Financial Fiduciaries, LLC WAMIC 2016 Directors seminar

Financial Implications of Defined Benefit Plans and Other Alternatives Presented By: Thomas W Batterman Fiduciary Advisor Financial Fiduciaries, LLC November 9/16, 2016

Contrasting Defined Benefit with Defined Contribution Plans Focus is on what is contributed The amount “is what it is” at employee’s retirement, and determines retirement benefit Defined Benefit Focus is on providing a certain monthly distribution for the employee at retirement E.g., equal to of 5 highest years of comp The amount of the contribution needs to be sufficient to fund the expected distribution

Reverse of a Mortgage Calculation Mortgage Example $100,000 Mortgage Amount 5% interest 15 year amortization Principal & Interest monthly payment $790.79

Defined Benefit Calculation Start with the designated benefit amount $790.79 How much money is needed to fund this benefit? It is a function of how long the benefit is going to be paid and what you are going to earn on the funds pending payout.

Variable Inputs Length of benefit payment Determined by life expectancy Single or joint life affects the calculation Fund Earnings How much are your investments going to earn?

Example If the plan needs to provide a monthly benefit of $790.79, the applicable life expectancy is 15 years and the assumed earnings rate is 5%, how much money does the plan need to have put away to fund this benefit? $100,000

Different Life Expectancy Assume the same benefit level and the same earnings rate, but different life expectancy 20 year life expectancy $119,825 10 year life expectancy $74,557

Different Earnings Rate Assume the same benefit level and same life expectancy (15 years) but different earnings rate 3% earnings rate $114,511 8% earnings rate $82,749

Different Payment Requirement What happens if the payment increases? Why would this happen? Increased salary increases pension amount Assume 15 year payout and 5% interest, but payment increases to $850 Required funding = $107,487

One Added Complication The required funding is the amount necessary to fund the benefit at normal retirement E.g., at age 65 Question: How much must you contribute today for a 45 year old employee in order to have the required funding in the plan when that employee attains age 65?

Present Value Calculation If the plan requires $100,000 when the employee reaches age 65 (in 20 years) and the plan assumes an investment return of 5%, how much do you need to deposit today in order to have that deposit grow to $100,000 in 20 years? $37,689

Effect of Employee Age $82,270 What if the plan just started (so there are no accumulated funds in the account) and a 61 year old employee needs $100,000 in the plan at age 65 to fund the projected benefit? $82,270 As this amount far exceeds what could be contributed to a DC plan, this is a planning tool for small employers looking for big tax deductions

Impact on Financial Statements High administrative costs Difference between accumulated fund and what is required to be in the fund is your required annual contribution Liability at year-end Reduces surplus Personnel expense on income statement

Company Guarantees Fund Balance The Company is essentially guaranteeing that the required fund balance will be in the plan What affects contribution requirements? Negatively (increases required contribution) Investment returns less than assumed rate (5% here) Retired employees outliving their projected payout New payroll (new employees or higher wages) Positively (decreases required contribution) Investment returns exceeding assumed rate (5% here) Retired employees dying early Reduced payroll

Other Types of Retirement Plans Defined Contribution Plans Focus is on calculating the amount to be contributed, not the amount to be received by the employee Types SEP SIMPLE 401(k)

Simplified Employee Pension (SEP) Company makes a contribution to each eligible employee’s IRA set up for this purpose Amount is completely discretionary with the Company and determined annually Broad eligibility – as little as $550 in comp May tighten up by adding 3 out of last 5 years Percentage of contribution in relation to compensation must be the same for all

$10,000 Company Contribution Sample SEP Allocation $10,000 Company Contribution Salary Contribution Cont/Salary % $50,000 $5,000 10% $30,000 $3,000 $20,000 $2,000

SEP Summary Benefits Contribution amount is flexible No administrative costs Detriments Broad coverage requires contributions for more employees than a standard retirement plan All contributions are 100% vested Employees may withdraw funds prior to retirement if willing to pay taxes and penalties No facility for employee voluntary saving

SIMPLE Employee establishes an IRA Broad eligibility $5,000 or more of comp in 1 or 2 of last 5 years 2 types of contributions Employee deferrals Employees direct funds they would otherwise receive as wages into the plan as deferrals Employer contributions are required Alternative formulas: 2% of employee compensation regardless of deferral, or 100% of what employee defers up to 3% of compensation

SIMPLE Employer Matching Example 100% up to 3% Compensation Deferral Match $40,000 $1,000 $1,200 $2,000

SIMPLE Summary Benefits No administrative costs Allows employees to save for retirement Detriments Broad coverage requirements All Company contributions 100% vested No facility for additional Company contributions Employees may withdraw funds prior to retirement if willing to pay taxes and penalties

401(k) Plans Employees can defer salary like SIMPLE Employees can direct their own investments like both SIMPLE and SEP No required Company contributions. Except: Safe Harbor election would lock Company into annually renewable SIMPLE-like contributions ADP, ACP & Top Heavy contributions may be required Company may contribute a percentage of salary like a SEP, match a certain amount of the employee’s contribution like a SIMPLE, or both. Company contributions (except from 3 above) may be subject to a vesting schedule

401(k) Summary Benefits Flexible funding alternatives for the Company Both employee and Company contributions are possible in the same plan Vesting helps ensure employee longevity In-service withdrawals can be denied Coverage may be limited to full-time staff Detriments Administrative costs - Hard charge or imbedded in investment costs Annual governmental reporting and other requirements

Non-Qualified Plans Qualified Plans generally: Have rules that require equal treatment for all employees Have assets segregated from the Company’s funds in a separate account for the employee Non-Qualified Plans Can be set up for a single employee or a small group of employees Not subject to rules of qualified plans Assets normally can’t be segregated from Company funds to avoid employee paying current income tax on the benefits

Non-Qualified Plans (cont’d) Can involve Company contributions, Employee contributions or both. No current tax deduction for the Company for contributions it or the employee makes Tax deduction is taken in the future at distribution Administrative complexities Written plan document required Governmental notice required Trust administration necessary if Rabbi Trust

Procedures to Change Plan Form Defined Benefit Plan Plan funding requirement must be fully funded Plan is terminated and accumulated benefits are paid out to the employees SEP Company stops making contributions Employees end up with an IRA SIMPLE Company announces the plan is ending Future contribution obligations terminate

Changing Form (cont’d) 401(k) Employer gives notice of plan termination Plan must be brought up-to-date with all required plan amendments before terminating ($$) Notice of termination provided to employees All non-vested Company contributions become 100% vested Upon termination, balances are distributed to employees to take in cash or rollover to their IRA

Financial Fiduciaries Questions? Thomas W Batterman Financial Fiduciaries www.financialfiduciaries.com (800)950-8110 tbatterman@yourfiduciaries.com