INSURANCE CONTRACTS USING UNALLOCATED FUNDING

The basic characteristic of unallocated funding instruments in a qualified plan is that employer contributions to the plan are not initially allocated to provide specific benefits. In an insurance contract with unallocated funding, the insurance company thus does not assume the risk of paying specific benefits. Instead, the contributions are held in an undivided fund, similar to a trust fund, until annuities are purchased at an employee's retirement or until benefits are actually paid to employees. Where long-term investment results are more favorable than the investment assumptions used by insurance companies for allocated contracts, the unallocated type of contract provides an advantage to the employer because the employer contribution level can be made lower initially and the employer can retain use of the money saved. Thus, unallocated contracts have been developed by insurance companies primarily to compete with other funding agencies, such as bank trust departments.

Group Deposit Administration Contract
In the conventional type of group deposit administration (DA) contract, employer contributions to fund benefits for employees who have not yet retired are held in an unallocated account, referred to as the active life fund, annuity purchase fund, deposit administration fund, purchase payment fund, or something similar. As each participant reaches retirement age, an amount is taken from the active life fund sufficient to purchase an annuity for that participant in the amount provided by the plan. The annuity purchase rate is determined by the insurance company under the terms of the DA contract. Typically, a DA contract provides a limited guarantee of annuity purchase rates. For example, the contract may guarantee annuity purchase rates for contributions paid during the first five years of the contract, with a year-to-year guarantee thereafter. More liberal guarantees are sometimes made available by insurers to remain competitive.

Under a DA contract, the rate of contributions to the fund is determined by the employer, using a reasonable actuarial method of the employer's choosing, subject to the minimum funding standards and other rules. The employer is entirely responsible for the adequacy of the active life fund and must make contributions accordingly. The insurance company does not determine the premium or funding level. Also, the lack of allocated funding allows the same flexibility in designing the plan's benefit structure as is available under a trust fund plan. Benefit and funding flexibility are the main reasons for the attractiveness of unallocated funding instruments to employers.

In addition to design flexibility, insurance companies can provide investment features under DA contracts that make these contracts attractive. Most DA contracts provide a minimum investment rate guarantee. As with annuity purchase rate guarantees, the investment rate guarantee will typically apply to contributions paid during the first five years of the contract, with a year-to-year guarantee thereafter; more liberal guarantees may be made available from time to time to increase the attractiveness of these contracts.

Immediate Participation Guarantee Contract
The conventional DA contract just described retains one difference from a fully unallocated fund—the purchase of annuities as participants reach retirement. In determining annuity purchase rates, the insurer includes a factor for expenses, and also a factor for a "contingency reserve" to cover the possibility of adverse actuarial experience. This amount must be conservatively determined by the insurance company, because if the annuity purchase rate turns out to be excessive, the company can return part of the excess through dividends on the contract; if the purchase rate is insufficient, the insurance company cannot require the contractholder to make additional payments.

Many employers, particularly those with many employees, would prefer to assume all of the risks of making postretirement benefit payments to avoid the withdrawal of funds to purchase annuities, thereby maintaining control of the funds for a longer period of time. The immediate participation guarantee (IPG) contract was developed to provide for this market.

In most respects, the IPG contract is similar to the conventional DA contract. The principal difference is in the method of providing annuities to participants reaching retirement. Under an IPG contract, there is a single fund into which all plan contributions by the employer are deposited. Under some IPG contracts, the fund is charged directly with benefit payments as they are made. Under other contracts, the IPG fund is charged as each employee reaches retirement with a single annuity premium; however, this is done in such a way as to provide the effect of a trust fund; for example, through annual cancellation and reissuance of annuities.

Although some insurers offer no guarantees under IPG contracts, principal and minimum investment return guarantees are sometimes made available. As with conventional DA contracts, separate accounts funding can be made available under an IPG contract.

INSURANCE CONTRACTS | Pension Plan Funding

Allocated and Unallocated Funding in Insurance Contracts
Insurance companies offer a variety of contracts either designed specifically for qualified plan funding or adaptable to it. In theory, an employer could negotiate a contract with the insurance company with provisions specifically tailored to the employer's needs. In practice, however, insurance contracts tend to fall into specific types, with some but not complete flexibility in their terms. This is partly a result of the fact that an insurance contract—particularly a life insurance contract—cannot be the subject of unfettered negotiation between insurer and contractholder. Often, the terms of the contract require state regulatory approval and, consequently, the insurer is not interested in varying them for each individual contractholder. Also, historical practices and needs in the insurance industry have determined the form of many of the contracts.

Insurance contracts used in funding qualified plans can be divided into allocated and unallocated types. When funding is allocated under an insurance contract, this means that the insurer has assumed the employer's obligation to pay specific benefits to specific participants. The employer is still primarily responsible, but under the terms of the insurance contract, participants and the employer can look to the insurance company for payment of specific amounts. With unallocated funding, the insurance company acts as a holder of the funds, much like a bank trustee. With unallocated funding, the insurance company is, of course, obligated to deal prudently with the funds, but it makes no guarantee that the funds will be adequate to pay any specific benefits under the plan. An insurance contract used in a qualified plan can be either purely allocated or purely unallocated, or can offer a mixture of both.

Insurance contracts can be classified—and will be discussed—in this order:

Allocated Contracts

• Individual life insurance or annuity contracts

  1. Fully insured plans

  2. Combination plans

• Group permanent contracts

• Group deferred annuity contracts

Unallocated Contracts

• Deposit administration contracts

• Immediate participation guarantee contracts