Reasonable Funding Method

[flosfur]

I have a takeover case with a BOY valuation date. Employees enter the plan immediately. Year of Service for benefit accruals is 1 hour credited svc during the plan year. For the 2003 valuation @ 1/1/2003 the following approach was used.

Eligible participants who terminated during 2003 but after 1/1/2003 were treated terminated and if they terminated non-vested, they were excluded from the funding calculations!

As a result, line 2b of Sch B has, say, 20 active participants but only, say, 15 participants were considered for the funding calcs!

Questions:

1. Is this a reasonable funding method?

2. Is one required to continue with this method even if it is not a reasonable method?

3. If the method is changed (to include the participants who terminate during the val year but after the val date), would it qualify for automatic approval under rev Proc 2000-40? I don't see anything on this.

[david rigby]

Seems inconsistent to me. For example, were all 2003 terms excluded, or only non-vested ones? What about someone who terminated on 12/31/03?

- If you are ignoring all terms, that sounds to me like an EOY valuation date.

- If you are ignoring only non-vested terms, that sounds like an assumption, which may be reasonable, but should be evaluated on that basis.

BTW, there are circumstances where a valuation may use a 100% turnover decrement in year one, and this can be considered reasonable.

[flosfur]

Seems inconsistent to me.  For example, were all 2003 terms excluded, or only non-vested ones?  What about someone who terminated on 12/31/03? 

-  If you are ignoring all terms, that sounds to me like an EOY valuation date. 

-  If you are ignoring only non-vested terms, that sounds like an assumption, which may be reasonable, but should be evaluated on that basis.

.......

2003 was the first plan yr and all terminees were non-vested because vesting service is from plan's effective date.

What kind of assumption is "ignoring non-vested terminees"? It is more like a method than an assumption.

[mwyatt]

Conceptually, a beginning of year valuation should ignore anything that transpires after that date. However, one thing of interest in your case is the immediate entry. Say you have a new hire on 12/31/2002; they enter the Plan on 1/1/2003. You obviously have no prior year salary to go on for valuation purposes, so I presume you would use some sort of estimate of annual compensation rate for val purposes. As Pax said though, I see some problems with taking into account terminations after the valuation date. I would go with developing a cost for these people, which would generate gains for the next year (either due to partial or no vesting at term). Something doesn't feel right if this is indeed a true beginning of year valuation and you're adjusting results for occurences after the fact.

[david rigby]

Right. And upon further reflection, I suggest it is not a reasonable funding method if it recognizes such demographic changes after the valuation date. Since this is 2003, you have already filed the Schedule B, so changing the valuation date will not be possible.

I wonder what is really going on here: is someone trying to "manipulate" the cost by ignoring plan participants who will not vest? If so, why not do the same thing with the turnover assumption?

[flosfur]

Right.  And upon further reflection, I suggest it is not a reasonable funding method if it recognizes such demographic changes after the valuation date.  Since this is 2003, you have already filed the Schedule B, so changing the valuation date will not be possible. 

I wonder what is really going on here:  is someone trying to "manipulate" the cost by ignoring plan participants who will not vest?  If so, why not do the same thing with the turnover assumption?

Yes, that's what is going on here. This way, owners' funding cost as a % of total is higher than it would be otherwise and thus it is to "sell" the plan to the client (I am not fond of the term "sell" but that's how the small plan industry operates) .

I have taken over many so called "BOY valuation" where the only thing BOY is the val date and the plan assets @ BOY. The compensations taken into account are those actually earned during the val yr, employees terminating during the val yr are treated as terminated (with no accrual after the Val yr) and if they are non-vested they are excluded from the calculations. On the other hand, the employees eligible to enter during the val yr are included [which is permitted under reg 1.412©(3)-1(d)(2)] in some cases but not in others.

By the way, in small plans, turnover rates are rarely used. I have seen them used in couple of cases and made no sense to me given that the majority of the laibility was for the owner(s) and they are unlikely to be terminating the employment soon!!

Anyway, crux of my message was: if the "unreasonable funding method" is changed to a reasonable method for 2004, is that a funding method change! And if so, is it an approved change under Rev Proc 2000-40 - I don't see this in the Rev Proc. Or is this a non-issue altoghether?

[david rigby]

If you want to hold down the cost, then why not merely exclude employees with one year of service? (This also can save some PBGC premiums, assuming the sponsor is covered.)

The purpose of the funding method (and assumptions) is not to manipulate the cost. If the cost is "too high", then the benefit promised by the Plan is "too high".