As the name implies, defined benefit plans (including cash balance arrangements) are retirement vehicles that provide benefits defined by the plan. Participants earn benefits as they continue to provide service to the employer, with full benefits available at retirement. Plan sponsors are provided a range of allowable contributions to keep the plan funded for the ultimate payment of benefits at each participant’s retirement age. Normally, terminated participants are allowed to receive their benefits in any form allowed by the plan, including a single lump sum. There are two instances where plan assets can fall below the level that would allow lump-sum payments, as follows:
Each year, the plan actuary determines the Adjusted Funding Target Attainment Percentage, or AFTAP. This is a measurement of the plan’s funding level, and is designed to safeguard plan participants from a plan sponsor underfunding their retirement plan. The AFTAP is determined based on specified measures of current benefits and assets. If the AFTAP is between 60% and 80% of full funding levels, benefit increases are prohibited and partial restrictions apply to lump-sum distributions until the funding levels are increased. Below 60%, benefit accruals must be frozen and no distributions are allowed from the plan.
In a defined benefit plan, lump-sum payments to terminated former highly compensated employees (HCE) are only allowed under certain circumstances. These rules are designed to protect the non-HCE participant benefits from being underfunded due to a large payout to a former highly paid individual. Generally, the plan assets must be 110% of the fully funded level (measured on different parameters than the AFTAP) to allow for a lump-sum distribution to an HCE. Annuity payments can be paid at any time.
The plan allows the former HCE to post a bond or other type of security to the plan to allow for the lump-sum payment at lower funding levels. This provides the plan with assurance that benefit obligations to the non-HCEs can be met in the event of a plan termination.
These restrictions are typically temporary and do not affect the plan benefits that have been earned by employees. They are, however, an important part of the communication process with current and former plan participants regarding their distribution options under the plan.