DEDUCTIBILITY OF PENSION PLAN CONTRIBUTIONS

Excessive contributions to a pension plan fund, if they are allowed to be deducted, will accelerate the employer's tax deduction and thereby increase the tax benefit of the qualified plan beyond what is considered appropriate. To prevent this, there are specific limits on the amount of pension plan contributions that an employer can deduct in a given plan year.

Unlike the deduction limit for profit-sharing plans, which is 15 percent of payroll ), the deduction limit for pension plans is based on actuarial considerations. For a given plan year, an employer can deduct contributions to a pension plan up to a limit determined by the largest of three amounts [Code Section 404(a)(1)].

1. The amount necessary to satisfy the minimum funding standard for the year.
2. The amount necessary to fund benefits based on past and current service on a level funding basis over the years remaining to retirement for each employee. However, if the remaining unfunded cost for any three individuals is more than 50 percent of the total of the unfunded costs, fundings for those three individuals must be distributed over a period of at least five taxable years.
3. An amount equal to the normal cost of the plan plus, if there is a supplemental liability, an amount necessary to amortize the supplemental liability in equal annual payments over a ten-year period.

In determining the applicable limitation, the funding methods and the actuarial assumptions used must be the same as those used for purposes of the minimum funding standards. Furthermore. the tax deduction for a given plan year cannot exceed the full funding limitation that was discussed earlier. Thus, there is little incentive for the employer to contribute beyond the full funding limitation.

Although these limits are expressed in actuarial language, the implications are relatively easy to understand. First of all, if the plan is funded on the basis of individual insurance contracts, the second limit will generally be the one applicable to the plan because most such contracts have premiums determined on the basis of level funding for the years remaining until retirement for each employee. On the other hand, plans funded with group contracts and trust funds using a variety of actuarial methods and assumptions will generally be governed by the third alternative limit.

Note that this limit specifies the maximum deductible amount. The amount required to be contributed under the minimum funding standard as applied to the plan may be somewhat less than this limit. Therefore, in a given plan year, the employer's actual contribution and deduction may be less than the maximum limit that applies. This is one of the reasons why a defined-benefit plan with a group pension contract or trust fund can be relatively flexible for the employer. Between the minimum limit required by the minimum funding standards and the maximum deductible limit discussed earlier, there may be a relatively comfortable range of contributions that can be adjusted according to the employer's specific financial situation.

Technically, the rules previously stated apply to both defined-benefit and defined-contribution pension plans. However, for defined-contribution plans, the minimum funding standards are satisfied whenever the employer makes the annual contributions specified by the plan document. In other words, the limit on the amount deductible under a defined-contribution pension plan is simply the amount specified in the plan document. For example, the plan document in a money-purchase plan might require that each year the employer must contribute an amount equal to 6 percent of each employee's compensation to that employee's account. The total of such contributions would then be both the amount required by the minimum funding standard and the maximum amount deductible.

If an employer has a combination of defined-benefit and defined-contribution plans covering the same employee or employees, a percentage deduction limit applies. The deduction for a given year cannot exceed the greater of 25 percent of the common payroll (compensation of employees covered under both plans) or the amount required to meet the minimum funding standard for the defined-benefit plan alone. This provision has its greatest impact on highly compensated employees.

Penalty for Nondeductible Contributions
Generally, there is no advantage in contributing more to a plan than is deductible, because not only is the deduction for the excess unavailable but under Code Section 4972, a 10 percent penalty is imposed on the nondeductible portion of the contribution, with some exceptions. However, if nondeductible contributions are made, they can be carried over and deducted in future years. The deduction limit for future years, however, applies to the combination of carried-over and current contributions.

Timing of Deductions
The rules for timing of contributions and deductions for qualified plans are relatively favorable. Contributions will be deemed to be made by the employer for a given taxable year of the employer, and will be deductible for that year, if they are made by the time prescribed for filing the employer's tax return for that year, including extensions. For example, a corporation using a calendar year could contribute to the plan for 2001 as late as September 15, 2002 (the basic tax filing date of March 15, plus the maximum six-month extension). The rules for timing of contributions and deductions are the same for both cash and accrual-method taxpayers; there is no advantage for this purpose in using the accrual method.

MINIMUM FUNDING STANDARDS

The minimum funding standards of Code Section 412 and corresponding ERISA provisions provide the legal structure for enforcing the advance funding requirement that applies to qualified pension plans. A plan to which the minimum funding standard applies must maintain a funding standard account. The funding standard account is annually charged with the plan's normal cost and certain other costs and credited with certain items that benefit the plan. At the end of the year, if the charges exceed the credits, there may be an accumulated funding deficiency. In that case, there is a penalty tax and other enforcement provisions. The penalty tax consists of an initial tax of 5 percent of the deficiency, with an additional 100 percent tax if the deficiency is not corrected after notification by the IRS.

Obviously, the employer's objective is to balance the funding standard account for each year. If the employer is unable to make sufficient contributions to do this, the employer can request a waiver from the IRS of the minimum funding standard for the plan year or request an extended amortization period for certain plan liabilities.

The employer is not required to contribute annually any more to the plan than an amount referred to as the full funding limitation, even if the funding standard account would then be left with a deficit for the plan year. This important limitation is generally defined as the difference between the accrued actuarial liability of the plan computed under the plan's funding method (or if this is not possible, under the entry-age normal method) and the value of the plan assets. Finally, certain plans are allowed to establish an alternative minimum funding standard account and can then avoid a funding deficiency by avoiding a deficit in either the funding standard account or the alternative minimum funding standard account, whichever is lesser. The alternative minimum funding standard account is somewhat simpler than the funding standard account and it is usually possible to avoid a deficit with a lower employer contribution.

Exemptions from the Minimum Funding Standard
The minimum funding standard rules basically apply to all qualified pension plans. However, government plans, church plans that have not elected to be treated as qualified plans, and various types of plans having no employer contributions are exempted in Code Section 412.

More significantly, the minimum funding standards do not apply to profit-sharing or stock bonus plans. Technically, the standards apply to defined-contribution pension plans as well as defined-benefit pension plans. However, for defined-contribution pension plans (money-purchase and target plans), the minimum funding standard will be met so long as the employer contributes the amount required under the plan's contribution formula each year.

Fully insured plans—those funded exclusively by the purchase of individual insurance or annuity contracts—are specifically exempted from the minimum funding standards, as long as the following requirements are met:

• The contracts provide for the payment of premiums in equal annual amounts over a period no longer than the preretirement period of employment.

• The plan benefits are equal to those guaranteed by the insurance carrier under the contracts.

• The premiums on the contracts have been paid when due or, if there has been a lapse, the policy has been reinstated.

• No rights under the insurance contract have been subject to a security interest at any time during the plan year.

• No policy loans are outstanding at any time during the plan year.

Plans that are fully insured under group contracts are also exempt from the minimum funding standard, as long as the contracts meet conditions similar to those previously listed. These would ordinarily have to be group contracts providing fully allocated funding.

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

TRUSTS | Pension Plan Funding

The trust is the leading funding agency for qualified plans, in terms of both the number of employees covered and aggregate plan assets. A trust used for qualified plan funding is based on the same general principles of trust law as trusts used for other purposes, such as estate planning and administering the affairs of minors or incompetent persons. A trust is an arrangement involving three parties—the grantor of the trust, the trustee, and the beneficiaries. In qualified plan funding, the grantor is the employer and the beneficiaries are the employees. The trustee is a party holding funds contributed by the employer for the benefit of employees.

Legally speaking, a trustee is a fiduciary. A fiduciary is a person or organization that holds money on behalf of someone else (here the plan participants and beneficiaries) and that must administer that money solely in the interest of those other persons. The trustee's compensation is a fee for services rendered; the trustee is prohibited from personally profiting as a result of investing the trust funds.

The duties of a qualified plan trustee, like those of any other trustee, are set out in a formal trust agreement. Usually, the duties of a plan trustee are to accept employer contributions, invest those contributions, accumulate the earnings, and pay benefits to plan participants and beneficiaries out of the plan fund. The trustee performs these acts only at the direction of the plan administrator and not at the trustee's own discretion. However, in some cases, a trustee is given direct responsibility for choosing plan investments or choosing an investment adviser. The trustee must account periodically to the plan administrator or the employer for all investments, receipts, and disbursements. The trustee does not guarantee the payment of benefits or the adequacy of the trust fund to pay benefits. That remains the obligation of the employer.

A trustee may be an individual or group of individuals or a corporation such as a bank or trust company. Often employers name individual trustees, such as the company president or a major shareholder, to obtain an extra measure of control over plan assets. This is permissible under the law; however, when acting as trustee, such an individual is legally obligated to act solely in the interests of the plan participants and beneficiaries and not in the interests of the employer or shareholders.

Although a qualified plan trust is created and exists under the laws of the state in which it is established, the most significant provisions of trust law affecting qualified plan trusts have been codified in federal statutes that supersede state law whenever they apply.