This section will discuss uses for group annuities and other types that are owned by businesses rather than by individuals. These are known as qualified annuities – i.e. those used to fund qualified retirement plans that benefit employees. By definition, a Group Annuity is a contract providing a monthly income benefit to members of a group of employees. A group annuity has the same characteristics as an individual annuity, except that it is underwritten on a group basis.
A life insurance company offers a business considerable flexibility in tailoring a funding vehicle to meet the needs of the various employers. While in this text names are assigned to various types of insured pension arrangements, it is important to also realize that these contracts may be modified to fit particular requirements.
Life insurance companies accept risks – indeed, that is their business – so they can underwrite various types of risks associated with pension plane, and to underwrite them also by degree, depending upon the desires and the needs of the employer. These risks include, but are not limited to the following:
Interestingly, if one considers these factors and how they “intertwine” it becomes obvious that a well-designed benefit plan – whether the plan is designed by an insurance company or consultants or pension specialists in pension services – that provides death, disability and retirement benefits with values that are at least reasonably comparable, the actual (and actuarial) experience will not vary much if more (or less) employees become disabled, more employees become disabled, or more simply live and retire. This is because the adverse experience under one plan can result in better results under another plan.
Consider that if a plan has higher mortality under the death benefit plan than anticipated, then they may have more favorable mortality under the retirement plan which results in lower benefit amounts being paid.
People who are self-employed, whether as sole proprietors or as business partners, may establish retirement plans for themselves under a law named for the congressman who introduced it. Known as Keogh or HR-10 plans, they receive beneficial tax deferrals provided they qualify under the Internal Revenue Code. While the extensive details of the legal requirements are beyond the scope of this course, the following paragraphs highlight critical features.
In addition to covering the self-employed person, Keogh plans must cover some employees as stipulated by law, while other employees, such as certain part-timers, may be excluded. The plan must have a funding formula that doesn’t discriminate unfairly among employees who are required to be covered, specifically not penalizing lower-paid employees while providing an unfairly greater benefit for highly-paid employees. The amount that may be contributed to a Keogh plan is limited by law.
FSelf-employed individuals who contribute to a Keogh plan may take a business tax deduction for contributions made for themselves and for employees.
The contributions and interest earned are not taxed as current income. These amounts are taxed when they are paid out as retirement income or otherwise withdrawn. Employees may make their own personal contributions to the Keogh plan. While these voluntary contributions are not tax deductible to the employees, they do accumulate and earn interest on a tax-deferred basis, with tax payable on the interest only when funds are withdrawn.
F Annuities may be used to fund Keogh plan benefits as either a defined benefit plan or a defined contribution plan.
As the name implies, a defined benefit plan is one that specifies or defines the amount of the benefit that will be paid at retirement. When the plan is established, a formula is included for determining the benefit amount. Contributions to the plan are then made in order to provide that predetermined benefit.
A defined contribution plan specifies a formula for the amount of the contribution that will be made, rather than the amount of the benefit to be paid at retirement. The law stipulates a maximum amount that may be contributed. While the future benefit amount is unknown, it can be estimated at various points based upon the participant’s length of service, amounts actually contributed, and the estimated and actual earnings on contributions.
Annuities may also be used to fund corporate pension and profit sharing plans. While Keoghs are designed for self-employeds, corporate and profit-sharing plans are aimed at retirement for people employed by corporations. Like Keogh plans. these corporate plans must meet strictly-written requirements to be considered “qualified” for special tax treatment.
A corporate pension plan may be either a defined contribution or a defined benefit plan. By law, pension plans must be established specifically to pay retirement benefits to employees. Contributions are paid by the employer on behalf of employees, subject to very detailed nondiscrimination requirements with regard to lower-paid and highly-compensated employees.
Pension plans must conform to a formula for determining the amount of contributions or the amount of benefits.
Corporate profit sharing plans. which are designed to share actual company profits with employees, are more flexible in terms of how contributions are made. Some plans have a formula to determine what portion of profits will be distributed to employee accounts, while others do not. Even when no formula exists, non-discrimination controls must be in place to ensure individual employee contributions will be made fairly.
A group deferred annuity is one option available to corporations for funding defined benefit or defined contribution plans. Every year, the employer uses the contribution to purchase a (Group) Single Premium Deferred Annuity for each employee included in the plan. After many years, the employee receives the benefits from all annuities purchased on his other behalf.
Group deferred annuity plans have been popular because, first, they guarantee income since they are provided by an insurance company with the same guarantees any other annuity enjoys; and second, the insurer takes responsibility for all of the administrative details. As new forms of funding have been developed, however, group deferred annuities have become less popular with larger businesses, although many smaller businesses still find them attractive.
There is a rather unusual situation in respect to group annuities whereby the employer determines the benefit that will ultimately payable to each employee, and the employer then makes a single payment to guarantee that these benefits will be paid as they become due.
This arrangement is generally used for a situation where there is a large body of employees who have already retired and where an uninsured trusteed arrangement is terminated for whatever reason, with the funds available from the trust used to purchase either immediate or deferred annuities for the employees that are covered by the plan. The employer usually then enjoys a favorable accounting treatment of retired-lives obligations. It is rarely used for employees who are still working and are then covered by an ongoing plan.
Often an employer will estimate the pension that will be payable when each of the employees reach their normal retirement age and will then ask an insurance company to quote a level payment that is guaranteed to provide the pension amount that has been estimated. The insurer will then guarantee to pay the indicated amount of benefit if the established premium is paid each year until the employee retires.
If this is an individual policy pension trust, the benefits are funded by individual policies that are issued on the lives of the employees but the policies are usually issued to and held by a trustee.
Under a group permanent contract, a level-premium group annuity contract, or a level-premium contract with lifetime guarantees, the benefits are funded through a master group annuity contract that is issued to the employer with certificates (of coverage) given to the employees.
Under either of these situations, a life insurance feature is usually provided prior to retirement. Also under these types of arrangements, the insurance company assumes all of the risk and provides all of the services and guarantees the pricing.
Under the Group Deferred Annuity programs, the employer contributes sufficient funds so as to purchase single premium deferred annuities for those employees, based on the amount of annuity benefits that is accrued by each employee each year. Each employee’s pension is broken into sections which are associated with the number of years that the employee has been employed by the employer. For example, for every year of employment, the employee could be entitled to an annual pension of a percentage of salary (such as 2%), or, a flat monthly amount for each year of employment ($50 for example). Each year the employer purchases this single premium deferred annuity that annuitizes upon the retirement age of the employee. The amount of pension for each employee then becomes the sum total of all of the units that is purchased for him/her.
It should be noted that even though the company’s risk in respect to any one employee, may extend to a lengthy period, even as long as 60 years, in respect to the premium that it has received, but the insurer does not guarantee the premium it will charge for additional units to be purchased in the future. As a general rule, insurers will guarantee their rates for the first five contract years.
These arrangements make it possible to inform each employee that a benefit has been purchased for him/her and the insurance company guarantees that it will be paid. The employer is then aware that it is not burdening future management with the problem of inadequate funding for the benefits promised to the employees. This also alleviates the problem of further management having to solve an inadequate funding problem by reducing benefits.
Simply put,
Fmoney is set aside to provide pensions for all employees who are qualified to receive such pension benefits.
However, it is a fact of life that many employees will not stay with the employer until their pensions have been vested, therefore oftentimes employers will discount those payments in advance because of the fact that many will not stick around long enough to become vested. Because of this problem, the level-premium and the single-premium deferred annuities are not nearly as popular as in the past, so the insurance industry – never the ones to allow profits to fly out the windows – developed the deposit administration concept.
A more popular way to use annuities for retirement funding is through a group deposit administration contract. Under this arrangement, funds deposited with the insurer are not allocated for individual annuities; but instead, provide a pool that the insurer invests as a whole. The employer may choose investments providing a fixed rate, equity investments with variable rates, or a combination. Typically, a group deposit administration plan allows the employer to move funds between investment accounts from time to time to capitalize on changes in the market.
Under this type of plan,
Fno annuity exists for an individual employee until the employee retires.
The insurance company transfers funds from the pool of money to purchase a single premium immediate annuity for the employee, beginning retirement income payments at that time. Therefore, the life insurance company takes all of the risks and provides all of the services, but only with respect to those employees who have retired.
For those employees who have not reached retirement, the insurance company does not directly guarantee the employer contributions, except that pensions will be provided according to the money available at the time of retirement of the employee. An actuary supplies the employer with the estimates of the amount of the funds that should be set aside each year to create sufficient funds to purchase the annuities for individuals at their time of retirement. The money is held by the insurance company (for both safekeeping and for investment). The insurer will, therefore, guarantee the employer that there will be no decrease in this capital and it will also guarantee to the employer that there will be at least a specified minimum amount of interest earned at that fund. The insurer will also guarantee a price structure to purchase annuities for the employees as they retire.
The deposit administration contract contains a schedule of annuity purchase rates and rates of interest applicable to these funds and guaranteed, usually, for the first five years. Needless to say, these rates are quite conservative. The minimum rate of interest at the rate schedules in force when money is paid to the insurer will apply to these funds - regardless of when these funds are withdrawn from the fund to provide an annuity. Some companies will guarantee purchase rates for 5 (or 10) years of retirement, but with the right to change the annuity purchase basis for new retirees after that period of time.
This may not sound like much of a “guarantee” but because of volatility of the investment portfolios, many companies now avoid long-term guarantees.
The immediate participation guarantee contract (IPG) is similar to the deposit administration contract described above, as the contributions of the employer are kept in an unallocated fund, but the insurance company will guarantee that the annuities for retired employees will be paid (in full). The principal difference is the extent to which the insurance company assumes the mortality, the investment income, and the expenses in respect to retired lives, and the timing of these assumptions.
The “active” period of the IPG continues just as long as the employer contributes sufficient funds which will keep the fund amount above the insurer’s price to provide guaranteed annuities for retired employees. If the fund amount falls below this level, it is considered as then being in the “critical” area.
Without being too technical, basically the initial (and sufficient) fund is charged with the contract’s share of the expenses of the life insurance company and all retired benefits that are being paid; the fund is also credited with its share of investment fund – minus a small risk charge. The fund is also credited or debited with its share of the insurer’s capital gains and loss, and investment and expense experience of the retired employees.
If, however, the employer allows the fund to become insufficient and then fall into the “critical” area, then the fund amount is used to provide fully guaranteed annuities for all of the benefits under the contract, and the fund ceases to exist.
As long as the employer’s contributions are sufficient to maintain the contract, then the insurance company does not have to maintain the risk of investment, mortality and investment in regards to active employees and the mortality risk for retired employees. If, however, contributions are not adequate (the critical area), then the fund amount is used to purchase fully guaranteed annuities for all benefits required under the plan – and the fund no longer exists.
In recent years, some IPG contracts have changed so as to eliminate the guaranteed annuity rates but provide an agreement that the non-guaranteed payments will be made until the fund is completely exhausted under an “investment only” type of contract. Then the employer is responsible for the adequacy of funding and the employees cannot look to the insurer for benefit payments to continue until their death.
Corporations that have a qualified profit sharing plan in place may use annuities to offer employees another type of qualified plan popularly called 401(k) plans (in reference to a section of the Internal Revenue Code). The actual terminology for a 40l(k) is a Cash or Deferred Arrangement (CODA) wherein the employee defers receiving some portion of current income in order for the 401(k) contribution to be made. Still another name for this arrangement is a salary reduction plan, again referring to a reduction in current salary with the remainder of the salary contributed to the 401(k).
Under a 401 (k), employee participation must be optional. Whether the income to be deferred is actually a salary reduction or included additional compensation such as bonuses, the individual must be able to choose whether to take the cash when earned and be taxed as usual, or defer receiving the salary or bonus, and therefore defer taxation until sometime in the future.
One of the primary advantages of a 401(k) plan from the employer’s point of view is that the contribution is essentially made with the employee’s money, rather than from an employer contribution over and above regular salary or bonuses paid. At first glance, a 401(k) might appear less advantageous for the employee since that person’s current salary will be smaller or a bonus will not be received currently. However, the employee not only has the benefit of tax deferral on accumulations, but also avoids paying federal income taxes on salary and bonuses deferred. Some state and local governments also defer income taxes for 401(k) funds.
A 401(k) plan is subject to many of the same rules as other qualified plans, plus additional rules unique to the 401(k). A fairly low maximum amount may be deferred into a 401(k) plan annually. The specific amount is indexed for inflation, so it changes periodically. This upper limit is the total deferral permitted for all CODAs in which an employee may be eligible to participate. Under certain circumstances, employees could be involved in more than one deferral arrangement, and the total maximum is specified by law. As a result, participants must be careful to coordinate how much is deferred into each plan or face penalties for paying in more than the maximum.
STUDY QUESTIONS
1. When lower-than-anticipated interest rates affect an insurers investment portfolio,
A. the insurer then lowers the premiums.
B. insurers have had to sell particular investments at a loss, sometimes defaults occur.
C. it has no effect on the insurance company because they are all so large.
D. the Department of Insurance takes control of the insurer.
2. People who are self-employed, may establish a retirement plan for themselves under a
A. Dashle plan.
B. 401(k) plan.
C. 1040 plan.
D. Keogh or HR-10 plan.
3. A benefit plan that specifies or defines the amount of the benefit paid at retirement is
A. a group deferred annuity.
B. a defined benefit plan.
C. a defined contribution plan.
D. a Keogh plan.
4. A benefit plan that specifies a formula for the amount of the contribution that will be made, is
A. a group deferred annuity.
B. a defined benefit plan.
C. a defined contribution plan.
D. a Keogh plan
5. An employer establishes a pension plan for employees by contributing to the purchase of an annuity for each of his employees. The funding annuity would be
A. a non-guaranteed plan.
B. a self-administered plan where the insurer does none of the administration.
C. illegal in most states as it is not allowed under ERISA.
D. a group single premium deferred annuity for each employee.
6. If an employer purchases another company that has a large body of retired employees and an uninsured trusteed arrangement is terminated, to continue providing benefits for the retired employees and also to enjoy a favorable accounting treatment of the retired-lives obligations,
A. the employer could use the funds freed-up from the retired lives trust to purchase a single
premium annuity for the retired employees.
B. the employer would just simply mix the retired employees benefits with active benefits.
C. the retired employees would have to be spun off to a fictitious corporation.
D. the employer would have to contribute stock to the fund, or sell stock to fund it.
7. When funds are deposited with the insurer that are not allocated for individual annuities, but instead, provide a pool that the insurer invests as a whole, this type of retirement program is
A. a group deposit administration contract.
B. a Keogh plan.
C. a non-funded retirement ensemble.
D. an immediate participation guarantee contract.
8. When contributions of an employer are kept in an unallocated fund, but the insurer guarantees that the annuities for retired employees will be paid in full, this is called
A. a group deposit administration contract.
B. an immediate participation guarantee contract.
C. a 401(k) plan.
D. a Keogh plan.
9. Under a 401(k) plan, employee participation
A. is not allowed.
B. is mandatory.
C. must be optional.
D. may be optional for some employees, mandatory for others.
10. One of the primary advantages of a 401(k) plan from the employer’s point of view is
A. the employer may take tax credit for the amount contributed by the employee also.
B. when the employee terminates employment, all plan funds are returned to the employer.
C. the IRS will not audit firms that have a 401(k) plan installed.
D. that the contribution is essentially made with the employee’s money.
ANSWERS TO STUDY QUESTIONS
1B 2D 3B 4C 5D M 6A 7A 8B 9C 10D