Potential Gap in Disability Benefits as a Result of Transition to Defined Contribution Plans By: Lawrence PetersCPA, EA, AIF® 2012.11.21

Issue

A disability has an impact on both the earnings of an individual prior to retirement, and on the eventual level of retirement benefits.  Currently, many employers address both of these issues.  A LTD program provides for the continuation of income during traditional working years and in many Defined Benefit Plans, a special disability provision ensures individuals will have income after reaching normal retirement age.

A Typical Solution Today

A Defined Benefit Plan can be designed to help provide for the eventual retirement of a disabled individual.  The plan can define disability as either satisfying the requirements for Social Security disability or by using a more liberal definition:   the same definition used in the Company’s LTD (Long Term Disability) program.  The Social Security definition requires an individual be unable to be gainfully employed in any occupation.  Typical LTD plans only require an individual be unable to continue in his own occupation. During disability, an individual can continue to receive both credit for service and compensation which can be assumed to continue at the same rate of pay as was earned prior to disability. Some plans even increase this imputed pay by an annual COLA (Cost of Living Allowance). 

The Problem

Defined contribution plans do not typically provide for contributions to a participant’s account during the period of disability.; With the elimination of Defined Benefit Plans, this will result in a significant reduction in retirement income when a disabled participant reaches retirement age. Unfortunately, this can’t be rectified with a simple amendment to a defined contribution plan to continue contributions during the period of disability. Rules applicable to defined contribution plans do not permit contributions to be credited to an individual’s account when there is no compensation, except in very limited circumstances (see IRC 415(c)(3)(C)(i)). In addition, many companies make only matching contributions to a defined contribution plan. If the individual is on disability there would be no participant contributions made that can be matched.

One circumstance where contributions can be made is in the event of a disability THAT SATISFIES THE SOCIAL SECURITY DEFINITION OF A DISABILITY (unable to work in any occupation). If an individual meets the Social Security definition of disability, income can be imputed at the rate in effect prior to disability. In this situation, contributions by the employer could be made during the disability. There is no provision for applying a COLA to income. The eventual retirement benefit in a defined contribution plan could fall short of what may be done in a defined benefit plan because of the restrictive definition of disability, the inability to assume increases in pay, and the inability of the employee to make contributions to the plan.

Another possible solution is to offer participants in defined contribution plans the opportunity to purchase individual disability coverage through automatic payments from their accounts. In the event of disability, the policy would make payments to the plan in an amount equal to the contributions that would have been made had they not become disabled.

Conclusion

A disability can be economically devastating to an employee, both during normal working years and after the date of normal retirement. Defined benefit plans can easily reflect provisions to address the hardship. Defined contribution plans do not offer the same flexibility or ease. Careful plan design and perhaps the availability for the employee to purchase special disability coverage though the defined contribution retirement plan can ease the burden. Give this some thought if your company is transitioning to a defined contribution retirement plan.

For other considerations, please see our article on Converting a DC plans into DB plans.

Lawrence R. Peters

Larry is a Senior Consultant at Westminster Consulting, LLC and is based in Princeton, NJ, Larry leads the Firm’s defined benefit practice. His experience includes plan design and funding, mergers and acquisitions, executive benefits and vendor benchmarking, among others.

Prior to joining Westminster...

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