This question was discussed in detail during the August 2020 episode of the BIF Bites podcast!
Assume that an 8% money purchase plan is to be integrated with Social Security. What is the plan’s maximum permitted disparity?
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Correct answer: C. 5.7%
Social Security retirement benefits inherently discriminate against higher paid workers. Social Security retirement benefits replace a much higher percentage of a lower paid worker’s income than do the benefits for a higher paid worker. This happens because the formula for benefits includes only compensation up to the Social Security taxable wage base each year and the “bend points” in the formula are heavily weighted at lower income levels. Considering the inherent discrimination, qualified plans can recognize the existence of Social Security retirement benefits in the plan’s benefit formula, allowing higher benefits for higher paid plan participants. An integrated qualified plan provides two levels of benefits:
- A first tier of benefits typically based on compensation up to the Social Security wage base (called the integration threshold), and
- A second, higher benefit structure based on compensation in excess of the integration threshold.
Integration of a defined contribution plan focuses on the plan contribution percentages and is called the excess method. Integration of a defined benefit plan typically focuses on the promised final benefit based on compensation at the two levels and is called the offset method.
CFP® Exam tip:
Most qualified plans in existence today are defined contribution plans. The CFP Board exam is more likely to test the excess method used for defined contribution plans. Under an excess method approach, contributions consist of a base contribution up to the integration threshold and a higher contribution percentage for income in excess of the integration threshold. The maximum excess contribution of the benefit level above the threshold cannot exceed the lesser of 1) 2x the base level percentage or 2) the base level percentage plus 5.7%.
For example, if the base level contribution is 5%, the maximum percentage above the threshold is 10%. If the base contribution rate is 6%, the maximum contribution above the threshold is 11.7% [6% + 5.7%)]. Memorize “maximum excess contribution is the lesser of 2x the base rate or the base rate plus 5.7%.”