412(i) Defined Benefit plans have a place in retirement planning for certain individuals, and may be appropriate to meet the following objectives:
Provide a retirement benefit with a high level of security:
insure against loss of principal
provide guaranteed income for lifetime (reduces risk of longevity)
Provide a high insured death benefit to meet estate liquidity or similar needs
The recent increased popularity of 412(i) plans stems in part from the recent market losses that investors have experienced, making the guaranteed 3 to 3.5% rate of return attractive.
In addition, the increased benefits and deductions available to all Defined Benefit plans since the repeal of combined plan limits and EGTRRA law changes (in 2000 and 2002) have given 412(i)s (along with traditional Defined Benefit plans) greater visibility and popularity.
Finally, the aging of baby-boomers creates a growing pool of entrepreneurs and decision makers who are prime candidates for Defined Benefit plans.
Factors to consider in choosing a 412(i) plan:
One of the objectives stated above should be insrumental in the decision to choose a 412(i) plan over a traditional Defined Benefit plan.
The above objectives should be weighed against the rigidity of the contribuion rate inherent in with 412(i) plans.
Consider that 412(i) plans are limited to paying the same retirement benefit amounts as traditional Defined Benefit plans.
Administrative expenses for 412(i) plans may (or may not) be less than for traditional Defined Benefit plans since an Enrolled Actuary doesn't necessarily have to be involved, but investment expenses are higher since it includes insurance against various risks.
412(i) Plan Features
A 412(i) Plan is defined by Internal Revenue Code section 412(i). It is a fully insured retirement plan, funded either through the purchase of insurance and annuity products, or solely through annuities. Greater security is provided at for the increased cost. A 412(i) Plan is a Defined Benefit plan, and generally provides the same level of benefits as traditional Defined Benefit plans, but with greater security, at increased costs, and with less flexibility.
Features in common with Traditional Defined Benefit Plans
A 412(i) Plan shares many characteristics in common with traditional Defined Benefit plans, such as:
benefit formulas based on pay and years of service
same maximum benefit levels apply
vesting schedule applies, so new participants are not immediately entitled to the full benefit if they leave
large deductible contributions are possible
contribution levels increase sharply for new participants near retirement age
non-discrimination regulations must be met
the plan may be amended or terminated
annual Form 5500 is required
Features Unique to 412(i) Plans
Requirements unique to 412(i) plans include:
benefits must be funded exclusively through insurance contracts (life insurance + annuity contracts, or solely through annuity contracts)
the actual benefits equal the benefits provided by the insurance contracts and guaranteed by the insurance carrier
the accrued benefit equals the Cash Value of the insurance contracts
premiums must be timely paid (first of the year) to the insurance carrier--policies must not lapse
contribution rate must be level and is completely rigid from year-to-year (but reduced by dividends or excess earnings)
contribution level is determined by the insurance company rate file--there is no flexibility in the actuarial assumptions
larger death benefits are permissible
participant loans (loans against policies) are not permissible
past years of service may not be counted in the formula
Schedule B to Form 5500 is not required, so an Enrolled Actuary is not required to implement the plan
due to the complexities of the plan, however, most 412(i) plans still retain an actuary to produce the annual valuation
exempt from the variable rate premium portion of PBGC premiums
but still subject to flat rate premiums ($19 per head)
Size of Deduction
It is often noted that 412(i) plans provide a larger deductible contribution than traditional Defined Benefit plans, and this is frequently, but not always, the case. The primary source of the higher contributions is twofold:
interest assumption is 3% to 3.5%
larger death benefits (insured) are permissible
Nonetheless, it must be noted that the projected retirement benefits can not be larger under a 412(i) plan. At times the benefit level (and the contribution level) may be smaller since past service cannot be counted in the benefit formula.
The determination of the deduction must be carefully coordinated between the insurance representative and the actuary. The actuary must have access to the rate tables from the insurance company. In order to compare different 412(i) options, it may be necessary to contact different insurance representatives. As with other insurance products, there may be considerable expenses in changing funding vehicles mid-stream.
The size of the premium contribution is determined by the Plan Formula (i.e., the projected benefit) and the current census data. While the contribution will be reduced by dividends or excess earnings in subsequent years, the sponsor must be able to commit to the premium on an ongoing basis. While the formula can be amended, and such amendment will affect future premium calculations, it cannot be amended after-the-fact to change the benefits which have already accrued and must be funded.