Guaranteed return

[Narith]

Hello,

I am sorry if this is a basic question. I'd like to ask what do we mean when we say that the employer has to guarantee a return of 3.75% on employee contributions? For example, assume that someone, aged 65, has just started in a company and this year's employee contribution is 10,000. Then what's the amount of the lump sum that he will receive when he retires (assume at 67)?

Thank you in advance for your help.

 

[Effen]

Are you are participant in this plan?

Is this a cash balance plan?

[Narith]

13 hours ago, Effen said:

Are you are participant in this plan?

Is this a cash balance plan?

Hello,

Thank you for your response.

I am not sure what a cash balance plan is. I want to understand how I would calculate the present value of the DBO by using the Projected Unit Credit method but I miss what this guaranteed exactly means.

Thank you a lot

[C. B. Zeller]

A cash balance plan is a defined benefit plan that defines the normal retirement benefit in terms of a hypothetical account balance. If your plan document or SPD defines the benefit in terms of pay credits (sometimes called contribution credits or principal credits) and interest credits, it is a cash balance plan. In a cash balance plan, the lump sum that is payable is equal to the hypothetical account balance.

In other plans, lump sums are subject to 417(e), which means that the lump sum payment may be greater than would otherwise be calculated using the plan's definition of actuarial equivalence. The exact amount will depend on the applicable interest rate and mortality table in effect at the time of the distribution.

You were asking about employee contributions originally. The exemption from 417(e) for cash balance plans only applies to employer contributions, so you can disregard everything I said in the first paragraph.

How employee contributions work in defined benefit plans depends on whether the contributions are mandatory or voluntary. Contributory DB plans are pretty rare - I don't personally work on any, so I am by no means an expert on the subject - but my understanding is that mandatory contributions count towards part of the normal retirement benefit, essentially offsetting the employer's annual cost, whereas voluntary contributions are allocated to separate accounts and treated basically like voluntary employee contributions in a DC plan, and the benefit is based on the actual investment performance in the separate account.

Projected unit credit is an actuarial cost method and is really only useful if you are an actuary using it to determine the plan's costs for the year. If you are interested in the math behind it you can read more about it here: https://www.asppa.org/sites/asppa.org/files/PDFs/White Papers/Actuarial Cost Methods A Review.pdf

In short - I think you need to ask the plan's actuary.

[Narith]

34 minutes ago, C. B. Zeller said:

A cash balance plan is a defined benefit plan that defines the normal retirement benefit in terms of a hypothetical account balance. If your plan document or SPD defines the benefit in terms of pay credits (sometimes called contribution credits or principal credits) and interest credits, it is a cash balance plan. In a cash balance plan, the lump sum that is payable is equal to the hypothetical account balance.

In other plans, lump sums are subject to 417(e), which means that the lump sum payment may be greater than would otherwise be calculated using the plan's definition of actuarial equivalence. The exact amount will depend on the applicable interest rate and mortality table in effect at the time of the distribution.

You were asking about employee contributions originally. The exemption from 417(e) for cash balance plans only applies to employer contributions, so you can disregard everything I said in the first paragraph.

How employee contributions work in defined benefit plans depends on whether the contributions are mandatory or voluntary. Contributory DB plans are pretty rare - I don't personally work on any, so I am by no means an expert on the subject - but my understanding is that mandatory contributions count towards part of the normal retirement benefit, essentially offsetting the employer's annual cost, whereas voluntary contributions are allocated to separate accounts and treated basically like voluntary employee contributions in a DC plan, and the benefit is based on the actual investment performance in the separate account.

Projected unit credit is an actuarial cost method and is really only useful if you are an actuary using it to determine the plan's costs for the year. If you are interested in the math behind it you can read more about it here: https://www.asppa.org/sites/asppa.org/files/PDFs/White Papers/Actuarial Cost Methods A Review.pdf

In short - I think you need to ask the plan's actuary.

Hello,

I am a student actuary, that's why I am interested on this method. But first i want to understand how these plans work.

Thank you very much for the link and all the information. I'll have a look at it!

[duckthing]

It sounds like maybe you're using the term "employee contributions" to mean "contributions made to an employee's hypothetical account", which is probably going to confuse things further if you're not actually talking about employees contributing to the plan. The "guaranteed" interest rate here is what's being used to calculate the value of the participant's hypothetical account as of a valuation date. This is probably not the same as the interest rate that you'd use to calculate the PV of that hypothetical account.

You're asking two separate questions (how does a cash balance plan work, and how does the PUC cost method work) and delineating them a bit might help you find answers faster. Good luck in your studies!

[Narith]

Hello,

By employee's contribution I mean employees contributing to the plan. i.e. if my salary is 40,000 per annum and I contribute 2%, then my contribution to the plan is 800.

Thank you a lot!

[Effen]

On 5/29/2019 at 2:36 PM, Narith said:

"what do we mean when we say that the employer has to guarantee a return of 3.75% on employee contributions?"

It means just that.  The sponsor is guaranteeing the EE contribution will earn 3.75% per year.  The sponsor is bearing the investment risk and is guaranteeing the rate of return.  

Normally, the EE contribution goes into the value of the total benefit.  If the EE terminates before becoming vested, they would get their EE contributions, plus interest back.  Sometimes, there is a similar provision related to death where they are guaranteed at least a return of contributions.  In other words, in most situations, the value of the EE contributions isn't really relevant since it just gets swallowed up into the overall benefit. 

The sum of the EE contribs would impact the taxation of the ultimate benefit, assuming they are post tax contributions.

Typically the employee contribution rate is below 5%, so your example of $10,000 is very high, but not impossible for a highly paid person. Also, a typical calculation might assume monthly/weekly contributions and therefore, often 50% of the rate is credited in the first year.  Therefore, it might be something like (10000 * (1.035)^.5) * 1.035.   (Looking at your OP)

Lots of variations and not a common provision outside of governmental plans.

[david rigby]

Pardon my skepticism, I'm not convinced the original question is about cash balance plans.

FYI, there are provisions in pension law that deal with mandatory Employee contributions that might be part of a traditional defined benefit plan.  See Internal Revenue Code section 411(c).

Is this (part of) the original question?