I.

Introduction

Retirement Plans, a variety of government, employer, and individual financial programs that help provide a livable income when a person stops working. The three principal sources of retirement income in the United States are the government-sponsored Social Security system, private employer-sponsored retirement plans, and individual savings plans. These three sources of retirement income have often been called the “tripod of economic security.” Most experts agree that people need to receive income from all three sources to remain financially secure during retirement.

Canada also has a similar “tripod of economic security.” Private pension plans are supplemented by the Canada Pension Plan, which supplies retirement and disability income and survivors’ benefits to older workers, keyed to the amount of their lifetime earnings. The Canada Pension Plan, in turn, is supplemented by Old Age Security and the Guaranteed Income Supplement, which are paid to people over 65 regardless of how much they earned.

The United States and many other industrialized countries have a growing retiree population and are expecting that growth to continue. This expected increase is due primarily to the baby boom, the rapid rise in population that occurred from 1946 to 1964 following the end of World War II (1939-1945). The baby boomers—people who were born during this period—are nearing retirement age. By the time this generation reaches the traditional retirement age of 65, they will represent 20 percent of the U.S. population.

In the early history of the United States, people did not retire but continued working until they died. As the United States changed from an agricultural economy to an industrial economy in the 1800s, some corporations began offering pension plans for their employees. During the Great Depression of the 1930s, millions of people lost their jobs, and economic hardships were particularly severe for the elderly, making the need for old-age benefits more apparent.

After World War II, several developments spurred greater interest in retirement plans. First, the Social Security Act of 1935 had established 65 as the age when workers could retire and receive full monthly Social Security benefits from payroll taxes deducted by employers and paid to the federal government. As a result many people began to plan for retirement at this age. Second, in the 1960s and 1970s, in order to absorb the large group of young baby boomers entering the work force, many businesses and institutions began to mandate a compulsory retirement age for older workers. Finally, advances in health care prolonged the average life span, as once-fatal diseases were brought under control. The current average life expectancy in the United States is 76 years. However, a person who reaches age 65 is likely to survive about 20 more years, statistical studies show. Due to these advances, many people began to realize that they would need retirement income for a long period of time.

II.

Social Security

The primary government-sponsored retirement program in the United States is the Social Security program. The formal name for the U.S. Social Security program is the Old-Age, Survivors’ and Disability Insurance (OASDI) program. This program was initially developed in 1934 and became law in 1935. Its provisions have been extended and modified many times since it was first introduced. Eligible participants are U.S. citizens and legal immigrants, except for some state and local government employees and railroad workers who have their own retirement plans.

As originally developed, the program established age 65 as the age when eligible participants receive full benefits. In 1983 the United States Congress amended the program to gradually increase the normal retirement age from 65 to 67. For people born from 1943 to 1954, the full retirement age is 66. For people born from 1955 to 1959, the full retirement age is 66 plus several months, the number of months gradually increasing with later birth years. The full retirement age is 67 for people who were born in 1960 or later. By delaying the retirement age, the legislators hoped to maintain the financial stability of the system.

Social Security provides a monthly payment that is annually adjusted for cost-of-living increases. The amount of the benefits depends upon a person’s age and their earnings. The Social Security Administration informs participants annually of an estimate of the benefits they will receive if they retire at 62 or later. The earliest age that a person can begin withdrawing Social Security is 62, but early withdrawal means reduced benefits. The only exception is for widowed spouses who can begin withdrawing at age 60. (See also Social Security.)

Social Security is not the only government-sponsored retirement plan. Other programs include pensions for war veterans, the Railroad Retirement System for railroad workers, and other special government employee pensions.

III.

Private Employer-Sponsored Retirement Plans

Many private employers in the United States maintain retirement plans for their full-time employees. About 66 percent of the labor force is covered by some kind of retirement plan. Very few companies offer retirement plans for part-time workers. These plans developed for a number of reasons. One reason was tax incentives. An employer may take an immediate tax deduction for a contribution into a retirement plan even though benefits will not be paid to employees until some future time.

Historically, various other factors contributed to the growth of private retirement plans. During World War II price controls restricted wage increases. However, employers were allowed to offer or improve retirement and other benefits, and many did so to make up for the lack of wage gains. Following the war, trade unions came to believe that the Social Security program did not fully provide for workers’ total retirement needs, and they negotiated with employers for retirement plans. To compete with other companies for workers, some businesses offered retirement plans as a way to attract and retain workers. Finally, to absorb a younger work force, many companies offered retirement plans as incentives for older workers to retire and make way for younger workers who earned lower salaries.

Employer-sponsored retirement plans fall into two categories: qualified plans and nonqualified plans. Qualified plans, in turn, take two major forms: defined benefit plans and defined contribution plans. There are also so-called “hybrid plans” that contain attributes of both forms. Nonqualified plans do not receive the same tax benefits as those provided to qualified plans.

A.

Qualified Plans

A qualified plan is any plan that meets the requirements of Section 401 of the Internal Revenue Code, which Congress passed to encourage retirement savings by providing tax incentives for both employers and employees. Many of these requirements were first enacted in 1974 with passage of the Employee Retirement Income Security Act (ERISA).

This act was one of the most important pieces of legislation affecting private retirement plans. It established employer responsibilities to plan participants. It set compliance standards for employers and gave several government agencies the power to regulate and insure private programs. The Internal Revenue Service (IRS) establishes the rules that qualify the plans for tax breaks. The Department of Labor ensures that employers comply with requirements in order to protect participants in the plans. The Pension Benefit Guaranty Corporation (PBGC) insures defined benefit pension plans.

ERISA’s standards forbid employers from engaging in certain dealings using plan assets. These dealings are called prohibited transactions. For example, employers cannot use plan assets to lend money or extend credit. ERISA requires that a licensed actuary examine some plans on an annual basis. An actuary is an expert on assessing whether a plan can fulfill its obligations to plan participants. For example, the actuary determines whether assets in the plan are sufficient to meet benefit obligations. ERISA also requires employers to disclose information to government agencies and plan participants and their beneficiaries about how the retirement plans are managed.

Qualified retirement plans have vesting requirements. Vesting refers to the amount of retirement benefits guaranteed to a worker after a certain number of years of working for the same employer. To be fully vested means that the worker is entitled to all the contributions or the benefits provided by the employer contributions to the retirement plan, regardless of whether the worker remains employed. There are two types of vesting schedules: graded vesting and cliff vesting. With graded vesting, an employee gradually becomes entitled to the amount of money the employer has contributed to the retirement plan. With cliff vesting, the employee becomes entitled to the employer contribution only after working for the employer for a certain number of years. Before that time, the employee is not vested at all in an employer’s contributions. Employees are fully vested in their own contributions immediately.

The Economic Growth and Tax Relief Reconciliation Act of 2001 impacted schedules for vesting in qualified plans. An employee enrolled in a qualified plan with a cliff-vesting schedule is fully vested in employer contributions after working full-time for the employer for three years. Before that time, the employee is not vested in employer contributions. An employee in a plan with a gradual-vesting schedule is entitled to 20 percent of the employer’s matching contributions after two years of service and is 100 percent vested after six years of participation. If an employer makes a contribution to a plan without requiring employees to contribute as well, the employer can use five-year cliff vesting or seven-year graded vesting.

Qualified employer-sponsored plans must generally conduct nondiscriminatory tests to receive tax-qualified status. They cannot unduly benefit highly compensated employees. The Tax Reform Act of 1986 strengthened the nondiscriminatory nature of qualified plans by instituting a series of precise mathematical tests to determine when highly compensated employees were being unduly benefited.

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.

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.

E.1.

401(k) Plans

A section of the Internal Revenue Code, Section 401(k), provides the framework for 401(k) plans, which have become increasingly popular with employers and employees. A number of employers have replaced their defined benefit pension plans with 401(k) plans. In 2000 about 42 million Americans participated in about 327,000 401(k) plans with assets totaling $1.8 trillion, increasing from 30,000 plans and 10 million participants in 1985.

The 401(k) plan allows employer and employee contributions and the investment earnings on these contributions to grow tax deferred—that is, as long as assets remain in the plan, they are not taxed. People pay taxes only when they withdraw money from the plan. Consequently, a 401(k) plan is known as a tax-deferred plan. In addition, a 401(k) plan allows an employee to make a pre-tax contribution to the plan. This means that the employee’s contribution is not subject to taxation at the time the contribution is made. For example, if an employee earns $50,000 a year and contributes 10 percent, or $5,000 each year to the plan, then the employee will have a taxable income of only $45,000. As a result, these plans are sometimes referred to as salary reduction plans. The provisions of 401(k) plans give employees an incentive to save for retirement and enable them to see their assets grow on a tax-deferred basis.

The 401(k) plans are available to employees of for-profit corporations, and although once prohibited at not-for-profit organizations they are now available at many such organizations. Also, similar specialized plans exist for employees of certain nonprofit, educational, and governmental organizations. For instance, another section of the Internal Revenue Code, known as Section 403(b) retirement plans, can be offered to certain charitable and educational organizations, including public school systems, community colleges, and state universities. These plans permit contributions by employees to be made on a pre-tax basis, as with a 401(k) plan. Section 457 of the Internal Revenue Code establishes special deferred compensation plans for employees of state and local government and to nonprofit and educational organizations. These special Section 457 plans are commonly used to build tax-deferred assets for retirement purposes, although technically they do not qualify as retirement plans.

E.2.

Corporate Profit-Sharing Plans

A typical corporate profit-sharing plan can be used for retirement but may not be exclusively created for this purpose. Often the purpose of such plans is to provide an incentive for employees to be more productive and thereby boost the company’s profits. Employer contributions to profit-sharing plans are discretionary. The employer does not have to commit to a set contribution, and contributions do not necessarily have to be made each year, although the law requires that contributions must be made on a “substantial and recurring basis.” Under ERISA, profit-sharing plans must be administered so that investments are diversified, thereby protecting participants from the possible failure of an investment in a single security.

E.3.

Stock Bonus Plans

A stock bonus plan is a type of defined contribution plan that does not require diversification. Instead, the stock bonus plan is limited to the securities of the employer, and its purpose is to give employees an incentive to contribute to the success of the company.

The employee stock ownership plan (ESOP) is a type of defined contribution benefit plan that buys and holds company stock. Company contributions to the ESOP are tax deductible within certain limits. In an ESOP, a company sets up a trust fund based on shares of its stock. The company can be private or it can be publicly traded. Shares in the stock are granted on the basis of salary or some other formula to individual employees who become fully vested in their shares within five to seven years. When an employee leaves the company or retires, the company must buy back the shares at its fair market value if the stock is publicly traded or on the basis of an annual outside valuation if the company’s stock is privately held.

E.4.

Money Purchase Pension Plans

A money purchase pension plan is a defined contribution plan in which an employer promises to make a set contribution to the plan each year. The contribution to the money purchase pension plan can be made either as a flat dollar amount or as a percentage of the employee’s pay. Only money purchase plans created prior to the passage of ERISA permit employee contributions on a pre-tax basis. Also, money purchase pension plans do not allow withdrawals while workers are still actively employed, and spouses have certain rights to assets in these plans, as with other tax-favored retirement plans.

Historically, many employers typically offered a money purchase pension plan and a supplementary 401(k) plan. If a 401(k) plan was offered alone, the IRS limited the amount that could be contributed to 15 percent of an employee’s pay. If both a 401(k) and a money purchase plan were offered, the limit on combined deductible contributions was 25 percent. Starting in 2002, the Economic Growth and Tax Relief Reconciliation Act of 2001 increased the allowable contribution percentage to 25 percent of an employee’s pay for the type of plan typically used with 401(k)s. As a result, the use of money purchase pension plans alone may decline in future years.

E.5.

SIMPLE Plans

The Small Business Job Protection Act of 1996 created a way for small businesses to offer retirement plans without having to meet the rigorous government standards required of 401(k) plans. The act created a plan known as savings incentive match plan for employees (SIMPLE). Two types of SIMPLE plans can be offered: SIMPLE individual retirement accounts (IRAs) and SIMPLE 401(k)s. To qualify, a business must have 100 or fewer employees and cannot offer any other retirement plans. Various types of business entities can establish SIMPLE plans.

SIMPLE IRAs enable people to save more annually than they could with a regular, individual IRA, and they require employers to contribute to the IRA. Employers must contribute to a SIMPLE IRA, either by matching 100 percent of the employee’s contributions up to a certain percentage of the employee’s compensation but no greater than a maximum contribution or by contributing a flat percentage of compensation for all eligible employees regardless of whether they participate in the plan. Maximum levels of contributions are adjusted for inflation. All contributions to a SIMPLE IRA, including employer contributions, are fully vested immediately.

A SIMPLE 401(k) provides tax-free advantages like a regular 401(k). For participating employees, employers must match 100 percent of the employee’s contribution up to a certain limit of the employee’s compensation. Alternatively, the employer can make a contribution without requiring an employee contribution, but if the employer chooses this alternative, it must make contributions for eligible employees whether or not they choose to participate. Maximum contributions are adjusted for inflation. Employees are fully vested in all contributions to a SIMPLE plan, and these contributions are nonforfeitable.

E.6.

Simplified Employee Pension (SEP) Plans

Simplified employee pension (SEP) plans are designed for small businesses and the self-employed. They predate SIMPLE plans. SEP plans utilize individual retirement accounts, but allow for higher contribution limits. However, contributions to SEP plans are not mandatory, and if an employer has a bad year, contributions may not be made at all. As with any type of IRA, an employee can specify the type of IRA investment that they want, such as mutual funds, stocks, bonds, or certificates of deposit. Employees are fully vested immediately in these plans.

SEPs require little record-keeping and minimal administration. For this reason, SEP IRAs have appeal. Another retirement plan for the self-employed are known as Keoghs, for the New York legislator who sponsored the Self-Employed Individuals Tax Retirement Act of 1962. Keoghs offer many tax advantages as do SEPs but require more administration to meet government requirements. However, more money can be set aside and sheltered from taxes with a Keogh.

IV.

Individual Retirement Plans

Many individuals do not work for an organization that offers a retirement plan, and many other individuals seek to supplement their retirement income by opening their own retirement accounts. These are known as individual plans, and they represent a part of the third leg of the “tripod of economic security.” There are two main types of individual plans: individual retirement accounts (IRAs) and Roth IRAs. In addition, there are a variety of life insurance products, such as annuities, that enable individuals to save for their retirement.

Beginning in 1975, employees without a retirement plan were able to contribute up to $2,000 into an IRA account on a before-tax basis. Similar to tax qualified plans, this contribution grew tax-free and was not subject to taxation until distributed at retirement. Subsequent legislation provided that IRAs could be started by anyone with earned income.

The Tax Reform Act of 1986, however, restricted the advantage of before-tax contributions to IRAs to those taxpayers and their spouses who were not covered by an employer-sponsored retirement plan. For those who already participated in an employer-sponsored retirement plan, the advantage of before-tax contributions was not available with an IRA unless income fell below a certain level. Workers covered by a retirement plan could continue to contribute to an IRA but only on an after-tax basis—that is, taxes are paid on contributions at the time they are made.

The Taxpayer Relief Act of 1997 created another type of IRA known as a Roth IRA, for Senator William Roth who sponsored the act. Under a Roth IRA, contributions are taxed at the time they are made, but contributions are withdrawn tax-free provided certain conditions are met. Investment earnings also accumulate tax-free. Under new rules established for the Federal Deposit Insurance Corporation (FDIC) in April 2006, both traditional and Roth IRAs are insured up to $250,000 at FDIC-insured banks, savings associations, and credit unions.

V.

Other Ways to Save for Retirement

In addition to the various formal retirement savings programs, individuals can use a variety of financial products in the marketplace to save for retirement. Although not offering the same tax incentives, individuals can save for retirement using bank savings accounts, mutual funds, and life insurance products. Life insurance products, particularly annuities, are commonly used for retirement saving purposes. Insurance products permit the tax-deferred growth of investment income similar to a retirement plan. Some insurance products are designed with a savings component and a death benefit.

Annuity contracts guarantee a stream of income as long as an individual lives, based on the value that has accumulated in the contract. Because an individual cannot outlive the stream of income from an annuity, these products have historically been used to fund various types of retirement savings plans.

VI.

Legislative Trends

Since the passage of ERISA in 1974, many laws have been enacted to regulate retirement plans. Much of this legislation occurs because of the tax-favored status enjoyed by retirement plans. Since large federal deficits are a national concern, Congress and the executive branch continually reexamine programs receiving tax-favored treatment. Most legislation concerning retirement plans has followed these principles: Tax benefits should not be provided unless the retirement plan benefits a broad cross section of employees, retirement plan rules should be kept as simple as possible, and special rules applying to various types of retirement plans should be made more consistent.

Recent legislation affecting retirement plans includes the Economic Growth and Tax Relief Reconciliation Act of 2001. This legislation was noteworthy for increasing maximum contribution levels to various retirement plans, for enabling people aged 50 and older to exceed these maximum contribution levels as they near retirement, for extending the tax-free withdrawal characteristic of Roth IRAs to 401(k) and 403(b) plans by creating Roth 401(k)s and 403(b)s beginning in 2006, and for providing retirement tax credits for people in low-income brackets. A specific purpose of the law was to address the problem of “late starters”—people who did not begin saving for retirement until later in life. Beginning in 2002, people aged 50 or older were allowed to contribute more to IRAs and 401(k)s than the maximum contributions allowed others as a way of helping late starters catch up.

The Pension Protection Act of 2006 was primarily meant to address underfunding and other serious weaknesses in some of the pension plans U.S. businesses have provided their employees. The legislation required most pension plans to become fully funded over a seven-year period beginning in 2008. The funding would need to meet strict guidelines. Companies would be allowed to deduct the cost of making additional contributions to fund their pensions but they would also be subject to a 10 percent excise tax if they failed to correct funding shortfalls. Other parts of the legislation made changes to 401(k)s and IRAs. Catch-up contributions by individuals 50 and older were extended and increased. Military personnel called to active duty are now able to make penalty-free withdrawals from their 401k or IRA between designated dates. Automatic enrollment of employees in a 401(k) plan offered by an employer would be permitted, with employees required to opt-out of the plan. IRA contribution amounts were raised. Non-spouse beneficiaries such as domestic partners are now allowed to roll over assets inherited from a qualified retirement plan into an IRA.

Due to continual changes such as these, Americans should carefully monitor their retirement plans and consult with experts on tax law and financial planning to ensure their financial security during their retirement years.