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21.4 Pension Plan Funding Techniques

Learning Objectives

In this section we elaborate on the employer’s pension plan funding options, which include the following:

  • Noninsured trust plans
  • Insured plans: group deferred annuity, deposit administration, immediate participation guarantee (IPG) contract, separate account plans, guaranteed investment contract (GIC)

ERISA requires advance funding of qualified pension plans. An advance funded plan accumulates funds during the period in which employees are actively working for the organization. Pension expense is charged against earned income while pension obligations are accumulating instead of being deferred until employees have retired. Pension plans are funded either through noninsured trust plans or insured plans.

The Pension Protection Act of 2006 includes provisions to strengthen the funding of defined benefits plans. Plans are required to be fully funded over a seven-year period.

Noninsured Trust Plans

With a noninsured trust planPension plan funding technique whereby the employer creates a trust to accumulate funds and disburse benefits; the trustee may be an individual, a bank, a trust company, an insurer, or some combination of cotrustees whose responsibilities are to invest funds contributed by the employer to the trust (and by employees, if contributory); accumulate earnings; and pay benefits to eligible employees., the employer creates a trust to accumulate funds and disburse benefits. The trustee may be an individual, a bank, a trust company, an insurer, or some combination of cotrustees. The duties of the trustee are to invest the funds contributed by the employer to the trust (and by the employees, if contributory), accumulate the earnings, and pay benefits to eligible employees. The trustee makes no guarantee with regard to earnings or investments.

Under a defined benefit trust plan, a consulting actuary is employed to estimate the sums that should be put into the trust. The employer is, in effect, a self-insurer. The consulting actuary does not guarantee that the estimates will be accurate. There is also no guarantee as to the expense of operating the plan. Thus, the employer that chooses a noninsured trust to fund a defined benefit plan should be large enough and financially strong enough to absorb differences between actual experience and past estimates of mortality, investment returns, and other cost factors.

Insured Plans

Several insurer options are available for funding pension plans. These are group deferred annuity contracts, group deposit administration contracts, immediate participation guarantee contracts, separate accounts, and guaranteed investment contracts.

Group Deferred Annuity Contracts

The group deferred annuityInsured pension funding option that is a contract between insurer and employer to provide for the purchase of specified amounts of deferred annuity for employees each year. is a contract between the insurer and the employer to provide for the purchase of specified amounts of deferred annuity for employees each year. For example, an annuity that would pay retirees $50 per month beginning at age sixty-five might be purchased by the employer from the insurer each year for each employee. The employer receives a master deferred annuity contract, and certificates of participation are given to individuals covered by the plan. Group plans usually require some minimum number of participants to lower administrative expenses per employee.

Under this plan, all actuarial work is done by the insurer, which also provides administrative and investment services. Neither the employees nor the employer are subject to the risks of investment return fluctuations. The only risk is the possible failure of the insurers. The employer’s only responsibilities are to report essential information to the insurer and to pay the premiums.

Group Deposit Administration Contracts

The deposit administrationInsured pension funding arrangement that requires the employer to make regular payments (as determined by actuaries) to the insurance company on behalf of employees, and these contributions accumulate at interest. arrangement requires the employer to make regular payments to the insurance company on behalf of employees, and these contributions accumulate interest. An actuary estimates the amount of annual employer deposits necessary to accumulate sufficient funds to purchase annuities when employees retire. The insurer guarantees the principal of funds deposited, as well as a specified minimum rate of interest. However, the insurer has no direct responsibility to employees until they retire, at which time an annuity is purchased for them. Before retirement, the employee’s position is similar to that under an uninsured trust plan. After retirement, the employee’s position is the same as it would be with a group deferred annuity contract.

Immediate Participation Guarantee Contracts

The immediate participation guarantee (IPG) contractInsured pension funding plan that is a form of deposit administration whereby the employer makes regular deposits to a fund managed by the insurance company and the insurer receives deposits and makes investments. plan is a form of deposit administration; the employer makes regular deposits to a fund managed by the insurance company. The insurer receives deposits and makes investments. An IPG may be structured like a trust plan in that the insurer makes no guarantee concerning the safety of investments or their rate of return. However, some IPGs may guarantee the fund principal and a minimum rate of return.

The IPG is distinct from other deposit administration contracts and attractive to employers because it gives employers more flexibility after an employee retires. The employer has the option to pay retirement benefits directly from the IPG fund rather than locking into an annuity purchased from the insurer. This gives the employer control over the funds for a longer period. The employer can also purchase an annuity for the retired employee.

Separate Accounts

Separate account plansInsured pension funding plans that are a modification of deposit administration contracts designed to give the insurer greater investment flexibility; contributions are not commingled with the insurer’s other assets and not subject to the same investment limitations. are another modification of deposit administration contracts and are designed to give the insurer greater investment flexibility. The contributions are not commingled with the insurer’s other assets and therefore are not subject to the same investment limitations. At least part of the employer’s contributions is placed in separate accounts for investment in common stocks. Other separate accounts pool money for investment in bonds, mortgages, real estate, and other assets. Usually, the funds of many employers are pooled for investment purposes, although a large firm may arrange for a special, separate account exclusively for its own funds. Separate accounts may be used to fund either fixed-dollar or variable annuity benefits.

Guaranteed Investment Contracts

Guaranteed investment contracts (GICs)Insured pension funding arrangements used by insurers to guarantee competitive rates of return on large, lump-sum transfers (usually $100,000 or more) of pension funds, usually from another type of funding instrument. are arrangements used by insurers to guarantee competitive rates of return on large, lump-sum transfers (usually $100,000 or more) of pension funds, usually from another type of funding instrument. For example, an employer may terminate a trust plan and transfer all the funds in the trust to an insurer who promises to pay an investment return of 7 percent for each of the next ten years. At the end of the specified period, the GIC arrangement ends and the fund balance is paid to the original investor, who may decide to reinvest in another GIC.

Key Takeaways

In this section you studied the methods of funding retirement benefit plans, as required by ERISA:

  • The employer assumes all retirement plan funding and benefit obligations in noninsured trust plans; the trustee makes no guarantee regarding earnings or investments and may be an individual, bank, trust company, insurer, or combination of cotrustees.

  • Funding of pension plans can be insured through several options.

    • Group deferred annuity—insurer handles all actuarial, administrative, and investment services
    • Deposit administration—insurer guarantees the principal and a specified rate of interest, but has no direct responsibility to retirees
    • Immediate participation guarantee (IPG) contract—form of deposit administration that may be structured like a trust plan
    • Separate account plans—form of deposit administration contract giving the insurer greater investment flexibility
    • Guaranteed investment contracts (GICs)—used to guarantee competitive rates of return on large transfers of pension funds from another type of funding instrument

Discussion Questions

  1. Under what circumstances might an employer fund retirement plans through a noninsured trust plan?
  2. What makes an IPG contract more attractive to employers?
  3. Explain the difference between a group deferred annuity contract and a deposit administration contract. Which offers more protection to employers against the risk of inadequate funding of a promised, defined benefit?
  4. Compare variable annuities with index annuities.