually, but rather a number less than that because the whole life has some CSV that reduces the $200 portion.

I hope that makes more sense because I am not saying:

"2/3rds of the benefit is purchasing life insurance" or the items in Burns' last post. At least I think I am not.

[Guest smhjr]

Blinky if I read everything correctly I think you are on the right track. Putting insurance into the plan will push the cost over $200, but you will still use only the $133 for the insurance premium. The eventual contribution might look something like $280 of which $133 is the premium for life insurance. You are then under 50% of the contribution being life insurance and it is considered incidental because you used one of the methods allowed in 74-307.

I think any method used to calculate incidental death benefits will end up with an amount that is similar to another method.

There are so many issues that have to be considered when using insurance in a plan though I am not sure if it is ever worth it.

I think your example was hypothetical, but things to consider would be will the insurance company issue a policy for only $133 a year? There is probably a minimum face amount. What happens when the person's salary increases or decreases in the future? Do you recalculate the incidental death benefit at that time? Will the policy allow for face amount changes? If it increases will the person have to go through underwriting again? Will they have to purchase a second policy for the increased amount? Will the increase satisfy the minimum face amount imposed by the life insurance company? I had a similar conversation once and the guy I talked to said that if a policy is decreased it might MEC. I didn't know what that was and he said it stood for Modified Endowment Contract. I still don't know what that is though.

I am pretty sure that a term policy and a whole life policy are pretty inflexible when it comes to the death benefit amount. I think a UL can have the death benefit face amount adjusted. One of the posts above Andy mentioned a UL jokingly, but seriously what is a UL? It's not term and its not whole life is it? So can it even be used when calculating incidental death benefits? I suppose a UL would work if you calculate 100x monthly benefit, but maybe not.

I find insurance in the context of qualified plans an interesting topic, but probably not worth the hassle if you can avoid it in the real world.

[SoCalActuary]

UL is treated in the same manner as term insurance for this illustration.

If the agent is pushing insurance product investments, UL can have a premium that more than covers the term insurance death benefit cost, and the remainder builds cash value. However, since it is not a rigid whole life policy structure, the cash value buildup in the UL policy is less the the WL policy.

The whole life policy has a firm cash value at retirement, stated in the guaranteed cash value part of the policy. The actuary then reduces the funding target by the guaranteed cash value since the policy is certain to provide at least that much funding. (I don't actually believe this, it's just the theory behind the rules! I never have seen a policy stay with level premium to retirement in 30 + years of practice.)

In applying the rules to UL policies, I use the market value of the UL policy as an asset of the plan, then apply the 25% limit rule for 74-307 purposes.

On a side note, some insurance purchases are better if the client uses UL policies, and does not take the maximum possible death benefit, but instead builds up some cash value to pay future premiums. Some of my clients do not have uniformly profitable businesses, so it is helpful if the policy can stay in effect even when the plan sponsor does not make a contribution.

On another side note, I agree that the theoretical ILP premium is intended to be used under 74-307. Once you are past the first year, you are expected to maintain records of the theoretical level annual premium taking consideration of the changes in benefits yearly.