Distribution of Employee Contributions at Termination

[Guest Bob_DB]

Suppose you have the following situation:

(a) You have a DB plan (small company, say 10 employees) that was funded by employee contributions and the plan is terminated.

(b) The plan assets at termination exceed the sum of the lump sum distributions calculated from the benefit formula (all employees elect lump sum payments).

© Moreover, each employee individually has put more into the plan than his/her individual lump sum distribution payable at termination based on the benefit formula (e.g., employee X has contributed $150k and the lump sum distribution is $100k).

Question: How much should employee receive at termination? Should employee X receive $100k, $150k, or some other amount? If employee X is only entitled to $100k, what happens to the remainder?

Thanks.

[david rigby]

Suppose you have the following situation:

(a) You have a DB plan ... that was funded by employee contributions and the plan is terminated.

Please clarify: is the plan funded only by EE contributions?

The plan will define each employee's accrued benefit. It will probably include language that states the total accrued benefit is no less than what would be provided by the EE contributions. If so, the accrued benefit might be greater than otherwise determined.

[Guest Bob_DB]

Yes, the plan is funded only by employee contributions.

Thanks.

[AndyH]

I don't think that is possible. Sorry to say, but I think you've got some facts wrong. Someone guarantees the "defined benefit". Who is the plan sponsor?

[david rigby]

I think it is possible, but there may be other materials (such as SPD) that imply otherwise. It is also possible (likely) that some facts are incorrect or are omitted.

[Guest Bob_DB]

Thanks for the responses. I was trying to simplify the situation, but I guess I oversimplified it to the point that it was meaningless.

Let me see if I can try again (numbers used below are illustrative).

I was an employee of a firm that sponsored a DB plan. My compensation at the firm worked as follows. I "earned" a percentage of my billings each year and such "earnings" were paid as a combination of cash and a contribution to the DB plan. The DB plan was funded using the individual aggregate approach. For example, if I "earned" $200k in a year and my DB normal cost for the year was $50k, I would be paid $150 in cash (normal W2 payment with appropriate withholding) and $50k would be contributed to the DB plan. I believe that the employer technically classified the $50k as an employer contribution.

Then, the plan was terminated. At the time of termination, I had contributed $200k ($50k normal cost for four years of participation, assume no interest is earned on the fund assets, no forfeitures, etc.). Using the benefit formula specified in the plan, the actuary calculated my lump sum distribution as $160k.

The employer wants to say: "tough luck, you get $160k even though you put in $200k."

I want to say that's not fair. One argument that I though I might use is that the contributions made on my behalf to the plan were really akin to employee contributions (even if they were technically classified as employer contributions). If they were considered employee contributions, I should get a $200k lump sum distribution (or I should get a lump sum of $160k plus a return of $40k in cash due to overfunding).

Another argument that I might make would go as follows. Prior to making contributions to the plan in the final year, the employer knew that the plan would be terminated (due to the firm merging with another firm). In that case, it would not be appropriate fund the plan in the final year with the normal cost calculated as if the plan were going to continue indefinitely. Rather, it should be funded with the amount needed to bring the assets allocated to each individual up to that individual's lump sum distribution amount (assume that everyone was going to take a lump sum distribution). In that case, prior to the final year, the assets allocated to me would be $150k (three years of $50k) and the lump sum amount is $160k, so $10k should be contributed for me in the final year (instead of $50k). That would mean I should get an additional $40k in cash for the final year.

I hope that clarifies the situation. I appreciate any thoughts.

[JAY21]

Bob, any chance this is a "non-qualified" plan ? Would make a difference.

[AndyH]

Bob, intentionally or not, you were misinformed about the significance of an actuarial cost method, as I tried to explain to you in your other post.

You had misinformation or disinformation.

What you get is stated in the plan document. It has absolutely nothing to do with the actuarial cost method.

Employee contributions are not a good analogy because they are subject to some specific, rather strict rules that do not apply to the situation that you have described.

It seems to me that you have some type of employment agreement issue, not a retirement plan issue. You did not understand what you got youself into. You probably need an attorney versed in labor law or employment contracts.

[RCK]

I agree with AndyH. As far as the plan is concerned, you contributed nothing, and are receiving a $160,000 lump sum distribution. Most of us would take that deal.

From the plan's perspective, you are entitled to an accrued benefit based on your earnings history and the benefit formula. And the lump sum value of that benefit is based on the plan's definition of actuarial equivalence. That calculation would have no connection with your expected $200,000.

If you have anything in writing describing the deal as you think it works, you might want to go back to the employer, and ask them to change definition of actuarial equivlaence behind the lump sum factors so that you can get closer to what you think that you deserve.

RCK

[david rigby]

I agree with Jay21, it smells like a non-qualified plan.

Or is it a target plan?

But if it is qualified, let's talk about elective deferrals. Just how was this $50K NC determined? Just how was it taxed?

[AndyH]

Normal cost and IA funding in a non qualified plan? There are technically no assets. That would be one weird animal.

I suspect that Bob was younger than the owner and therefore Bob's Normal Cost included a salary scale which never materialized because the plan terminated before he reached NRA but the owner did reach NRA (or was closer). Bob, in that case, the Normal Cost for you would have been inflated and ficticious.

So the "surplus funding" for Bob that was "intended" to accrue to him in his later years actually went to the Boss.

Either that or the funding was on a level dollar basis and Bob didn't age sufficiently before the plan was terminated.

My best guesses.

[JAY21]

I agree that IA funding methods and Normal Cost aren't terms normally found in a non-qualified plan, but I've seen a few cases where "structurally" the non-qualified plan is set up and funded similar to a qualified DB plan, in which case a qualified plan DB software may have be used and resulting reports generated for a non-qualified plan. The structure of his "earnings" is what sounded like a non-qualifed plan to me.

I realize we're still trying to ascertain the facts here (pre-tax, after-tax contributions, type of plan etc...) so I'm probably jumping ahead by mentioning if it's determined to be a qualified contributory DB plan he should received his contributions plus interest at 120% of the Federal Mid-Term rate (assuming that hasn't changed in recent years) at a minimum. In addition, there is a strict ERISA formula for excess asset allocations when there are employee contributions (certain employees must get a share). However, I'm not convinced it's such a plan just yet so I'm probably getting ahead of the facts.

[Guest Bob_DB]

Let me try to answer the questions.

(1) I think it is a qualified plan.

(2) I have not been told how the normal cost was calculated, but I think I have figured it out.

In the first year that I was a participant, the normal retirement benefit was calculated based on the benefit specified in the plan, with no assumed growth in wages. This was then converted to an equivalent lump sum at my normal retirement age using an assumed interest rate and mortality table. The normal cost was then calculated as the level amount that would have to be contributed each year to produce an amount equal to the lump sum using a pre-retirement interest rate.

In the second year, the equivalent lump sum was recalculated. Then, the normal cost was calculated as the level amount required to produce an amount equal to the new lump sum taking into account what had been contributed on my behalf previously (normal cost in year 1 plus an allocation of earnings and forfeitures).

The third and fourth years were done as year 2, each time taking into account what had been previously contributed on my behalf.

(3) I was not taxed on the $50k normal cost (i.e., as far as the IRS was concerned, I never earned that money). I assume the company treated the contribution as an expense.

(4) AndyH is right that I am younger than the principal owner, which seems to have worked to my disadvantage.

Again, thanks for the thoughts.

[david rigby]

Upon reflection, I believe AndyH has given an accurate summary. If there is a "scam", it is that your employer used money that you "earned" (your term) and told you it was to fund your retirement. Thus, it became a way to divert some of the total compensation otherwise allocated to you.

[Guest Bob_DB]

Yes, I agree with AndyH and pax re: the basic problem is contractual.

I wanted to try one more question:

Suppose you have a DB plan that has assets of $1.8 million at 12/31/03. The plan has been funded using the individual aggregate normal cost approach. You know that the plan is going to be terminated in 2004 and the total lump sum distributions at termination will be $2.2 million.

How would you go about determining the funding for 2004?

Could the actuary just say: total funding is $400k (so the fund is in balance at termination) without making any assignment to individuals?

In other words, in the year of termination, does the actuary even care about the allocation of the funding to individuals or does the actuary only care about the total?

Thanks.

[Blinky the 3-eyed Fish]

I don't know that you could classify it as a "scam". It could be that the people involved didn't understand how the funding works. For IA, depending on the level of the benefit and the periods available to fund, by the mathematics of the funding method it can fund higher amounts in the first years. I have clients all the time ask me how much is being funded for participant X without telling me what they will use this information for. It's only when I pry that I find out that some are considering the plan as part of a participant's overall compensation package and they are reducing salary or bonuses by these contribution amounts. I have to explain to them that there isn't a dollar for dollar correlation to what they are doing and provide them with more accurate numbers. These are cases where the client wasn't trying to rip off the participant, but just didn't understand the innerworkings of a DB plan.

Bob, the answer to your question depends on many variables. Suffice it to say it could be done both ways possibly.

[GBurns]

All that I see here is what amounts to an impermissible recharacterization of income. In reality a scam to cheat the employee and the IRS. It is no different in concept than what is now under attack by the IRS with the first salvo being the just issued EP Plan letter which is available on today's Benefits Buzz.

In the past I was, like many other "advanced market" insurance agents, encouraged to sell these schemes pushing it as an asset transfer method or as a way to get more money out of your corporation. None of the designs were any different in substance from what has been posted. The employee was led to believe that money was being put away for their future, however, the plans are designed so that if they stay they never get as much as they thought they would get. If they did not stay forfietures etc were even worse.

I personally would demand, at minimum, the $200K and only allow the employer to keep the FICA savings and the "earnings". However, an argument will be made by some that $160K is still good, you could have lost more.

The problem is that if, one day in the future, the IRS comes knocking, they will not only go after the employer for misreporting and underwitholding, but they will also come after the employee for some taxes plus penalties.

So regardless of what is taken, there is the possibility of a problem in the future. This should also be taken into consideration when decicing how much to settle for.

[david rigby]

Strong words. Much depends on what was communicated to the employee about compensation.

[mbozek]

Bob: You need to have counsel review the plan documents to determine the following: Who was required to make contributions to the plan? how were the contributions determined and from what source were they taken? How is the accrued benefit defined? IRC 414(h)(1) forbids the deduction by the employer of amounts designated as an employee contribution. If the contributions are made by the employees then the rules of IRC 411(b)(2) will apply to determine the accrued benefit attributable to employee contributions. I am assuming that the plan has received a favorable determination letter from the IRS and is subject to ERISA. Is this correct? If it is a qualifed plan then there will be an annual report form 5500 which you should get a copy of and look for schedule B to determine the funding method.

The employee cant be liable for taxes on wages that were never paid by the employer.