Maximum Deduction and Calculation of Funding Target

[YankeeFan]

A client would like to set up a new defined benefit plan for 2008 allowing for the maximum deductible contribution. The client is a sole proprietor with no other employees. The client has past service and very high compensation in prior years.

In the case of a new plan in 2008 with no past service benefit, the minimum and maximum contribution would be the same since there is no Cushion Amount. However, if the formula is based upon years of service, then as of 1/1/2008 the accrued benefit would be 1/10th of the 415 dollar limit. The accrued benefit as of 12/31/2008 would remain unchanged from the beginning of the plan year since the participant accrues 1/10th of the 415 dollar limit as of the first day of the plan year. In this scenario, we get $0 as the Target Normal Cost and the minimum contribution is basically the 7-year amortization of the Funding Target. Under the new PPA funding rules, the maximum contribution is equal to the Funding Target, plus the Target Normal Cost, plus the Cushion Amount which is equal to 50% of the Funding Target, all reduced by fair value of assets. Everyone agree so far?

Lets assume the plan is designed such that a single lump sum is an optional form of benefit and the normal form of benefit is a single life annuity.

My Question: For purposes of determining the Funding Target, it appears that our valuation software uses the plan’s Actuarial Equivalence factor (1994 GAR at 5.0%) to calculate the lump sum at NRA and then discounts back to attained age using the funding segment rates. Does this make sense in the case of a participant who is at the 415 limit? Shouldn’t the lump sum at NRA be calculated using the 1994 GAR Mortality Table at 5.5% and then discounted back to attained age using the funding segment rates?

Furthermore, if we used an unreduced 100% joint and survivor annuity as the normal form of benefit, how should the Funding Target be calculated? It appears that our valuation software is using the plan’s Actuarial Equivalence factors (1994 GAR at 5.0%) assuming a 100% joint and survivor annuity as the normal form to calculate the lump sum at NRA and then discounts back to attained age using the funding segment rates. Does this make sense if the plan is designed such that a single lump sum is an optional form of benefit?

Any guidance, thoughts and comments would be appreciated.

[Effen]

Your software only does what you (or your programmers) tell it. Unless it was designed by Noonien Soong, it can't read regulations.

There is still debate about much of this, but I think most people agree that if you are:

1) funding for the 415 maximum as a lump sum you should use 5.5% w/ 94 GAM Post and discount at 436 interest and mortality(depending on death benefit).

2) funding for non-415 limited lump sum based on 417(e) rates, you should use 436 interest rates (maybe adjusted for 417(e) transition rules) w/ 417(e) mortality post and discount at 436 interest & mortality (depending on death benefit)

3) funding for non-415 limited lump sum based on rates lower than 417(e), you MUST use the plan's lump sum rates (interest and mortality) and discount at 436 interest & mortality (depending on death benefit)

4) funding for 415 max as the J&S annuity, I think you would use standard 436 rules pre/post - what justification would you have to use anything else?

[AndyH]

Effen, regarding the mortality/death benefit, wouldn't you agree that any ERISA plan that provides at least a REA death benefit is not required to discount the 415 benefit for mortality, except in the case of an employee-pay death death benefit. I understand that your answer is complete and thorough; just checking my understanding.

I agree on all counts otherwise, just like A-Rod and Madonna to the poster.

[Andy the Actuary]

How would you justify funding toward the J&100%? There is likely a 0% chance that plan will be settled in other than a lump sum.

I remember seeing Noonien Soong on Dick Clark's Where the Action Is circa 1966. I believe they were singing "Purple Rice and Pink Lima Beans."

[Effen]

wouldn't you agree that any ERISA plan that provides at least a REA death benefit is not required to discount the 415 benefit for mortality, except in the case of an employee-pay death death benefit

I think I'm bi-mortal (kinda like Madonna) - I have done it both ways. I don't think the IRS has ever issued a firm directive. If the plan offers only the REA death minimum, then you could argue either way. If the death benefit is the PVAB (like most small plans), then I don't think pre-mortality would be appropriate, but I have seen plans that still call for it.

How would you justify funding toward the J&100%? There is likely a 0% chance that plan will be settled in other than a lump sum.

I agree, this assumptions would probably be a stretch.

[tymesup]

If you fund for the J&100, you're probably stuck paying it out that way. Hoping that participant and spouse are good and healthy, cringing every time their number shows on caller ID. Agonizing over the bill for a plan that nobody wants anymore. Wondering if the participant would have been better off with smaller contributions and much smaller minimum required distributions. Hoping the assets plummet so you can cash out the plan and have one less albatross.

[AndyH]

Just annuitize them with AIG.

Don't worry, be happy. They're fully insured with the full faith and credit of your tax dollars.