* A defined benefit plan must meet its funding target. To determine the funding target at the beginning of each plan year, a defined benefit plan's funded level is measured by comparing the value of benefits earned as of that date to plan assets. Divide the assets by the value of benefits earned to determine a funded percentage, called the funding target attainment percentage (FTAP).
* A defined benefit plan that experiences losses must contribute the normal contribution or "target normal cost" plus an amount to make up the losses over the next seven years. If these plans are converted to cash balance defined benefit plans, lump-sum distributions may be limited or, in many cases, not available. All cash balance plans require actuarial certification and an FTAP calculation that must be completed by Oct. 1, or the plan will be "deemed" to be underfunded, preventing lumpsum distributions.
* IRC [section] 412(e)(3) exempts a plan from the minimum funding rules under the Pension Protection Act of 2006 and the Worker, Retiree, and Employer Recovery Act of 2008 provided the plan's assets are in certain investments such as annuity contracts that have guaranteed returns.
* Modern portfolio theory dictates that a mix of equities and bonds will perform better than a portfolio comprised exclusively of one or the other. Diversification can be accomplished by incorporating a profit sharing plan along with the pension plan, or adding a pension plan to a profit sharing plan.
* When paired with a 412(e)(3) plan, most existing 401(k) plans will need to be modified. If the plan is a match plan or safe harbor plan, the plan needs to be converted to a 401(k) profit sharing plan because the employer contributions for safe harbor or match cannot be used to satisfy IRC [section] 401 (a)(4) in a cross-tested plan with a defined benefit plan.
* The PPA allows 6% of pay to be placed into a profit sharing plan and deducted along with the pension plan if the plan is not covered by the PBGC. Non-PBGC plans allow up to $14,700 to be placed into the profit sharing plan in 2009 along with an additional $16,500 in elective deferrals for a total of $31,200 in 2009. If the pension plan is covered under the PBGC, the plan sponsor may deduct the entire contribution to the 401(k) profit sharing plan (up to $49,000 in 2009) and the entire contribution to the 412(e)(3) pension plan, which in some cases can be as high as $300,000 per participant.
Many traditional defined benefit pension plans are underfunded due to market declines. As a result, barring congressional action, they could face future excise taxes ranging from 10% to 100% of the underfunded amounts as mandated by the Pension Protection Act of 2006 (PPA). Funding liabilities are especially difficult for smaller plans whose sponsors typically have fewer options to make up shortfalls caused by rapid declines in plan assets.
This article reviews key laws and regulations impacting defined benefit plans and explores options available to plan sponsors and their advisers.
MINIMUM FUNDING STANDARDS
A plan must fully fund its funding target, although not in one year. The funding target is the present value of accrued benefits determined under IRS rules. To determine the funding percentage at the beginning of each plan year, a defined benefit plan's funded level is measured by comparing the value of benefits earned as of that date with plan assets. Divide the assets by the value of benefits earned to determine a funded percentage, which is called the funding target attainment percentage (FTAP).
Example 1: Market Value of Trust Investments = $2,000,000 Present Value of Accrued Benefits = $2,000,000
$2,000,000/$2,000,000 = 1 or an FTAP of 100%
In 2008, the S&P 500 lost 37%. If a 40% loss is applied to the assets in Example 1, the calculation becomes $1,200,000/ $2,000,000 = 0. …