Pension Plans and Vested Benefits

When participants earn benefits in a defined benefit plan (DB plan), they can also earn the permanent legal right to receive those benefits in the future. This can occur after a participant reaches certain milestones, such as attaining a certain age, or working for a specified number of years. This concept is known as “vesting.” In order to measure the value of vested benefits, one must first determine which benefits are considered to be vested and when.

Current pension plan law outlines the specific rights that participants have regarding their benefits under a qualified U.S. DB plan. The minimum vesting standards and rights applicable to non-governmental DB plan participants and their spouses is outlined in 26 USC §401 and §411:

• Accrued benefits are generally considered to be fully vested once an employee has completed five years of service, with certain exceptions such as a three-to-seven-year graded vesting schedule and three-year vesting for cash balance plans. [§411(a)(2)(A) and §411(a)(13)(B)] 
• Accrued benefits are generally not permitted to be decreased via a plan amendment. This restriction also applies to any early retirement benefits, subsidized benefits and/or optional forms of payment associated with that accrued benefit. [§411(d)(6)]
• Married participants have the right to receive their vested retirement benefits as a qualified (50% or greater) joint and survivor annuity. [§401(a)(11)(A)(i)]  
• If a participant dies before their annuity starting date, the surviving spouse is entitled to receive a qualified (50% or greater) preretirement survivor annuity, based on the participant’s vested accrued benefit. [§401(a)(11)(A)(ii)]

Plans may provide additional benefits in excess of the benefits described above. However, the fact that a plan provides a certain benefit does not mean that it should automatically be considered vested, as these additional benefits may be considered to be ancillary benefits that can be removed by the plan sponsor at any time. It is important to make the distinction between a benefit that is guaranteed by law and one that is provided by the plan.

Vested benefits are mainly calculated for three specific purposes:

• The ERISA vested current liability or vested funding target to be provided on Form 5500 Schedule MB or SB, respectively
• The Pension Benefit Guaranty Corporation (PBGC) premium funding target for variable rate premium calculations
• FASB ASC Topic 960 (Topic 960) results to be included in the auditor report, which is submitted to the IRS/DOL as part of the Form 5500

The actuarial literature regarding the calculation of vested benefits is somewhat sparse, but a general framework can be developed by reviewing the information available from the various sources. One relevant concept is provided in Actuarial Standard of Practice No. 4 (ASOP 4). 

In ASOP 4, §3.9 Measuring the Value of Accrued or Vested Benefits outlines the information that an actuary should take into account when determining whether certain benefits are considered vested or not. Items that an actuary should take into account include (i) “the extent to which participants have satisfied relevant eligibility requirements for accrued or vested benefits and the extent to which future service or advancement in age may satisfy those requirements” (§3.9(d)) and (ii) “whether or the extent to which death, disability, or other ancillary benefits are accrued or vested” (§3.9(e)). It is notable that this information does not include the purpose for which the determination is made (e.g., PBGC, ERISA, Topic 960, etc.). For this reason, it would be reasonable to conclude that the determination of whether or not a benefit is vested is independent of the reason for the measurement, and should therefore be consistent for all purposes.

For the ERISA calculations, the Schedule MB instructions do not indicate how vested liabilities are to be calculated, while the Schedule SB instructions simply state that for vested benefits, “...benefits considered to be vested for PBGC premium purposes must be included.” 

The PBGC rules related to the calculation of vested benefits for premium funding target purposes are provided in 29 CFR §4006.4(d) and the PBGC’s Comprehensive Premium Filing Instructions. Highlights of these rules include the following:

• A benefit does not fail to be considered vested solely because it is not protected under Internal Revenue Code Section 411(d)(6) and thus may be eliminated or reduced by the adoption of a plan amendment or by the occurrence of a condition or event. Such a benefit is vested for premium purposes (if the other requirements for vesting have been met) so long as the benefit has not actually been eliminated or reduced. 
• Certain benefits payable upon a participant’s death do not fail to be considered vested solely because the participant is still living. The benefits to which this rule applies are a qualified pre-retirement survivor annuity (QPSA), a post-retirement survivor annuity such as the annuity paid after a participant’s death under a joint-and-survivor or certain-and-continuous option, and a benefit that returns a participant’s accumulated mandatory employee contributions.
• A participant’s pre-retirement lump-sum death benefit (other than a benefit that returns accumulated mandatory employee contributions or a QPSA paid as a lump sum) is not vested if the participant is living.
• A disability benefit is not vested if the participant is not disabled.

Topic 960 provides that certain types of benefits are not includable in vested benefits, such as .”..a death or disability benefit that is payable only if death or disability occurs during active service.” [960-20-25-4]  The PBGC rules are more specific and provide additional guidance on how vested benefits are to be determined. Questions #3 and #4 from the 2010 PBGC Blue Book provide additional information related to benefits such as COLA and Social Security supplements.

Regarding the QPSA, the PBGC has indicated that the entire QPSA should be considered vested. A plan that provides a QPSA based on a 100% Joint and Survivor basis has the right to reduce the percentage to 50%, but the full value of the QPSA is to be considered for premium purposes. Alternatively, the value of a lump sum benefit payable upon pre-retirement death in excess of the value of the QPSA would not be considered vested.

The determination of a vested disability benefit is slightly more complex. As an example, a standard DB plan might provide for the commencement of a participant’s accrued benefit at normal retirement date (NRD), in the event that the participant terminates or becomes disabled before NRD. If the plan provides for the immediate payment of a participant’s accrued benefit upon disability, the value of the standard benefit payable at NRD upon termination would be considered vested, but the increase in the value of this benefit due to the accelerated payment date would be considered non-vested. 

Topic 960 defines vested benefits as “...benefits for which the employee's right to receive a present or future pension benefit is no longer contingent on remaining in the service of the employer.” Based on this definition, it would be reasonable to conclude that if a certain benefit or feature is available upon the participant’s survival to a certain age (and nothing else), it should be considered vested, while a benefit that depends on continued or future employment with the employer should not be considered vested.

Regarding payment of benefits that depend on future events other than continued employment, the PBGC rules state that “...a benefit otherwise vested does not fail to be vested merely because of the circumstance that the benefit may be eliminated or reduced by the adoption of a plan amendment or by the occurrence of a condition or event (such as a change in marital status).” The actuary may need to take the nature of the future condition or event into account when determining whether or not a certain benefit should be considered vested.

Vested Liability Calculation Examples

The principles outlined above can be applied to the determination and subsequent valuation of vested benefits. The DB plans in the examples below will either be a traditional plan (such as a final average pay plan) that provides annuity benefits at normal retirement date (NRD), or a cash balance plan. The following facts are also applicable:

• The traditional plan provides full vesting after five years of service.
• The cash balance plan provides full vesting after three years of service.
• The participants in all examples will have at least five years of service (with the exception of Example 1).
• The plans have the following actuarial assumptions:
  • 80% of the active and terminated vested participants are married.
  • Active participants are subject to a disability decrement.
  • There are no withdrawal decrements from age 50 to age 54.
  • There are retirement decrements from age 55 to age 64, with 100% retirement at NRD (age 65).

Example 1—Vesting

A participant in a traditional plan has four years of service. The plan vests all participants after attaining three years of service.

> The benefits for this participant are fully vested. If the plan sponsor wished to modify the vesting schedule to a five-year vesting schedule as permitted by law, this change would only apply to future benefit accruals. The plan sponsor is not permitted to decrease participants’ benefits by amendment.

Example 2—Subsidized Early Retirement

A traditional plan provides a subsidized early retirement benefit at age 55. This benefit is equal to 60% of the accrued benefit payable at NRD (4% reduction per year). Both active and terminated vested participants are eligible for this benefit.

> The subsidized early retirement benefits for both the active participants and the terminated vested participants are fully vested. They are available regardless of whether or not an active participant continues to work to age 55.

Example 3—Subsidized Early Retirement

A traditional plan provides a subsidized early retirement benefit to active participants who retire on or after age 55. At age 55, this benefit is equal to 60% of the accrued benefit payable at NRD (4% reduction per year). Terminated vested participants who terminate before age 55 can receive benefits at age 55 on an actuarially equivalent basis. Participants who terminate after age 55, but who do not commence payments immediately, are still eligible for the subsidized benefit.

> The subsidized early retirement benefits for the active participants under age 55 are not vested, since an active participant is required to work until age 55 to receive the subsidy. The benefits for the terminated participants are fully vested. The valuation will need to distinguish between participants who terminated before and after age 55, in order to assure that the proper early retirement factors are being applied. In addition, the valuation of vested benefits should reflect the actuarially equivalent early retirement factors for current active participants under age 55 who are projected to retire at age 55 or later. 

Example 4—Death Benefits

A traditional plan provides a qualified pre-retirement survivor annuity (QPSA) upon the death of a participant before commencing benefits. The benefit is provided to the spouses of married employees, and is based on the standard 50% joint and survivor annuity form of payment.

> The benefit payable to the married participants is fully vested. There is no benefit payable to unmarried participants.

Example 5—Death Benefits

A traditional plan provides a pre-retirement death benefit based on a 50% joint and survivor annuity form of payment. The benefit is provided to the beneficiary of the employee regardless of marital status.

> While the death benefit payable to the married participants is considered to be a QPSA and is vested, the death benefit payable to the unmarried participants is not considered to be vested. Therefore, only 80% of the total benefit is considered vested, due to the 80% marriage assumption.

Example 6—Death Benefits

A traditional plan provides a pre-retirement death benefit based on a 100% Joint and Survivor annuity form of payment. The benefit is provided to the beneficiary of the employee regardless of marital status.

> Similar to Example 5, the death benefit payable to unmarried participants is not considered vested. Although the plan is only required to provide a 50% Joint and Survivor annuity to the married participants, the plan defines the QPSA as a 100% Joint and Survivor benefit, and it is therefore considered fully vested for the married participants. As a result, 80% of the total benefit is considered vested, due to the 80% marriage assumption.

Example 7—Death Benefits

A cash balance plan provides that the spouse of a married participant is entitled to receive an annuity based on applying a 50% joint and survivor annuity to the annuity equivalent of the participant’s cash balance account. It also provides that the spouse has the right to elect a lump sum distribution of the participant’s entire account balance.

> The value of the QPSA benefit (the benefit based on the 50% joint and survivor annuity) would be considered to be vested. However, the additional benefit attributable to the excess of the value of the account balance over the value of the QPSA benefit would be considered non-vested.

Example 8—Death Benefits

A cash balance plan provides the participant’s account balance to the beneficiary of a participant upon the death of that participant, regardless of marital status. The beneficiary is entitled to elect to have the account balance paid over their lifetime.

> In this situation, it could be reasonable to treat the entire benefit for married participants as vested. However, the plan document should be reviewed for references to a QPSA, as the determination of the vested benefit will depend on the specific language used to define the QPSA in the plan document. The PBGC has indicated that death benefits in excess of a QPSA are not vested for premium purposes, but has also indicated that for a plan with a 100% QPSA, the entire QPSA is to be considered fully vested. Question #1 of the 2009 PBGC Blue Book and Question #4 of the 2012 PBGC Blue Book provide additional guidance for consideration. 

The death benefit for the unmarried participants is not considered to be vested.

Example 9—Disability Benefits

In a traditional plan, there is no special disability benefit. The benefit provided at disability is the same that would be provided to the participants upon termination. 

> The disability benefit is fully vested, since it is equivalent to the termination benefit.

Example 10—Disability Benefits

In a traditional plan, when a participant becomes disabled while active, the participant is permitted to immediately commence payment of their accrued benefit, regardless of age.

> The difference between the value of the disability benefit and the value of the benefit payable at termination is considered to be nonvested. In other words, the value of the immediate annuity minus the value of the deferred annuity is the nonvested liability.

Vested and Total Liability Calculations

In certain situations, the vested liability calculation can sometimes exceed the total liability calculation. If this were to occur, adjustments would be necessary. Consider the following:

A traditional plan provides a subsidized early retirement benefit to active participants who retire on or after age 55, as long as they have at least 10 years of service when they retire. At age 55, this benefit is equal to 60% of the accrued benefit payable at NRD (4% reduction per year). Participants who leave active service with fewer than 10 years of service are required to wait until NRD (age 65) to receive their accrued benefit. 

An active participant is 53 years old with eight years of service. For the total liability calculation, the participant will work until age 55, and then retire based on the given assumptions from age 55 to age 65. For the vested liability calculation, the participant does not have enough service to retire early, since no future service is assumed for this calculation. The participant’s entire benefit is assumed to be payable at age 65.

If the plan is valued with a discount rate that is in line with historical averages, such as 5% or 6%, this approach would typically generate results that would be considered reasonable, as the vested liability calculation would have a lower value than the total liability calculation, and the difference between the two amounts would represent the non-vested amount (i.e., the value of the subsidy). However, in an extremely low interest rate environment, the vested liability calculation could exceed the total liability calculation. Assume the following scenario:

• accrued benefit of $1,000 per month
• 100% retirement rate at age 55
• 0% discount rate

Using a reasonable mortality table, the value of $1,000 per month at NRD under the vested liability calculation would exceed the value of $600 per month payable at age 55 under the total liability calculation.

While the calculations are correct based on the given facts, the result may not be logical. A participant cannot have a greater stake in a benefit than the value of the benefit itself. Under this calculation, the participant would be better off (in an actuarial sense) by waiting until age 65 to receive their retirement benefit.

This issue could be resolved in a number of ways, which include the following:

1) If the assumption is that employees will elect immediate commencement of benefits at retirement, even though they are sacrificing some value to do that, then the vested liability could be reduced so that it equals the total liability.

2) If the assumption is that employees will elect the benefit that provides the greatest value to them, then the retirement assumption could be modified to assume that participants elect to defer payment of their benefits to age 65. That would make the vested liability calculation equal to the total liability calculation.

The assumed retirement rates (and lump sum election rates, if applicable) should reflect the environment at the time of valuation, but participant behavior can depend on the economic environment. For example, participants in cash balance plans are more likely to elect lump sums than annuities when interest rates are low. This is something to consider when performing stochastic modeling that includes projections of PBGC liability and premiums.

There may be situations in which the vested liability calculation is greater than the total liability calculation for some individuals, but less for others. Even if the total liability calculation for the plan as a whole is greater than the vested liability calculation, it may be appropriate to compare the liabilities at the participant level. No participant should have a vested liability that exceeds the total liability.

While the calculations of the total liability for accounting and minimum funding tend to garner the most attention, calculations of vested liability are not to be overlooked. Vested liability calculations are used to determine PBGC premiums for single-employer plans, and are also relevant for ERISA and Topic 960 results submitted annually with the Form 5500. The principles outlined above and in ASOP 4 provide meaningful guideposts for the actuary to follow when performing vested liability calculations.

David E. Forbes, EA, FSA, MAA, is a principal and consulting actuary with the Little Falls, NJ office of Milliman. Contact David at [email protected].