What are 'correct' assets for funding?

[FAPInJax]

I have come across what appears to be an unusual situation (however, maybe I am just not doing the calculations correctly).

Client has an end of the year valuation (let's assume 12/31/2003) and has prepaid contributions during the 2003 calendar year. These contributions receive an interest credit for purposes of the FSA.

Let's assume the following at 12/31/2003:

Assets 100,000

Prepaid contribution 20,000 (designated for the 12/31/2003 plan year)

Interest on prepaid 500 (5% interest rate and made mid-year)

Funding method Entry age normal

EAN accrued liability 250,000

Expected UAL 125,000

What is the gain/loss base for the current year??

My initial reaction was {250,000 - (100,000 - 20,000)} - 125,000 = 45,000

However, IF I follow my initial reaction, then in 2004 assuming that all assumptions are met, a gain/loss is created equal to 525 (the interest on the prepaid contribution plus a years interest). Given that I exactly met my assumptions this answer does not appear intuitive.

OK. So I modify the gain/loss in 2003 by subtracting the interest on prepaid as well. This gives me a gain/loss of 45,500 and then in 2004 a zero gain/loss which is what I expected.

The latter calculation does not seem right for 404 purposes (not recognizing the prepaid interest because it is NOT real).

Comments???

[Blinky the 3-eyed Fish]

Perhaps you could post a mathematical example as to why you think that if the assumptions were realized that there would be a gain. I am not seeing it intuitively.

[FAPInJax]

OK. I was trying to shortcut the data and I will put together the data to present the facts (as I know them)

[FAPInJax]

OK. Here is the data as I have been able to determine. Valuations are performed as of 12/31 of each year and the interest rate is 6%.

First year (12/31/2001)

EAN accrued liability 962,530

EAN normal cost 69,472

Assets 0

Initial amortization base 962,530

Contribution of 150,000 made on 1/1/2002

Credit balance 14,559

Second year (12/31/2002)

EAN accrued liability 1,093,922

EAN normal cost 69,472

Assets 261,981

The assets include a contribution of 100,000 made 7/1/2002 for the plan year (2,981 interest credit for 412 purposes).

The interest earned is 6% on the original 150,000 and 6% on the 100,000 from the date of the contribution.

Now, the question is what the gain/loss for the year??

The actual and expected accrued liabilities are equal.

What are assets actual and expected used in the determination of the gain/loss??

[Blinky the 3-eyed Fish]

The actual and expected UAL are not equal.

The expected is as follows:

UAL prior year - 962,530

NC prior year - 69,472

Cont prior year - (150,000)

Total - 882,002

With interest to 12/31/02 = 882,002 * 1.06 = 934,922

The actual UAL = 1,093,922 - 161,981 = 931,941

The gain is then 2,981. Sure your assets earned exactly 6% and your liabilities increased as expected, but you also contributed mid-year, which accounted for increased earnings.

The balance equation would be:

Amort charges = 950,355

Amort credits = (2,981)

CB = (14,559 * 1.06)

Total = 931,941

UAL = 931,941

[FAPInJax]

Thanks for the explanation Blinky. I guess I missed the fact that the early contribution caused the increase in the earnings.

So, if we keep going with the example:

FSA = 69472 + 65969 - 14559 - 874 - 150000 - 2981 - 668 = (33641)

Credit balance with the last subtraction the 5 year amortization of the gain. The 50,000 contribution being made on 1/1 following the valuation.

Assets at the next year end earn exactly 6% are equal to 261981 + 50000 + 18719 = 330700.

Liabilities increase as expected to 1,233,198.

Therefore, my actual unfunded is 902,498.

However, my amortization bases are:

(950,355 - 65,969) * 1.06 = 937,449

(2,981 - 668) * 1.06 = -2,452

Credit balance -33,641

Interest -2,018

899,338

This seems to create a loss in the following year equal to the gain in the previous. Where is the loss coming from since it appears that all assumptions have been recognized in both liabilities and assets? (OR is my math goofy??)

[Guest Ron Sevcik]

I would argue that the actual UAL that Blinky calculated is incorrect. The assets that should be used in the calculation are $159,000 which are derived by subtacting the contriubtion during the year as well as the 412 interest on that contribution. If you don't subtract the 412 interest from the assets, you then use that interest twice. Once when you calculate the assets and produce a lower cost for the year and then you use it again on the Schedule B adding it to the credits for the FSA.

Using the above assets in the calculation of the actual UAL:

1,093,922 - 159,000 = 934,922

Thus, your actual UAL is equal to your expected UAL and there is no gain/loss for the year.

[Blinky the 3-eyed Fish]

Frank, I agree with your figures. Personally, I have never subtracted the interest credits off the assets when running the valuation, but it certainly is logical to do so, both to avoid an illogical loss in the year following and as not to "double count" as Ron points out.

I will point out that reducing the assets by the interest credits would be contrary to the asset reporting instructions on the Sch B. I suppose you could argue that they are vague though. I wonder if any promulgations say more on the matter.

[FAPInJax]

Just thought I would thank all of you for your comments and offer some finality to the discussion (at least from the government).

I submitted the same question to the IRS and the answer from Paulette Tino was that of course the gain/loss for the second year is zero.

The assets must be adjusted for the interest to arrive at the correct result. This then carries forward to subsequent years.