It’s official, Fall has arrived in the Northeast and the green leaves of Summer are beginning to turn into vibrant hues of red, orange and yellow. As the Employee Benefit Plan Form 5500 deadline of October
15 deadline has passed, it’s a great time to reflect and implement recommendations from your Plan auditor, investment advisor, and ERISA counsel. Also, don’t forget to check your participant count as, in general, if you have 100 or more eligible participants, as of the beginning of the Plan year, you’ll need an audit.
Although, the most common type of Employee Benefit Plan is the Defined Contribution Plan (ie: 401(k), 403(b), Profit Sharing Plan) there are quite a few Defined Benefit Plans still in effect. We’ll focus our attention on Defined Benefit Plans, explain the major differences between a Defined Benefit Plan and Defined Contribution Plan, and provide best practices for reviewing and understanding Defined Benefit Plans. Plan fiduciaries, including plan committee members and plan administrators will find this information most useful when meeting to discuss the plan.
The key differences between a Defined Benefit Plan and a Defined Contribution Plan is how the plans are funded and who bears the investment risk. Defined Benefit Plans are funded by the employer, who guarantees a specific retirement benefit amount for each participant; whereas Defined Contribution Plans are funded primarily by the employee and the ultimate benefit to be distributed is whatever is in a participant’s account at the time of distribution.
For Defined Benefit Plans, generally the benefits are defined as a percentage of compensation or a certain dollar value based on years of service. When determining how much money to contribute now to pay a benefit in the future, present value calculations are required. Each defined benefit plan sponsor engages an actuary to perform the calculations and determine annual contributions required taking into account the demographics of the participants, the benefit levels to be paid out, the timeline to distribution, as well as discount rates and mortality rates.
Many defined benefit plans are “frozen” for eligibility and/or benefit accruals. When eligibility is frozen, the plan is closed to new participants. When benefit accruals are frozen, participants are no longer earning future benefits. Plan sponsors freeze defined benefit plans since they cannot terminate them unless they are able to pay the benefits due (meaning the plan is fully funded).
The actuarial calculations are performed using a census of all the participants. It includes relevant information such as date of birth and date of hire (if benefits are based on length of service) and salary information (only if the benefits provided for in the plan are based on compensation). Each year the actuarial census is prepared and updated to reflect current information. The actuary utilizes the actuarial census to prepare the actuarial valuation which includes calculations to determine the annual contribution required to meet the plan’s minimum funding requirement and the actuarial present value information required to be disclosed on the plan’s financial statements and the employer’s financial statements. The actuarial census is not to be confused with the payroll census. The actuarial census includes participants who have terminated but are vested, retired and receiving benefits, as well as those who are active and eligible. The payroll census is only those who received a paycheck in the current year. Since the actuarial census is designed to assist in determining the amount of the annual contribution to the plan, it generally is prepared as of the beginning of the year, however is can be prepared at the end of the year.
It is important to ensure the actuarial census is complete. This can be accomplished by counting the number of persons on the actuarial census and comparing it to the summary count in the actuarial valuation, as well as the summary count on the applicable Form 5500. The actuarial census generally separates participants into groups such as: Actives, Terminated Vested & Retired receiving benefits, and the count can be compared for each group.
The count should be reviewed for reasonableness. For instance, if a Plan is frozen for eligibility, the number of active participants should not increase. If prior year active participants have since terminated, their status would be changes from active to a status such as terminated, terminated vested or retired, as applicable. In addition, relevant information (ie: date of birth, date of hire, compensation) should also be reviewed to ensure accuracy.
Key actuarial assumptions used in the valuation must be reviewed for reasonableness. The most significant assumption is the discount rate. Essentially, it is the assumption of what investment earnings will be over time. The more those investment earnings are, the less the employer would have to contribute and vice versa. The other main assumption is the mortality table. The longer participants live, the higher the plan obligation. It’s important to ensure the mortality table used in the valuation is not outdated. The American Society of Actuaries publishes the mortality tables and, in more recent years, the updated tables have been published after October 15.
It is important for Plan administrators to ensure newly eligible participants are included in the actuarial census (if the Plan is not frozen for eligibility). Best practice is to obtain the payroll census and sort by date of hire, date of birth, etc. to determine newly eligible and compare to the actuarial census.
Contributions need to be tested for timeliness as well as to ensure the contribution is applied to the proper Plan year. Plan sponsors generally have until the filing of their Company’s tax return to make contributions to the plan. The due date can be 9 ½ to 10 ½ months after the Plan year end, depending on Company tax return extensions. Therefore, it can be tricky to determine which contribution is for which Plan year. It is best practice to compare the schedule of contributions in the actuarial valuation and Schedule SB of the Form 5500, to the contributions received by the Plan. It may be necessary to verify with the actuary as well.
The actuary generally calculates the benefit to be paid to participants. It is a best practice for plan administrators to trace the distribution amount to the actuary’s calculation, compare the inputs used in the actuary’s calculation to the actuarial census and the components identified in the plan document, such as date of termination, date of birth, date of hire, compensation and title, as well comparing to the participant’s election, such as joint and survivor annuity, single life annuity, to ensure the distribution amount is proper. If the Plan’s third party administrator writes the distribution checks to participants, inquire if they have a SOC 1 report that covers distributions.
The significant amount of reliance on third party service providers, including the actuarial firm’s calculation of defined benefit plan obligations, contributions and distributions, may lead a Plan sponsor to feel as though they can run the plan on auto-pilot. This may be even more prevalent in the case of frozen defined benefit plans. However, it is important to remember, while Plan administrators can delegate responsibility to third party service providers, they cannot abdicate their responsibility. Ultimately, it is the Plan administrator’s fiduciary responsibility to ensure the accuracy of the information reported on the Form 5500.