Funding When Early Termination is Expected

[Guest Bob_DB]

Suppose you have a small consulting firm in the following position:

-- Virtually all of the business is generated by person A (i.e., person A has the client contacts that lead to projects and the rest of the staff executes the work as directed by person A). As such, without person A, the firm could not exist in its present form.

-- Person A is 60 years old. The rest of the staff ranges in age from 25 to 60.

-- The firm has a DB plan with a normal retirement age of 65.

-- The DB plan is funded using the individual aggregate approach.

In this circumstance, is it reasonable to fund the plan based on the normal cost (level contributions) assuming that the plan will continue indefinitely, given that it is expected that the firm will be disbanded and the plan terminated in the relatively near future (5 years assuming that person A actually retires at the normal retirement age)?

For example, suppose person B is 35 years old. At person B's normal retirement age, person A would be 90 years old. Thus, the company would surely have been disbanded and the plan terminated long before person B reached the retirement age. In that case, would it be appropriate to calculate the funding for person B as the normal cost (level contribution) over 30 years?

If not, what should be done in this circumstance?

Thanks.

[FAPInJax]

The funding method is fine - Individual Aggregate. The issue is that the owner intends to retire in 5 years and there will probably be a shortage of funds to pay the other employees their lump sum benefits. This will cause the owner to take a smaller distribution that is expected.

A different funding method might help (Unit Credit) but probably the same issue arises.

Actuarial assumptions could be adjusted to more accurately reflect the probability of the early termination (basically advance funding for the termination liability).

Last but not least, the plan should probably not grant past service credits (creating a liability before the plan even starts) because it would just exacerbate the problem.

[david rigby]

Good comments from Frank. A minor point: sometimes these situations have a simplified view of actuarial assumptions. For example, if the comp for A is greater than the 401(a)(17) limit and significant to all other compensation, a salary scale might be ignored. In this case, and with the IA method, that assumption might not be the best approach. Try it both ways.

[Blinky the 3-eyed Fish]

Frank, whether or not IA funding will cause the plan to be underfunded entirely depends on the DB formula. Using IA in this situation may even cause more funding to the plan versus unit credit. Consider a unit formula of 1% of pay per year of participation, here is how the funding would look for a new entrant who is 25 years old:

(assume 6% interest)

UC: $20,000 * 1% * APR65 / (1.06)^(65-25) = 19.44*APR

IA: $20,000 * 1% * 40yrs * APR65 / (1.06)^(65-25) = 777.78*APR

777.78*APR / 15.9491 = 48.77 APR

See how IA funds 2.5 times UC?

Now of course IA can fund less, when there is a cap on the benefit or the projected benefit hits a 415 limit. Here if a 10 YOP cap is put in place then the UC would remain unchanged but the IA would change to:

IA: $20,000 * 1% * 10yrs * APR65 / (1.06)^(65-25) = 194.44*APR

194.44*APR / 15.9491 = 12.19 APR

So to answer Bob's question is the funding method just needs to be reasonable. As as side note, who says you have to assume that the business will die once A retires? Is it not possible that someone will be groomed to take it over?

[Guest penman]

This is a good example of looking ahead in order to avoid problems. Let's say the benefit is based on participation. In this situation, I would want to be sure that the lump sum value of the accruals are being covered by the plan's normal cost. Ind Agg would probably cover the 60 year olds accrual but not the 35 year olds accrual, although it may if a reasonable salary increase assumption were added. I think a reasonable salary increase assumption is generally appropriate for rank and file employees anyway. If Ind Agg doesn't work then you can look at unit credit as discussed.

The miniscule normal cost for B doesn't look so good in 5 years when A has to cough up $25,000 or so to B in order to get the plan terminated.

[Blinky the 3-eyed Fish]

I would want to be sure that the lump sum value of the accruals are being covered by the plan's normal cost. Ind Agg would probably cover the 60 year olds accrual but not the 35 year olds accrual,

Penman, did you read my last post? As illustrated, whether or not IA covers anything depends on the formula. It may generate funding to cover the benefit earned or it may not. You can't just make a blanket statement about it though.

In any event, if concerned about the funded status near termination, there is always the UCL max deduction available each year. It works well if no amendment to raise HCE benefits occurred in the last 2 years.

[Guest penman]

Blinky,

I must have been writing my post and didn't see yours. Nonetheless, I stick by what I said. It is meant as a generality, that is the context in which I wrote it, that's why I said "probably". This has been my personal experience having worked with many similar plans. THE UCL is a good point, but, to tell the sponsor they have to make some "extra" contribution in order to make the plan sufficient for the rank and file is a only slighly lower volume chewing out than telling them they have to reduce their own lump sum to cover the rank and file. Unfortunately, also my personal experience.