According to the Bureau of Labor Statistics, in March 2022, 15% of private industry workers and 86% of state and local government workers had access to defined benefit plans. How these types of retirement plans, commonly known as pensions, are designed and administered makes an important difference as to how well they will serve employees and their families during their retirement. Understanding and applying best practices is in the best interests of both employees and employers/plan sponsors who must comply with two key federal laws – the Internal Revenue Code (i.e., Part 1 of Subchapter D of Chapter 1) and the Employee Retirement Income Security Act of 1974 (ERISA), as well as various other regulations. Failure to comply with these legal requirements can lead to significant penalties and the possibility of losing the tax-favored treatment of benefits provided under the defined contribution plan.
Establishing the Right Benefit Formula and Payment Forms
Designing the plan begins with determining the formula for the benefit to be paid; which is typically at an employee’s normal retirement age or normal retirement date (i.e., the date on or after attaining normal retirement age). The formula can be a set dollar amount paid each month, for life, as of the employee’s normal retirement age. Alternatively, it can be a monthly dollar amount multiplied by the employee’s years of service; which is often used in collectively bargained plans.
Other ways to establish the benefit formula include: to base the benefit on the employee’s compensation over the years worked and provide a fixed percentage of that amount, often determined as a function of the years of service; or to provide a benefit based on the employee’s compensation for the entire period he/she was covered by the plan. Benefit payments can be in the form of a single life annuity, which is a fixed amount determined under the benefit formula for as long as the plan participant is alive. Another payment formula is for a certain period and life annuity for which the payment is the actuarial equivalent of the normal benefit and payable for the life of the participant. It guarantees a minimum number of years of payments.
Administering the Defined Benefit Plan
Just as it is important to establish the right benefit formula and payment form, it is essential that defined benefit plans be optimally administered. This is a complex task which demands the expertise and experience of professionals knowledgeable on all aspects of defined benefit plan administration. Due to the associated complexities, including those relating to regulatory compliance, many organizations opt to outsource this function to a qualified third-party administrator (TPA). This firm will provide end-to-end pension and annuity administration encompassing several key functions. They include:
- Maintaining records of participant benefits, eligibility, and payment history
- Maintaining full financial records
- Processing pension applications in compliance with fund benefit rules
- Processing annuity plan distributions and loan applications
- Assisting in the preparation of government filings
- Preparing and issuing 1099s
- Administering fiduciary liability and fidelity bond insurance
- Attending and reporting at trustee meetings
- Assisting with annual audits
- Managing all billing, collection and reconciliation of monthly employer contributions or withdrawal liability payments; data maintenance; delinquency and standard reporting
- Handling member inquiries (i.e., eligibility, application status, contributions, pension payments, and annual pension and annuity statements)
- General administration, coordination, and communications with other plan professionals (i.e., accountant, auditor, attorney, actuary, benefit consultant) and the preparation of annual valuation reports, funding notices, SSA files for 5500s
- Managing appeals (i.e., documentation, presentation, recommendations, receipt of final determination, communication of resolution)
- Maintaining records (i.e., plan documents and amendments, SPDs/SMMs/benefit overviews, trustee meeting minutes, trust agreements, rate/fee adjustments)
As part of its administrative role, the TPA will also assist in ensuring that a defined benefit plan complies with federal laws and regulations. For instance, ERISA requires plan administrators to furnish a funding notice annually to each plan member and the Pension Benefit Guaranty Corp. (PBGC), labor unions representing the plan participants and/or their beneficiaries, as well as employers that are obligated to contribute to the plan when multiemployer plans are involved. It is important to note that regulations require employers to meet minimum funding levels for defined benefit plans.
Decisions relating to defined benefit plans must be well thought out. It is advisable to consult with both internal and external advisors (i.e., CFO, CPA, corporate and general counsel, and benefit consultants) to make certain the best decisions are made.