Individual Aggregate Funding in Year of Termination

[Guest Bob_DB]

(Please note: I am not a pension professional. I have been trying to learn about DB plans myself from various sources. I have come across the situation described below and would appreciate any assistance. Please let me know if I need to clarify anything. Thank you.)

Suppose you have the following situation:

(1) Company X has a DB plan which it knows is going to be terminated on July 1, 2004 (company X is going to be acquired by company Y).

(2) Company X has 10 employees that participate in the DB. The plan is funded using the individual aggregate approach.

(3) As of January 1, 2004, the plan assets are $1.7 million. (Assume that there is no change in the value of the assets from 1/1/04 to plan termination).

(4) Company X knows that at plan termination all employees will the elect to take lump sum distributions and the sum of such distributions will be $2.0 million.

My question is: how should company X apply the individual aggregate funding approach for 2004? Here are a couple of options that I can think of:

(a) Calculate the normal cost for each employee assuming that the plan was not going to terminate. Suppose this came to a total of $0.5 million. Then, set the funding for each employee to equal 60% of the normal cost (total of $0.3 million). This would leave the plan with assets of $2.0 million at termination, which is equal to the amount to be distributed.

(b) Calculate for each employee the difference between the lump sum distribution and the funding for that person as of 1/1/04. Presumably, the sum of these amounts would equal $0.3 million ($2.0m less $1.7m), as long no employees had been funded as of 1/1/04 with more than the lump sum distribution.

There may be other approaches as well that result in funding of $0.3 million. One might conclude that it really doesn't matter how the funding is implemented as long as the total is equal to $0.3 million, leaving the fund in balance at termination.

Here is a situation in which the specific implementation of the individual aggregate funding approach matters. Suppose Employee Z has a compensation plan under which Employee Z receives $100k per year, where such amount includes both cash received and the contribution to the pension plan on behalf of Employee Z for the year.

There would not be any issue with this compensation structure with a DC plan. For example, employee Z might be paid $90k in cash and have $10k contributed to the DC plan. That $10k contributed to the DC plan would belong to employee Z. Alternatively, employee Z might be paid $95k in cash and have $5k contributed to the DC. In either case, employee Z has $100k (ignore the differences in tax treatment of cash vs. DC contributions).

However, it is not so simple with a DB plan. Suppose that as of 1/1/04 funding for employee Z's DB plan was $120k and that employee Z's lump sum distribution at closing is $130k. Further, assume that the normal cost for employee Z in 2004 (assuming the DB is continuing indefinitely) is $50k.

With approach A above, employee Z would receive $70k in cash in 2004, with $30k contributed to the DB plan (60% of $50k normal cost), for a total of $100k. Employee Z would then receive a $130k lump sum. This would result in employee Z receiving a total of $200k ($70k cash plus $130k lump sum).

With approach B, employee Z would receive $90k in cash in 2004, with $10k contributed to the DB plan ($130k less $120k funding at 1/1/04). Then, with the $130k lump sum distribution, employee Z would receive a total of $220k.

Thus, employee Z would be better off under approach B and approach A ($220k vs. $200k).

I would appreciate it if anyone has any thoughts on the above and/or anyone can point me to anything that deals with the above (code sections, regulations, text books, etc.).

Bob_DB

[Blinky the 3-eyed Fish]

Bob, since you are a self-proclaimed non-pension professional, I won't go into detailed explanation. The short of it is that you can't do either A or B, but you very well may be able to get there based on the 404 code changes made by EGTRRA. You should really be asking this of the actuary who works on the plan.

I answer to your Employee Z situation, with a DB plan the amount the participant receives from the plan and the amount funded for his benefit are not the same. So, A or B doesn't matter to the particpant. His benefit is worth what it is worth. This too should be a discussion with the actuary who works on the plan.

[AndyH]

Bob, the funding method most likely is irrelevant to the situation. The funding method does not determine the amount that a participant is entitled to. It merely illustrates in general terms on whose behalf the money is intended to go to provided the plan continues to normal retirement date. Plan termination changes everything.

What goes in does not match what goes out.

If you are certain that you need a contribution of $x to have enough money to terminate the plan, then you need to ask the plan actuary whether or not x will be a deductible contribution either through the normal valuation calculation or by adjusting the "current liability" interest rate to provide a higher "unfunded projected current liability" which may be greater than the normal deduction limit. The actuary may default to a high current liability interest rate but with knowledge of what you wish to accomplish may be able to lower that rate and increase your deduction range.

Second, if the plan is subject to PBGC termination insurance you may be able to contribute and deduct any termination shortfall as part of the termination process, not the valuation process.

You need to hire a good actuary right away if you do not already have one that can help you with these matters.

Regarding you compensation question, the relevant question is how much is the person's lump sum if his current pay is $100K versus how much the lump sum if his current pay is $70K. What the IA funding method illustration report says is almost certainly irrelevant to reality when you interject a plan termination into a low interest rate environment.