Can a pension plan’s funding be expressed as a percentage of the one participant’s salary?

[Peter Gulia]

An S corporation maintains a defined-benefit pension plan for its only employee, who also is the corporation’s only shareholder. The plan provides a pension that’s designed to meet exactly the IRC § 415(b) limit.

This business owner has flexibility in setting her salary: for example, she might pay herself as little as $50,000 or as much as $150,000. (For this inquiry, assume that she could defend anything in that range as no less than, and no more than, reasonable compensation for the owner’s leadership of the business.)

If feasible, this hypothetical client would prefer to get an actuary’s work only once for a year, and before she decides how much salary she wants to pay herself for the year. Moreover, deciding how much income to devote to pension funding rather than other investments is a part of the business owner’s financial planning.

Assuming that all other amounts and facts are constant and the only variable is the participant’s salary, could it really be as simple as saying that the amount needed to fund the current year’s accrual of the pension varies proportionately with the salary? Would this funding amount needed on a salary of $100,000 be simply double the funding amount needed on a salary of $50,000?

My small brain worries that the idea that funding falls in a line following the salary is too facile. But I’m hoping that the BenefitsLink mavens can show me why it isn’t that simple.

[david rigby]

There are lots of actuaries more expert at 415 than I, but I don't think it's that simple. For example, if the high-3 comp is $100K (based on some prior years) but the current comp is $50K, the 415 limit will be based on the former. If the current comp and all expected future comp is less than some prior high-3, then the actuary may be able to accomodate your goal.

I'll leave it to the experts.

[SoCalActuary]

An S corporation maintains a defined-benefit pension plan for its only employee, who also is the corporation’s only shareholder. The plan provides a pension that’s designed to meet exactly the IRC § 415(b) limit.

This business owner has flexibility in setting her salary: for example, she might pay herself as little as $50,000 or as much as $150,000. (For this inquiry, assume that she could defend anything in that range as no less than, and no more than, reasonable compensation for the owner’s leadership of the business.)

If feasible, this hypothetical client would prefer to get an actuary’s work only once for a year, and before she decides how much salary she wants to pay herself for the year. Moreover, deciding how much income to devote to pension funding rather than other investments is a part of the business owner’s financial planning.

Assuming that all other amounts and facts are constant and the only variable is the participant’s salary, could it really be as simple as saying that the amount needed to fund the current year’s accrual of the pension varies proportionately with the salary? Would this funding amount needed on a salary of $100,000 be simply double the funding amount needed on a salary of $50,000?

My small brain worries that the idea that funding falls in a line following the salary is too facile. But I’m hoping that the BenefitsLink mavens can show me why it isn’t that simple.

Generally, this is best done with a cash balance plan design, where the plan investments are kept within relatively small range of volatility.

The pension cost is actually a combination of:

Salary, age and service are applied against plan benefit formula to produce a promised benefit. This also must consider the maximum limits under IRC 415.

Promised benefit is measured in current value, separately for the portion earned in the past vs amount earned currently.

Assets are compared to value of past benefits. If assets are too low (volatility in performance or moral neglect in govt plans) then you need to make up the underfunding as part of the current cost. Otherwise, the current cost is the value of the benefit being earned in the current year.

So, no simple formula is exact. That's why actuaries have to make the calculations. But the closest you come to your goal is by using a cash balance formula tied to current pay.

[rcline46]

Cash balance only works first year, then PPA takes over and voila - cost starts deviating from the cash balance formula and it is as if you were back with a traditional formula - such as a career average plan.

[SoCalActuary]

Let me restate your position from the perspective of the actuary.

Managing risk is easy until you actually have risk. Once the assets are invested, you have risk.

But you must also consider this: PPA funding allows a range of contributions, so you usually can fund the CB plan to exactly match the pay credit. The exception is when investments just get too far outside the acceptable range.