Assume you are the enrolled actuary for a traditional calendar year defined benefit plan sponsored by a small employer. The owner of the business generates about 90% of the firm’s revenue and his benefit from the plan represents about 95% of the total benefit liabilities for the plan. The employer is a cash basis taxpayer; it does not need significant working capital to support its ongoing operation, relying instead on its current cash flow to meet its operating requirements. As a result, the employer only has limited assets at the end of each year, as almost all of the annual income is paid out in expenses, wages and contributions to the plan. In other words, this is what we often see as a typical “small” employer with a pension plan.
Our dilemma: The owner dies on Jan. 15, 2016!
The plan was 100% funded as of Dec. 31, 2015, so the required contribution for 2016 will be based almost exclusively on the target normal cost. Since this is a small plan, the actuarial valuation could be on the last day of the plan year; there is no dilemma since you would know that the owner did not accrue a benefit for 2016. The resulting minimum required contribution would be relatively small and something that the firm can pay despite the loss of its owner and the revenue he generated.
Unfortunately, this plan has a beginning-of-year actuarial valuation date. You typically complete the valuation in late March or early April. So before you prepare the 2016 actuarial valuation, you are aware that the owner has died and will not accrue a benefit for 2016. Now what?
First, let’s start with IRC §430 and the regulations. The language in the law and regulations support the position that the valuation only uses information known on the valuation date. The IRS has affirmed this position in presentations at various meetings. Historically, you have not made an explicit assumption as to whether any individual participant or group of participants who were employed on the valuation date would accrue a benefit for the current year. In other words, your unstated assumption is 100% of the active participants on the valuation date will accrue a benefit and that benefit will be included in the target normal cost.
The minimum required contribution for 2016 when you include the 2016 benefit accrual for the deceased owner is $100,000. Hey, not a problem, right? Wrong, the firm only has $10,000 left to make a contribution to the plan. So, now the plan will have a funding deficiency of $90,000 and will need to pay an excise tax of $9,000. Oops, not so fast. After considering the potential excise tax, which is $10,000 if none of the contribution is made, that means the firm pays nothing to the plan and incurs an excise tax of $10,000. Doesn’t sound like a great result, especially to the owner’s heirs, who see the $10,000 as money they could have received, but instead was unnecessarily given to the IRS.
Okay, so what’s the solution?
One alternative is to amend the plan in early 2016 to cease benefit accruals for the owner. If the amendment is designated as a 412(d)(2) amendment, you could then consider the amendment in your Jan. 1, 2016 valuation, effectively reducing the minimum required contribution to approximately $5,000, which is within the firm’s available assets. This would work provided you know about the issue soon enough for the amendment to be adopted so as to preclude an accrual for 2016. However, if you didn’t find out about the owner’s death until you finally received the 2015 data in August 2016, technically it would be too late to eliminate accruals for 2016, since under normal circumstances the participants would have already been credited with more than 1,000 hours for 2016. Now we are back to the original problem… remember your unstated assumption is that participants who were active on Jan. 1 will accrue a benefit when determining the target normal cost. Thus, a 412(d)(2) amendment adopted after a benefit would normally have accrued would probably not be sufficient to eliminate an accrual from the 2016 target normal cost.
From the signature requirement on the 2014 Schedule SB:
“To the best of my knowledge, the information supplied in this schedule and accompanying schedules, statements and attachments, if any, is complete and accurate. Each prescribed assumption was applied in accordance with applicable law and regulations. In my opinion, each other assumption is reasonable (taking into account the experience of the plan and reasonable expectations) and such other assumptions, in combination, offer my best estimate of anticipated experience under the plan.” [emphasis added]
The important part of the above requirements is the “each other assumption” sentence. Clearly, if you simply include a mortality assumption using a current table, the reduction in the target normal cost would probably be less than 1%. Not much help in this case. Can you assume that the owner will die before accruing a benefit? Probably not directly if you follow the literal requirements of IRC §430, since that would be information you did not know on Jan. 1.
However, you could consider the following from ASOP #4:
"3.4.2 Events after the Measurement Date—Events known to the actuary that occur subsequent to the measurement date and prior to the date of the actuarial communication should be treated appropriately for the purpose of the measurement. Unless the purpose of the measurement requires the inclusion of such events, they may, but need not, be reflected in the measurement."
From the original version of ASOP #34 as adopted in 1999:
“3.10.4 Knowledge Base—The demographic assumptions selected should reflect the actuary’s knowledge as of the measurement date. However, the actuary may learn of an event occurring after the measurement date (for example, plan termination or death of the principal owner), that would have changed the actuary’s selection of a demographic assumption. If appropriate, the actuary may reflect this change as of the measurement date.”
In the current version of ASOP #34, there is a similar provision in 3.10.5 – Change in Circumstances, that reads almost identical to the original language shown above including the reference to the “death of the principal owner.”
The original requirement under IRC §412 that an actuarial valuation be based on generally accepted actuarial principles and practices is still applicable. Actuarial Standards of Practice are clearly part of generally accepted actuarial principles and practices. So, to the extent that you have knowledge of a post-measurement date event, such as the death of an owner who represents 95% of all plan benefits, that information could be incorporated into the valuation. In other words, you could consider the owner as a deceased participant in the Jan. 1, 2016 valuation (i.e., 100% probability of the owner’s death prior to accruing a 2016 benefit).
Certainly, there are actuaries who adhere to the position that incorporating the death of the owner is not appropriate under IRC §430 and its regulations, and say that considering the owner’s death in the Jan. 1, 2016 valuation is not permitted. However, in this case, as the drafters of ASOP #35 intended, I find that it would be acceptable to include such knowledge in the Jan. 1, 2016 valuation. It should be noted that as one of the drafters of the original ASOP #35, I can confirm that was the intention when this provision was included in the ASOP.
Thus, the answer to the original question is the actuary should be permitted to assume that an owner who dies shortly after the valuation date will not accrue a benefit for that year.
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