412(i) plans - the basics

[Guest seissler]

A 412(i) defined benefit plan has a benefit formula of 100% of compensation reduced 1/25 for years of participation less than 25 years. The participant will have 30 years of participation at normal retirement date, and benefits accrue pro rata over years of participation. The participant's compensation is $50,000. Therefore a deferred annuity is set up for $50,000/year beginning at normal retirement date. Level annual premiums are paid from now until the year of normal retirement. Compensation is 3 year average compensation for years of participation. Next year the compensation is $45,000. I assume I am now funding for a benefit of ($45,000 + $50,000 /2). How is the adjustment made to decrease the benefit at retirement?

Can a deferred annuity be set up assuming a salary scale?

Or is a deferred annuity purchased each year for only the amount of the benefit accrued that year? - and if so, how does that tie in to the requirement for level annual premiums for funding?

Susan Eissler

[could be me maybe not]

Calling Dom Firmani...........

[Guest Carol the Writer]

First of all, I am Dom Firmani's in-house actuary, and I have a few comments. Dom is out selling 412(i) plans, and is presently unavailable. You do not buy a deferred annuity for the benefits accruing during the year. That would be unit credit funding. You do level "premium" funding for the anticipated normal retirement benefit. Note that a salary scale is not used here.

As far as recognizing decreases is concerned, our prototype plan - the Datair prototype - does not recognize decreases until they have been in effect for three years. I do not have the cite handy, but I'm pretty sure that's standard in the insurance industry.

[Guest seissler]

So there really isn't much for a TPA to do. Just determine eligibility, normal retirement date, calculate the normal retirement benefit, and vesting. The insurance company determines the level annual premium and cash value at the time of distribution (if lump sums are permitted.) Correct?

[Guest Carol the Writer]

We, in our rol as TPA, compute the contributions, as well. We have the annuity tables, pre-retirement assumptions, and life tables loaded into our system for the companies with whom we do business. These tables and assumptions were approved by the particular insurors. And the insurance companies say (I emphasize, say) that they will be bound by our computations. We haven't experienced a problem as of yet. (By the way, we also compute the excess interest and any forfeitures that arise to offset the subsequent year's contributions.) Hope that helps.

[Guest seissler]

So, the plot thickens...

I was under the impression that there were either individual deferred annuities or a group annuity contract that governed the premiums and cash value. Are you making calculations within the framework of such a contract, or there is no contract?

[Guest DOM]

Here we go again!!! Since the embarrassing dialog perpetrated on the members of this site by myself, Andy and Blinky months back when the three of us vented our immaturity discussing the attributes of 412i plans, I have been very quiet and frankly seldom visiting these boards.

Carol The Writer has encouraged me to read todays postings and I always follow orders from my actuary, lo and behold I find a reasonable question presented by Seisaler and an equally reasonable reply from Carol. Unfortunately also found is another example of an arrogant, self serving, uninformed and frankly dumb remark from "quint the shark hunter" proving once again that my decision to remove myself from these discussions was sensible and sound. However when you consider the handle "quint the shark hunter" derives from the book and picture "Jaws" and further remember that Quint ended up as shark dinner this all makes perfect sense.

By the way, Seisaler, your follow up question regarding the use of individual and/or group deferred annuities is correct. The annuity purchase rates in the contracts are the same as in our software.

Goodbye again...

[mwyatt]

Hey Dom:

Not trying at all to be snide or anything of the sort, but I'm surprised that the insurance company doesn't have final say on the amount of premium due on the annuity contracts. My impression from the TPA side is that it is all well and good to calculate the numbers given tables etc., but the final bill (and overriding check) would come from the insurance company. What's a decimal point between friends, as they say...

[AndyH]

Dom or Carol, do the policies cover top heavy benefits? And, BTW, Carol's comments are always sensible and civil. No surprise there.

[Blinky the 3-eyed Fish]

Here we go again!!! Since the embarrassing dialog perpetrated on the members of this site by myself, Andy and Blinky months back when the three of us vented our immaturity discussing the attributes of 412i plans, I have been very quiet and frankly seldom visiting these boards.

I want to know what I ever said to Dom, but whatever.

Regarding the premium, I do happen to know a little bit on how it works. If the insurance company is setting up a 412(i) plan and they don't do the calculations in house, they will use "preferred TPA's". These TPA's sign contracts with the insurance company which shift the liability of the calculations to the TPA. The insurance company provides all the information related to their contracts to the TPA who then prepares the calculations and informs the client how much to deposit.

[Guest seissler]

Does the same go for lump sum distributions, or does the insurance company calculate those?

[AndyH]

Good question, as is mine, which is as yet unanswered.

[WDIK]

I want to know what I ever said to Dom

In summary:

1) indicated that dom was "a bit combative."

2) classified dom as not being a bad apple.

3) inferred that dom was a black kettle.

Perhaps Blinky could be accused of being too metaphorical, but probably not "embarassing".

[Blinky the 3-eyed Fish]

Thank you for the summary. The plane is sluggish like a wet sponge. (There is a simile for you, although it's a completely random statement, it is a paraphrased movie reference.)

[could be me maybe not]

Careful Blinky. In the immortal words of Moe Howard2,

I realize that Blinky may be the Boss Hog in these boards, but I would suggest that he, and others like him, follow in the steps of of Tom & WDIC who seem to have something of substance to say in their replys. Endless replys which lack substance lead to lack of credibility. No one benefits.

Sounds a bit like your friend GBurns, doesn't it?

Perhaps you might wish to answer seissler and qtsh's questions?

[Blinky the 3-eyed Fish]

I can try

Dom or Carol, do the policies cover top heavy benefits?

This depends on the policy. If the benefits accrued under the plan are greater than TH, then yes. If they aren't then a side fund is needed. Of course then you need to go and get yourself an actuary.

Does the same go for lump sum distributions, or does the insurance company calculate those?

I think nearly all 412(i) plans describe the PVAB as equal to the CSV. (I know there was one question on these boards recently where that wasn't the case, but I attribute that to a crappy document.) Thus, it really is as simple as a DC plan that provides annuities. I think generally if the TPA is calculating the contribution, they will be handling this aspect as well, although it depends on the individual arrangement.

So how's that Sybil?

[could be me maybe not]

Very informative, thank you. Now we'll consider you to be the resident 412(Eye) guru.

[Blinky the 3-eyed Fish]

And that's I title I strive to have. Just please don't forward any fliers you receive from me to the government in a little brown envelope. It's really is legit when I promise a 25 year-old a 2 million dollar deduction.

[Guest Carol the Writer]

To answer your question about top-heavy, I think that's one practical reason that the 412(i) plan cannot be funded exclusively with life insurance contracts without requiring a side fund and a Schedule B. The annuity computations with only incidental life insurance have always assured, in every plan that I have seen thus far, that tha annuity cash values are at least as great as the lump sum equivalent of the top heavy benefit. Does that make sense?

[could be me maybe not]

I think that's one practical reason that the 412(i) plan cannot be funded exclusively with life insurance contracts without requiring a side fund

Carol, then it is not a 412(i) plan at all, is it? If you put some fancy stuff inside a safe harbor plan then it is not a safe harbor plan at all. What you describe is a DB plan with life insurance in it, right? And doesn't that make fiduciary considerations important, i.e. diversification of assets among other things?

But I do not follow your last two sentences.

[Guest Carol the Writer]

I would make a distinction between the safe harbor design of the plan's benefit structure, and the method of funding. The former is directly related to discrimination testing, but is also a function of the funding instrument chosen, in that contributions to the plan are related to the actuarial assumptions (annuity rates, etc.) specified by the insurance company. The method of funding is subject to fiduciary concerns - and that does not include benefit adequacy or who might or might not get benefits. The perspective of ERISA might be that insurance companies are "safe" and, therefore, are not as explicilty subject to fiduciary concerns as are ordinary defined benefit plans. Does this make sense?

[Blinky the 3-eyed Fish]

Carol, I have to say I didn't understand either of your last two posts.

[mwyatt]

Safe? Executive Life, Mutual Benefit, Baldwin, Fred's Bait and Tackle & Insurance... Having all eggs in one basket isn't exactly safe.

[Lame Duck]

I think Carol was saying that some 412(i) plans are funded exclusively with life insurance contracts, and these life insurance contracts will be used to provide the full retirement benefit. In this case, there may be a need to provide a side fund to cover the top heavy benefit since the cash value of the life insurance may not be sufficient to provide it.

However, in cases where the retirement benefit is funded with annuity contracts and the plan provides only incidental life insurance coverage, the annuity contracts will usually be sufficient to cover the top heavy minimum.

[Blinky the 3-eyed Fish]

Well I hope neither she nor you are saying that a plan could be funded exclusively with life insurance because that will surely violate the incidental benefit rules.

[Guest Carol the Writer]

I think that Lame Duck expressed my observations better than I did. Do you disagree with my (reworded) position, Blinky?

[Lame Duck]

I made no statement regarding the validity of such an arrangement. I was merely making an attempt to clarify what Carol said. I don't work with 412(i) plans enough to make a statement of that nature.

[could be me maybe not]

Is it true that a 412(i) plan that has a side fund is not a 412(i) plan and becomes subject to all the normal DB rules including 412, etc.?

Or is that not true?

[Guest Carol the Writer]

No, a 412(i) plan that is split funded with insurance contracts and annuity contracts, both of which specify the settlement options (annuity purchase rates) that are the same throughout the policy series, is not a DB plan subject to Schedule B reporting. Consult the 412(i) regs. Also, Dom Firmani NEVER said - and I do not want to leave you with the impression that - we ever had 412(i) plans that were funded exclusively with life insurance policies.

Let's not re-invent the whell here. 412(i) plans are older than ERISA. They have evolved over the years as the IRS has changed its position on incidental life insurance. But the plans that we have put in have been fully in compliance with the current 412(i) regs.

The difference between the standard split-funded defined benefit plan and a 412(i) plan, is that the insurance company specifies the actuarial assumptions in a 412(i) plan - and stands behind them. They are as good as the insurance company is. On the other hand, the standard defined benefit plan that is split-funded with life insurance is as good as the enrolled actuary's certification - subject to IRS restrictions - that the plan is soundly funded. Some people are so conservative, particularly with an unstable stcok market, that the 412(i) arrangement looks very good and reassuring to them. This is much of the 412(i) market.

That's really all that I have to say. I am told that I am too philosophical in my writings on this message board. Therefore, I stop here.

[Blinky the 3-eyed Fish]

Carol, you didn't understand the question. A plan funded with insurance and annuities does not make a side fund.

Could be me - yeah, I know it's you - see 1.416-1 M-17. It describes how a side fund, if needed for TH purposes, will continue to allow the plan to satisfy 412(i), except that the side fund info will need to be reported on a schedule B.

[GBurns]

Blinky,

Where can the side fund money be put? Could it be put in an annuity?

[Blinky the 3-eyed Fish]

Yes, that is one of the options listed in the cite I mentioned.

[Guest rp401k]

Servicing 412(i) plans can be a bit tricky. You have all the usual calculations relating to eligibility and vesting (and forfeitures). You must also compute benefits which can be tricky in self employed entities, especially when salary average comes into play. If non-owners are involved, then there could be top heavy minimum calculations. This can be tricky because you must look at the paid up benefit purchased with the current year's premium. You cannot rely on the accrual under the plan formula. Generally, the lump sum equivalent equals the cash value- by regulation. There is no calculation to do except for the maximum lump sum which can be an issue in plans seeking maximum deductions, since the APR's of the insurance companies will be far more expensive than GAR 94 at 5.5%. As prior writers have pointed out, there can be an issue with how to fund a benefit decrease. The technique can be specific to how the contract operates. I have seen language about a 3 year reprieve, but I am a little skeptical, particularly in light of last year's guidance. The origin of this language is with life insurance contracts in plans, which are incidental benefits. Here, in 412(i) the contracts fund the actual retirement benefits themselves. I believe language avoiding immediate reduction in the contracts could be drafted if it was careful to say that the benefits due under the plan would not exceed the benefit due under the formula. I also believe there are deductibility issues with paying premiums on benefits above that required under the plan formula.

These are some of the issues that can arise.

Richard

[Guest Carol the Writer]

I must admit that I have not tested it, and all of our 412(i) plans are top-heavy. However, the Datair valuation system (which is the one that we use) makes available an option that guarantees the top heavy minimum benefit, even in a non safe harbor plan, as the larger of the plan's cash value of the fractional rule accrued benefit or the cash value of the top-heavy minimum benefit. Further, the Datair system (and prototype) allows the user to opt out of providing top-heavy benefits for key employees.

As I said, I have not tested this, and I am not a Datair spokesperson. But it seems to me to be as foolproof as you are going to get without going to a side fund (which would go into the annuity anyway) and a Schedule B.

I will be out of the office for the next three weeks for gall bladder surgery. So, don't expect to hear from me again for a while. Thanks!

[AndyH]

Well, good luck on your operation, Carol.

Would someone mind explaining the following comments, though? I for one don't understand. At all.

an option that guarantees the top heavy minimum benefit, even in a non safe harbor plan, as the larger of the plan's cash value of the fractional rule accrued benefit or the cash value of the top-heavy minimum benefit.

How does a program guarantee a benefit?

But it seems to me to be as foolproof as you are going to get without going to a side fund

What is foolproof?