A PENSION PLAN is a tax deferred savings plan. Typically, during
the years of employment, contributions are made by the employee or on behalf
of the employee to a retirement plan. The contributions and earnings generated
accumulate tax free until retirement. At which time, the employee receives
a specific monthly income for life or a lump sum payment. There are two
general types of retirement plans:
DEFINED BENEFIT PLAN
This type of plan promises that upon retirement the employee will receive
a defined (known) monthly income for life. The yearly contributions necessary
to provide the promised monthly benefit upon retirement are unknown and
depend upon a number of variables, such as:
the amount of the monthly benefit to be received upon retirement;
the number of years left until retirement;
the length of time benefits will be received;
the amount of income that can be earned on yearly contributions;
etc.
The amount of the defined monthly benefit is determined by the type of Defined
Benefit Plan. Most Defined Benefit Plans fall into one of the following
categories:
FIXED BENEFIT PLAN
This type of Defined Benefit Plan establishes the monthly benefit as a definite
(fixed) percentage of the employee's remuneration. The plan usually takes
the average of the annual compensation for a period of years prior to retirement
and multiplies it by the fixed percentage.
EXAMPLE: 50% of the average yearly compensation over the 4 consecutive plan
years which produced the highest annual compensation.
FLAT BENEFIT PLAN
Under this type of Defined Benefit Plan, the employee receives a monthly
benefit expressed as a fixed dollar amount, such as $1,000 per month.
UNIT BENEFIT PLAN
Upon retirement, under this type of Defined Benefit Plan, the employee will
receive a monthly benefit determined by a pension unit. This unit is multiplied
by each year of service for which the employee receives credit. The pension
unit is a percentage of compensation, such as 2% or a defined dollar amount.
How Defined Benefit Plans are Valued
In order to determine the value of a benefit under a Defined Benefit
Plan as of a specific date, the appraiser actuarially determines the
present value of receiving pension benefits in the future. In other words,
the appraiser determines the amount which must be invested today, so that
upon retirement, the plan has sufficient funds to provide the employee with
the appropriate monthly benefit for life. In determining the present value,
the appraiser considers mortality, age on date of valuation and separation,
normal retirement age, the monthly entitlement upon retirement, an appropriate
interest rate, and other variables.
TYPICAL SCENARIO: The Jones' were married on April 30,
1970. Mr. Jones has been employed by the XYZ Company since April 15, 1965.
On April 1, 1996, the Jones' separated. As of the date of separation, Mr.
Jones had accrued a vested benefit of $842.14 per month payable at age 62.
He was born on April 2, 1940. What is the present value of Mr. Jones' Defined
Pension Benefit? The services of a pension appraiser are secured to determine
the present value of the Defined Pension Benefit by the PBGC Actuarial and
Mortality Tables Method, Life Expectancy Method , GATT Method or a Specific
Method (dictated by state law).
DEFINED CONTRIBUTION PLAN
This plan is one in which the contributions to the plan are known (defined).
The amount of money to be distributed upon retirement is unknown and is
depends upon the manner in which the yearly contributions have been invested,
and the investment growth experienced over the years.
EXAMPLE: The employee and/or the employer contributes yearly into the plan
a fixed percentage of the employee's earned income each year. The money
contributed to the plan is used to purchase stock, bonds, mortgages, certificates
of deposit, treasury notes, etc. The value of these investments, and the
interest generated thereon, will be distributed to the employee in one lump
sum upon retirement. Upon receiving this lump sum distribution, the employee
usually purchases an annuity which provides him with a specific monthly
income for life.
How Defined Contribution Plans are Valued
The value of a benefit under a Defined Contribution Plan on any date
is the sum of the market values of all investments in the plan on that date.
The services of a pension appraiser normally would not be required to determine
the value of this type of plan, unless a coverture fraction needs to be
applied to the value or opposing council needs confirmation of the value.
In most cases, the administrator of the plan can advise the employee as
to the market value of his share of the investments in the plan on any specific
date.
TYPICAL SCENARIO: On April 1, 1996, Mr. and Mrs. Jones
separated. Mr. Jones had been enrolled in a Defined Contribution Plan. The
benefit he is entitled to receive has vested but not matured. On June 1,
1996, you request from the plan administrator, the value of the plan as
of April 1, 1996. The administrator replies that Mr. Jones' share of the
plan was worth $40,000. For equitable distribution purposes, the present
value of Mr. Jones' plan on April 1, 1996 was $40,000 unless a coverture
fraction is applicable.
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