Retirement Plans

B

Nonqualified Retirement Plans

A nonqualified employer-sponsored retirement plan is any plan that does not meet the requirements of Section 401 of the Internal Revenue Code. Other sections of the Internal Revenue Code provide for special types of retirement savings plans, some of which must meet special requirements. Some of the nonqualified programs can be offered on a discriminatory basis to certain employees. Typically, nonqualified plans are offered to key executives in the organization. They are used to provide additional income over the limited amount offered by qualified plans, and they are often an effective device for recruiting executive talent. These programs lack the legislative protections guaranteed by qualified plans. Nor do they enjoy the same tax benefits as qualified plans. These plans generally must be unfunded arrangements. Unfunded means that the assets held in these plans are not protected from general creditors if the firm experiences financial difficulties. Plan participants have no greater claim to these assets than general creditors of the firm.

C

Defined Benefit and Defined Contribution

The two major types of qualified retirement plans are the defined benefit plan and the defined contribution plan. A defined benefit plan is often referred to as a pension. It establishes a fixed formula for determining the precise benefit amount an employee receives upon retirement. Contributions to the plan are made entirely by the employer. There is no fixed formula for how much the employer must contribute to the plan; instead, the employer is obligated to contribute as much as necessary to meet the defined benefit amount.

The employer faces certain risks and rewards associated with the defined benefit approach. Risks may include the failure of the plan’s assets to earn the expected investment returns required to pay the defined benefit. In that event the employer must make additional contributions into the plan to make up the difference. Rewards include the ability of the employer to take an immediate tax deduction for contributions to the plan and to reduce future contributions if investment returns are better than anticipated.

The employee as well faces certain advantages and disadvantages with the defined benefit approach. The advantages are that the employer typically funds the retirement plan without any contributions from the employee. A certain level of benefits is also guaranteed by the Pension Benefit Guaranty Corporation (PBGC), which was created by ERISA. Even if the company goes out of business, all or a portion of the employee’s pension is protected. A disadvantage of the defined benefit plan is that the employee has no control over the pension fund’s investments. Some employees believe they could earn higher returns if they controlled their retirement benefit investments, although employees often cannot outperform retirement plans investing for the long term.

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C

1

Defined Benefit Formulas

Employers use various types of formulas in determining the defined benefit amount. A flat amount formula establishes the pension benefit as a flat monthly amount—for example, $1,000 per month to any eligible employee upon retirement for the remainder of their life. A flat percentage of earnings formula provides a percentage of either career earnings or earnings averaged over a set number of years, usually the final years of employment. For example, if an employee earned an average of $50,000 per year during the last five years of employment and the employer established a flat formula of 20 percent of those earnings, then the employee would receive a pension benefit of $10,000 per year.

Other common formulas involve providing a flat amount per year of service. Such a formula might be $20 per month for each year of service. Another slightly more complex formula, but one that is fairly common, is the percentage of earnings per year of service. An example of this formula might be 1.25 percent for each year of service multiplied by the average amount of earnings during the last five years of employment.

D

Defined Contribution Plans

Defined contribution plans require fixed contributions into a plan. Rather than guaranteeing a fixed payout, as the defined benefit plan does, an employer commits to a defined contribution. For example, an employer may contribute 6 percent of each employee’s salary or match a certain percentage of an employee’s contribution to the plan. The resulting pension payout depends on the amount of assets that have accumulated in the plan by the time the participant retires. Many defined contribution plans are participant-directed, meaning the participant determines how the funds in the account are invested. Therefore, the individual participant, rather than the plan sponsor, bears the investment risks, responsibilities, and rewards of investing plan assets.

E

Types of Defined Contribution Plans

There are many types of defined contribution plans. Among them are 401 (k) plans; corporate profit-sharing plans; stock bonus plans; money purchase pension plans; savings incentive match plans for employees, known as SIMPLE plans; and simplified employee pension (SEP) plans.