Fully Insured Pension Plan

Transcription

1 Fully Insured Pension Plan Marketing Guide

2 There are approximately 23 million small businesses in the U.S.* *Small Business Administration: Small Business Trends (sba.gov)

3 The Market for Fully Insured Pension Plans Discover how the fully insured approach can differentiate you from your competitors. Many small business owners and self-employed professionals put off saving for retirement to build their businesses. Now that they are older, the need for increased retirement savings has intersected with their desire to minimize current income taxes. This dilemma has made the Fully Insured Pension Plan an attractive topic among small business-owners, and because the plan is funded with fixed annuity contracts and life insurance policies among agents. With interest piqued, let s review how this plan can stimulate your sales while capturing the imagination of your clients. Fully Insured Pension Plan A Fully Insured Pension Plan offers guaranteed, rather than promised, retirement benefits to its participants through funding vehicles that can only be provided by a life insurance company. Funding Vehicles Fixed annuity contract, or Combination of fixed annuity contract and whole life insurance policy. Features Fully guaranteed retirement benefits, Largest possible tax deduction compared to other retirement plans in the early years, and Pre-retirement death benefit. Many small business owners are looking for: larger income-tax deductions, guarantees with their retirement plans, and opportunities to purchase insured survivor benefits on a tax-deductible basis. 1

4 Prospect Profile A Fully Insured Pension Plan is ideally suited for a mature small business owner who has been unable to save for retirement in earlier years. Now, with stable income flow, the businessowner desires to put away a very large, tax-deductible contribution for retirement. A Fully Insured Pension Plan is not apropriate for all businesses. Accurate prospect selection will allow you to effectively match the plan with the client. Businessowner Characteristics Age 50 and up Less than 10 employees Most employees much younger than owner Stable high income Plans to retire in years Ideal Plan Sponsor Businessowner: Dentist, age 52 Income: $420,000 net annually Employees: 2, with wages of $40,000 and $24,000 annually Goal: To create a large retirement fund quickly to replace 50 percent of his earnings during retirement and yet generate an immediate tax deduction for funding the plan. 2

5 Overview of the Fully Insured Pension Plan A Fully Insured Pension Plan provides protection in down markets and offers the highest income tax deduction available through a Qualified Retirement Plan. A defined benefit plan is a qualified, employer-sponsored retirement plan that is funded, in most cases, solely by the employer. It is a traditional type of pension plan that promises to pay employees a specified monthly benefit after retirement. Benefit is usually defined as a monthly payment based on compensation and years of service. Many plans calculate an employee s retirement benefit by averaging the employee s earnings during the last few years of employment (or, alternatively, averaging an employee s earnings for his entire career), taking a specified percentage of the average and then multiplying it by the employee s number of years of service. An actuary reviews the plan each year and calculates the amount that is to be contributed so the plan will have sufficient assets to pay the promised benefits to participants at retirement. Because the rate of return one of several key factors in the calculation used by the actuary is an educated guess based on the past performance of the fund or similar funds, it is likely that the plan s actual return will be greater or less than the assumed rate. Consequently, ERISA places stringent funding rules on defined benefit plans resulting in much complexity and often high administrative costs. A Fully Insured Pension Plan, however, addresses such issues and provides for a simpler, easier-to-understand plan. Fully Insured Pension Plans A Fully Insured Pension Plan is a particular type of defined benefit plan offering a guarantee of future benefits with funding requirements under IRC Section 412(e)(3). Specifically, a Fully Insured Pension Plan is exempt from the minimum funding requirements contained in other provisions of Section 412 and is guaranteed exclusively by fixed annuity contracts, or a combination of fixed annuity contracts and whole life insurance policies. Further, unlike a defined contribution plan, the Fully Insured Pension Plan provides a guaranteed positive rate of return on investments by shifting the risk from the employer/employee to the insurance company. Mechanics An employer funds the plan by making annual deductible contributions for eligible employees; the employees are not taxed on the contributions. The plan then purchases annuity contracts with a guaranteed rate of return from an insurance company. The minimum interest rate guarantee for the annuity and the guaranteed settlement option become the funding assumptions for the plan. The accrued benefit for participants is measured by the cash surrender value of all insurance contracts. When an employee retires, the annuity pays an annual retirement benefit taxable to the employee. Any death benefit distribution from the annuity is taxable income to the beneficiary. By including an insured death benefit in the plan, the employer can make additional tax-deductible contributions to the plan to purchase life insurance on the employees lives. No income taxes are payable at the pre-retirement death of the participant on the net amount at risk that is the difference between the policy s cash value and its total death benefit so the beneficiary receives these dollars income tax free. This treatment is allowed because the participants must recognize the cost of the current economic benefit as taxable income each year. The current taxable benefit is determined by multiplying the difference between the policy s death benefit and its cash value by the one-year term rates in IRS Notice Employee Benefit Plans: These plans treat owners and key employees the same as other employees and do not attempt to weight the plan benefits in favor of any one individual or group. Traditional 401(k) plan Profit sharing plan Target benefit plan Money purchase plan Defined benefit plan - large companies, government entities, public education institutions Tax Shelters: These plans are designed on the premise that owners and key employees are typically older and more highly compensated and plan benefits are weighted in favor of these groups. Defined benefit plan less than 10 employees Fully insured pension plan less than 10 employees New comparability profit sharing plan Age-weighted profit sharing plan Safe harbor 401(k) plan 3

6 Advantages The appeal of the fully insured plan is exemption from IRC Section 412 funding requirements and the elimination of market risk for the employer. Elimination of Actuarial Certification Contributions for this plan are calculated using a simple present value formula based on the contract s guaranteed rate of return, the retirement benefit and the number of years until the employee s retirement. This eliminates actuarial expenses to calculate yearly contributions. And, unlike the traditional defined benefit plan, a Fully Insured Pension Plan is not required to provide actuarial certification. No Quarterly Contribution Requirements This fully insured plan is not subject to the requirement of making quarterly contributions; instead it requires annual funding. In a traditional defined benefit plan, quarterly contributions are usually a nuisance for small businesses. Allows Maximum Contributions and Deductions Most qualified retirement plans are limited in contribution amount to a maximum 25 percent of compensation. Because a Fully Insured Pension Plan guarantees a specific benefit, that benefit must be funded over the remaining available time before retirement. This means that significantly larger contributions can be made over a relatively shorter period of time for an older owner participant. And, because the Fully Insured Pension Plan is a qualified plan, the contributions are tax deductible to the employer. Further, annuity and life insurance guaranteed assumptions are conservative. Most often the traditional defined benefit plan has an interest rate assumption much higher than the guaranteed interest rate in a fully insured plan. So, with a Fully Insured Pension Plan, the lower the plan interest rate assumptions, the higher the required initial contribution will be. Always Fully Funded The Pension Benefit Guarantee Corporation (PBGC) is a federal corporation that administers the pension insurance program established by ERISA. The PBGC generally insures workers in the event that their defined benefit plans do not have sufficient assets to pay benefits if the plans are terminated because of bankruptcy or other financial distress of the sponsoring employers. The program is funded with premiums (flat-rate fixed premium and variable-rate premium) paid by defined benefit plan sponsors. By definition, if a plan conforms to IRC Section 412(e)(3), plan assets will never be insufficient to pay benefits when due. This results in a significant cost savings for employers as the variable-rate premium is eliminated for Fully Insured Pension Plans and the flat-rate fixed premium per participant is optional. Advantages of a Fully Insured Pension Plan CONTRIBUTIONS Higher contribution limits for older owner participants Greater tax deduction potential ACCUMULATION Earnings accumulate tax-deferred Assets protected from creditors DISTRIBUTION Pre-determined defined benefit guaranteed by insurer Potential for death benefit to beneficiaries 4

7 Funding Vehicles Fully Insured Pension Plans must be funded by certain insurance contracts. At Ohio National, we offer the following options: Prime II Annuity Prestige 100 Whole Life Insurance Policy Prime II Fixed deferred annuities are the primary funding vehicles due to incidental insurance rules (discussed later) and provide the majority of retirement benefits. The guaranteed annuity interest factor must be used as the pre-retirement interest rate assumed for funding the plan. The annuity interest paid in excess of the guaranteed rate must be used to reduce the contribution for the following year. Ohio National s Prime II annuity is designed to meet these plan requirements and is an ideal funding vehicle for this type of plan. To qualify, all assets of the plan must be used to purchase guaranteed insurance products (fixed annuities and whole life insurance). Prestige 100 Prestige 100 is Ohio National s whole life insurance policy suited for Fully Insured Pension Plans. Keep in mind the primary purpose of a pension plan is to provide retirement benefits. However, plan contributions can be used to purchase life insurance for participants with pre-tax dollars thus increasing the deductible contributions for the employer, while creating additional benefits for the participants. If Prestige 100 is used in combination with a Prime II annuity, advisers must follow the incidental benefit rules.* There are two practical tests developed by the IRS to consider whether a death benefit is incidental (Revenue Ruling ). The first test, primarily used for defined benefit plans, is the 100-to-one test. The participant s insured death benefit must be no more than 100 times the expected monthly retirement benefit. The second test is referred to as the percentage-of-benefits test. This test states that if the life insurance premium portion does not exceed 50 percent of the employer contribution, the resulting death benefit is incidental to the plan. This percentage is applicable with ordinary whole life policies. Though this test is primarily used for defined contribution plans, it may also be applied to defined benefit plans. *Treasury Regulation Section (b)(1)(i) IRC Requirements Certain requirements must be met for a plan to qualify under IRC Section 412(e)(3): The plan must be funded exclusively with annuity products, or a combination of annuity products and life insurance with the exact same settlement options, issued by an insurance company. These contracts must be from the same series and must also use the same mortality tables and rate structures for all participants. Universal life insurance, variable life insurance and variable annuity contracts cannot be used for funding. The benefits provided to each individual must be equal to the value provided in the contracts and guaranteed by the insurance carrier. All participants must receive a fully guaranteed retirement benefit. Life insurance dividends and excess annuity interest must be used to reduce the following year s plan contribution. 5

8 Premiums must be paid each year. No policy loans are allowed under the contracts. Nondiscrimination, participation and vesting rules found in other qualified retirement plans also apply to Fully Insured Pension Plans. Consequently, as the number of employees increases, and as the age of the employees becomes closer to that of the owner, the total cost of contributions in the plan rises, which could potentially hinder the owner s retirement goals. The insurance policies must provide for level annual premiums that are to be paid beginning with the date the individual became a participant in the plan (or, in the case of an increase in benefits, at the time such increase becomes effective) and extending not later than the retirement age for each individual participating in the plan. The assets of the plan may not be used as collateral. Eligible Businesses Since these plans require large contributions each year, the plan only works when a business is established and highly profitable. Businesses eligible for a Fully Insured Pension Plan include: Sole proprietors General or family limited partnerships C or S corporations Limited liability companies Contributions The annual contribution amount is determined by the amount required to fund the benefit specified in the plan formula. It s important to note that the plan sponsor must have the cash flow to fund the plan at the beginning of each plan year. Regardless of how the business is performing, a level contribution is required. The cash outlay will normally decrease gradually since any excess interest earned over the guaranteed rate must be used to reduce the following year s contribution. Any dividend payable on the life insurance policy will also be used to reduce the following year s contribution. However, if the deduction decrease becomes a problem, it is likely the plan benefit can be increased to compensate for that since the maximum benefit levels are subject to cost-of-living increases declared by the IRS. Employee Eligibility A Fully Insured Pension Plan is required to comply with both the minimum coverage and minimum participation tests which, in the small business environment, typically results in the plan covering most, if not all, eligible employees. However, IRC Section 410(b) does afford the businessowner some basic exclusion allowances from eligibility. The following employees can be eliminated outright if they: are under age 21, work fewer than 1,000 hours per year, do not meet a service requirement (typically one year), are union employees whose union has bargained in good faith for pension benefits, or are nonresident aliens. 6

9 Benefits of a Fully Insured Pension Plan To achieve the maximum benefit, and hence greatest income tax deduction, requires 10 years of plan participation. A Fully Insured Pension Plan provides substantial retirement benefits through insurance products that provide tax-deferred growth. The accrued benefit for participants is measured by the cash surrender value of those products. Maximum Retirement Benefit The maximum yearly retirement benefit is the lesser of the maximum allowable benefit per year, 1 or 100 percent of the participant s average compensation for the three highest years. 2 This number is reduced if the normal retirement age is younger than 62 or increased if older than It is also reduced if participation in the plan is less than 10 years. 4 The maximum retirement benefit is reduced 10 percent for every year of participation less than 10. Example: The maximum benefit for a participant age 60, with a normal retirement age of 65, is only 50 percent of the maximum allowable benefit due to the reduced length of participation in the plan (five years as opposed to 10). The Fully Insured Pension Plan produces an understandable accrued benefit since, at any point, it is simply measured by the cash value of the contracts funding the participant s account. Distributions At retirement, the participant may have several different options to choose from, such as lifetime annuity payments or a lump-sum distribution, depending on the plan document. If an annuity retirement income stream is chosen, the participant may have a choice between a single life annuity or a joint life annuity covering the participant and the participant s spouse. If one of these annuity options is chosen, the plan trustee annuitizes the plan assets held in the annuity contract. At the time of annuitization, if the current settlement options are higher than the guaranteed settlement options, the higher current ones can be used, resulting in a higher benefit, up to the maximum allowable annual benefit limit, up to the maximum allowable amount. If life insurance is held in the plan, it is exchanged for an annuity, eliminating the additional life insurance death benefit associated with the plan. The participant, and participant s spouse in those cases where a joint life annuity option is chosen, will pay ordinary income tax on the annuity distributions. 1 Subject to cost-of-living adjustments 2 IRC 415(b)(1) 3 IRC 415(b)(2)(C)-(D) 4 IRC 415(b)(5)(A) 7

10 If the plan document allows, the participant may elect to take a lump-sum distribution from the plan at retirement. Upon distribution, the taxation of the annuity and the life insurance is different. Annuity The nontransferable annuity is taxed only when distributions are taken from the annuity itself. The annuity may be rolled over into an individual retirement account (IRA) to avoid current income tax, and potentially a federal premature withdrawal penalty. A life insurance policy may not be rolled over into an IRA. Life insurance The fair market value of the life insurance policy is taxed as ordinary income to a participant upon distribution from the plan to the participant. Any economic benefit that was included in the participant s income during employment years would reduce the amount of taxable income upon distribution. The distribution of the policy may also be subject to the federal premature withdrawal penalty. Death Benefit If death occurs prior to retirement, the plan will pay the retirement balance to the participant s beneficiaries. The death benefit above the cash value represents the amount of pure life insurance and passes to the beneficiary income tax free. The cash value portion of the policy, however, is taxable income to the beneficiaries and represents income in respect of a decedent. Any economic benefit that was included in the decedent s income during life would be the basis in the policy and decrease the amount of taxable income. 8

11 Administration of a Fully Insured Pension Plan You have administration choices with Ohio National. To provide your clients with the best plan for their circumstances, Ohio National offers a choice in plan administration. Ohio National s Advanced Sales department can tailor a plan design with ongoing administration provided by Security Administrators, Incorporated (SAI). Or, alternatively an approved third-party administrator (TPA) can custom design and administer a Fully Insured Pension Plan. The proposal takes into account such factors as definition of eligibility, vesting schedules, definition of compensation, etc. Implementation Once a plan is sold, there are a number of actions that must be taken to implement the plan. There are also certain disclosures that the IRS and Department of Labor require. SAI or the TPA will work with you to make sure these steps are accomplished in a timely fashion: 1. Adopt the plan with a board of directors resolution (if applicable). 2. Establish the plan in writing before the end of the calendar or fiscal year for which a tax deduction is desired. 3. Enroll eligible employees. 4. Apply for the annuity and life insurance for each participant. 5. Make the initial contribution to the plan to fund the benefits. Applications All policies must be owned by the plan trust, with all benefits payable to the trust. Applications must be completed as follows: Annuity Annuitant: Individual participant. Owner: Name of the pension plan as it appears on the plan trust document. Example: X Corporation Defined Benefit Pension Plan and Trust. Beneficiary: Name of the pension plan as it appears on the plan trust document. Life Insurance Owner: Name of the pension plan as it appears on the plan trust document. Relationship to insured: Qualified pension plan in which insured is participant. Beneficiary: Name of the pension plan as it appears on the plan trust document. Dividend: Reduce premium with excess in cash. 9

12 Compliance The plan will be required to file the Annual Return/Report of Employee Benefit Plan, IRS Form 5500, each year and, if life insurance is included or distributions are made to the participants, an IRS Form 1099R, Distribution From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., must be sent to each participant required to recognize income from the plan. The upcoming year s contributions must be calculated based on any dividends and/or excess earnings that may have been credited. Contributions may also require adjustments due to changes in legislation or regulations. Finally, plan amendments may be necessary due to legislative or design factors. SAI or the TPA will make certain that all necessary requirements are met to keep the plan compliant. Caution: A potential problem may arise in the event of a standard termination within the first five years where the sole intent of the client is merely to incubate the policy for a few years and then distribute the policy. This is an issue that must be evaluated carefully by the client s attorney. 10

13 Frequently Asked Questions What is the profile of a target prospect? Owner needs or desires a significant retirement account and current tax deduction. Profitable small business. Owner is age 50 or over and significantly older than the employees. Business maintains sufficient cash flow to fund a fixed, annual contribution. Zero to 10 employees. What are the advantages of a Fully Insured Pension Plan over a traditional defined benefit plan? A Fully Insured Pension Plan magnifies the current income tax deduction an employer receives for contributions to the plan. In addition it: Does not require an enrolled actuary. Is not subject to the full funding limitation tests of a traditional defined benefit plan. Is required to use the contract guarantees as funding assumptions, shielding the plan from IRS attack as unreasonable funding assumptions. Produces an understandable accrued benefit since it is measured by the cash value of the contracts funding the participant s account. Provides retirement benefits that are guaranteed by the insurance company and not just the financial strength of the particular employer providing the plan. Who can adopt a Fully Insured Pension Plan? All business entities are eligible, including sole proprietors, C and S corporations, partnerships and limited liability companies. However, the business must have stable income as fluctuating income may lead to funding failure. Why is a Fully Insured Pension Plan so appealing to small businesses? By design, this plan requires significant cash outlays, so a Fully Insured Pension Plan works best for a business entity with few employees. Consider this question when reviewing a census: Does my client have three or fewer employees for every key employee? If the answer is yes, you may have the ingredients for a good Fully Insured Pension Plan. What key facts are needed to determine suitability for this plan? Age and health status. Desired retirement age. Tax deduction desired. Funding flexibility needed. Income levels of proposed plan participants. Number and roles of employees. Existence of other qualified plans. Can a plan be terminated? While a plan must be considered permanent, it can be terminated through one of two procedures: a standard termination or a distress termination. 11

14 Can the whole life policy be distributed or sold to the businessowner or other participants? The plan participant may, under certain circumstances, receive the whole life policy as a distribution from the plan. However, several major issues should be considered when discussing this with the client. Prohibited Transactions Normally, the distribution of a plan asset to a participant, except as a regular benefit payment, would be a prohibited transaction. However, an exemption is granted if certain requirements are met. You should review these requirements with SAI or your TPA. Valuation Issues Historically, valuation of a life insurance policy is its cash surrender value for tax purposes. This valuation would certainly apply to the Prestige 100 policy. The IRS has indicated, however, that the cash surrender value does not always reflect the full fair market value (FMV) and cash value is a more appropriate measure. The IRS has now provided specific guidelines to ascertain the FMV. What if a participant terminates employment prior to normal retirement age? Assuming the participant is fully vested, the participant will receive the insurance contracts or the cash surrender value of the contracts. Specifically, the participant can elect to have either systematic payments over the participant s lifetime, a lump-sum cash settlement, or a combination of cash and annuity payments, depending on the plan document. If my client owns multiple companies, can my client sponsor a Fully Insured Pension Plan in only one of the companies? The answer depends upon whether or not the two companies are classified as a controlled group. If so, the minimum coverage and participation tests must be applied to all eligible employees from both companies. The test to determine if there is a controlled group is largely dependent upon the amount of common ownership between the two companies. However, other tests, such as the affiliated service group or management affiliated service group test, factor in the working relationship between the two companies. Failing either of these two tests would also result in the coverage of eligible employees from both companies. The client s attorney and CPA should be consulted for status confirmation. What about the rights of creditors? Plan assets are not subject to claims by creditors of the participant since it is a pension asset which is provided federal protection by ERISA. What is FASB 87, and what do I need to know about FASB 87 if discussing a Fully Insured Pension Plan with my client s CPA? FASB 87 refers to the Statement of Financial Accounting Standard Number 87 issued by the Financial Accounting Standards Board (FASB) in December FASB 87 defines how an employer should account for pension plan assets on financial statements. Paragraphs set out the reporting requirements if all or portions of the benefits are guaranteed by insurance contracts. Balance sheet liabilities under FASB 87 should be eliminated due to the full-funded nature of a Fully Insured Pension Plan. 12

15 Ready to Begin? Submit your Request for Proposal (Form 3405) to the Advanced Sales Department, or call (Option 9) for assistance. 13

16 The Ohio National Life Insurance Company Ohio National Life Assurance Corporation One Financial Way Cincinnati, Ohio Post Office Box 237 Cincinnati, Ohio Telephone: Form 3401 Rev Ohio National Financial Services, Inc. Life insurance and annuities are issued by The Ohio National Life Insurance Company and Ohio National Life Assurance Corporation. Guarantees are based on the claimspaying ability of the issuer. Dividends are not guaranteed. Product, product features and rider availability vary by state. Issuer not licensed to conduct business and products not distributed in AK, HI and NY. FOR REPRESENTATIVE USE ONLY. NOT FOR USE WITH THE GENERAL PUBLIC.